Archives for June 12, 2018

Don't Let The General Electric Noise Distract You From The Bigger Picture

Calling a spade a spade, all the suggestions that General Electric (GE), could, and probably should, cut its dividend aren’t off base. The company’s a train wreck right now. On a mathematical/GAAP basis, it can’t justifiably afford to maintain its current payout, which is only half of what it was a year ago.

Equally obvious is activist investor Nelson Peltz’s recent suggestion that GE is seriously considering a significant breakup. Nobody really doubted that’s at least one of the things new CEO John Flannery had in mind when in January he said all options were on the table. (Observers weren’t thrilled with the idea then, but have warmed to it now, but that’s a different story.)

And, if we’re being honest, nobody was truly shocked when Flannery said last month that the company’s energy division wasn’t on the road to recovery yet; most investors know there’s no quick fix to what really ails General Electric.

So why all the wild swings to news that really isn’t news? Because the market doesn’t “get” GE right here, and right now. It’s little more than an instrument of speculation, which is anything but normal for the iconic blue chip.

The good news is, the unusual situation the company – the stock – is in actually sets up an opportunity for long-term investors that can look past the headlines d’jour.

Perspective

It’s maddening how overused the Benjamin Graham axiom “In the short run, the market is a voting machine but in the long run it is a weighing machine” is used, so it’s with great trepidation I invoke it now.

On the other hand, if the shoe fits and the cliché applies… well, you get it. GE shares remain mired in hysteria, and that’s preventing long-term-minded investors from seeing what’s plausibly in store one year from now, let alone three years from now. In the end though, where GE is likely to be three years from now is in better shape than the market’s giving it current credit for.

Analysts think so anyway. Take a look.

Source: Thomson Reuters/image made by author

But cash flow? Yeah, that’s a hang-up, though not as much as one might fear. A closer look at General Electric’s books clarifies that on an operational basis, GE is cash flow positive. It’s just not cash flow positive enough right now to service its pension and debt obligations and also make meaningful, much-needed investments in growth that will supply more cash flow in the foreseeable future.

Maybe that’s in the cards sooner than we’re being led to believe though.

Yes, the power division is a liability. There’s at least a path to profitability in the arena though. Flannery explained during the first quarter call:

“First, we continue to have leading technology, deep domain, digital solutions and broad and deep customer relationships. We continue to be viewed as a go to provider in our industry and we are fighting for every opportunity in the market.

On the cost side, in an industry that clearly has excess capacity, we are aggressively moving to right size our footprint and base cost. We took out $800 million of structural cost in 2017 and an additional $350 million in the first quarter. We are on track to exceed our $1 billion target for 2018 and headcount and sites are coming down….

…We are driving out cost and addressing the quality issues we had last year. The team has introduced a new sales force compensation program specifically aimed at driving transactional services and margins. We have a new leadership team in our supply chain and they are reinvigorating the use of lean and Six Sigma to drive better execution. The H cycle time is down 20%. Ultimately our goal is to cut this another 50% or more…

… we are also exiting non-core assets as we simplify the business.”

OK, it’s not sexy, but it was never going to be. It’s a multi-year project, and a long-term project that becomes increasingly viable each day crude oil prices linger above $60 per barrel. Corporations aren’t fully opening their wallets until they know capital expenditures on GE’s power wares make sense.

In the meantime, aviation and healthcare are still performing well, and growing. The IATA forecasts that air traffic demand will double over the course of the coming 20 years, and the need for healthcare equipment is never going away even if that market is ever-changing. The Centers for Medicare & Medicaid Services reckoned that healthcare spending would grow 5.5% per year through 2026, largely driven by the 10,000 baby boomers that are retiring every day.

Meanwhile, the decision to shed its locomotive business is a big step towards the streamlining of the company that will ultimately unlock the value Flannery and Peltz (among others) have been talking about for a while.

Baby steps.

Green Shoots from GE Stock

To that end, some bulls are occasionally peeking their heads out in the meantime, planting seeds for a few green shots from the stock.

This is where things get interesting, and tricky. All of the technical recovery efforts made thus far have been up-ended. Even the best technical rebound we’ve seen in months – the one from last month – was largely wiped away. Take a closer, second look at the chart though. The tumbles are hurting less and less, and the rallies are making more and more progress.

Source: TradeStation

It’s still a fits-and-starts process, but the tide is turning.

It’s also turning more than you might guess with that second glance. The rising Chaikin line (bottom) says there’s a good amount of volume behind the recovery effort. Those bulls aren’t terribly vocal, but they’re putting their money where their mouth isn’t.

It’s largely a matter of greater confidence that will get – and keep – the stock back on track.

That confidence will be built on someone else being willing to stick their neck out, by the way. Moreover, that confidence will be built on the heels of certainty that the company is indeed going to unlock value by selling pieces of itself. Again though, that’s a multi-year process. The market is slowly starting to digest this reality, which old-school GE shareholders never had to chew on in the past.

Patience

It’s still more of a trade than an investment, to be clear. But, it’s one of those trades that could slowly morph into an investment… that rarest kind of stock picks.

Fanning those would-be-bullish flames even more than getting better income out of the company’s revenue-bearing assets will be, as was noted, more apparent progress on the breakup front. As Stifel analyst Robert McCarthy recently put it, GE is only rated a hold “absent a more material, dynamic breakup.”

That stance puts Peltz’s comments from late last week back in the spotlight, reminding investors that Flannery wasn’t just blowing smoke a few months ago when he alluded to the same. It’s coming, even if investors can’t fully see it yet, and even if they can’t fully appreciate the fullness of the prospect. Melius Research estimated late last month, when General Electric shares were priced at $13.28, that such a price “likely undervalues the assets by 25 percent or more” were the company broken into marketable pieces. With a current price of still less than $14, the bulk of Melius’ upside is in front of the stock.

It’s also possible that even Melius’ outlook underestimates how well GE’s aviation and healthcare arms could perform.

As for a target, Melius effectively says a post-breakup value would make GE stock worth around $16.60, at least. The chart wrestled with the $17.35, as support, and resistance, late last year and early this year. The figure is still within Melius’ “or more” range.

The toughest part of such a trade? Sticking with it even when the headlines are terrifying. They’re taking smaller and smaller bites out of the stock, as investors understand the situation better and better. It’s a process though, and GE shares aren’t fully out of perception-purgatory just yet. They’re getting closer though, and may be worth the risk of getting into before it fully happens.

The risk profile plunges dramatically if-and-when GE shares hurdle the converged 20-day and 50-day moving average lines at $14.39.

If you’re looking for stock picks that are less speculative and better-founded investments, take a test drive to The Well-Rounded Investor service. You’ll get top-down sector analysis and bottom-up market analysis that identifies the market’s best bets… names you may have never found on your own.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

AT&T: The 6% Yield Window Is Closing

Without doubt AT&T (T) has been generating substantial income for dividend investors. Equally indisputable is the fact that the development of the stock price has been consistently and greatly lagging the overall market. More importantly, with AT&T trading 15% below its 52-week high investors, in the worst case scenario, would currently require around three full years of dividends to just compensate for the capital loss.

The number one rule in investing is always to at least preserve capital and while a 6% yield looks good on paper it does not help if your principal declines almost three times more.

Chart

T data by YCharts

I have been caught on the wrong foot with AT&T as well as I quickly grew it into my largest portfolio position, both in terms of income and capital, as I focused too strongly on the former. It’s mind games here. With AT&T paying such a high yield you can easily get double and triple-digit income per quarter with relatively little capital which in turn motivates you to invest even more. What is largely neglected at this stage is that as the yield increases and reaches the illustrious 6% barrier this is also means that the markets place higher risk into the stock.

However, despite all the capital losses I have incurred (but not realized) so far, the stock’s current yield could still be a great long-term opportunity provided the outlook is not as bad as expected. Now that the Time Warner (TWX) trial is approaching its end (outcome remains as uncertain as always) and the proposed Sprint (S) and T-Mobile (TMUS) deal also receiving regulatory scrutiny, this 6% yield window is closing with the stock now trading below 6% for the first time in almost two months. Let’s review the investment case for a dividend investor.

What is going on at AT&T?

Source: AT&T Investor Relations

The stock is currently trading at a lackluster 7 times earnings implying almost no growth whatsoever as the company finds itself right in the middle of a complex and challenging business setup.

The outcome of the Time Warner trial, which is expected to close this week on Tuesday, has been lingering over the stock and the company like a Damocles sword with investors fearing the excessive post-merger debt load of AT&T in a hawkish interest rate environment but equally expecting that AT&T needs some sort of vertical integration in order to compete with one of its fastest growing competitors Netflix (NFLX). Regardless of the outcome investors react as if AT&T will lose either way. Also, if the trial does not get approved AT&T will have spent hundreds of millions on lawyers, bankers and penalty statements and even worse it will cast a big shadow of doubt across the entire M&A sector in a Trump-led U.S. administration.

It is highly subjective to speculate on the stock’s reaction to whatever decision is being taken but given Time Warner’s booming business and vertical integration opportunities I am certainly rooting for the DoJ to approve this deal. Everything else, not only for AT&T but in general for the M&A landscape, should be rather detrimental. AT&T is not building a monopoly here but simply complementing its very own chain of distribution with very useful content.

Speaking in terms of Time Warner, the company is really rocking. Revenues are up 9% in the fourth quarter and EPS came in at $1.60. That strong revenue growth was driven by all segments with Turner up by 22%, HBO up by 13.3% and Warner Bros. growing 10.8%. This has been of the strongest quarters for Time Warner and bodes extremely well for AT&T should the acquisition get approved.

In fact, despite the seemingly high acquisition price of $85B, Time Warner could be worth much more given that despite that impressive growth it is only valued at 14 times sales. On top of that Time Warner also generated strong FCF of $4.4B.

It will probably be painful to watch the court’s decision and investor’s reaction to the verdict but it should help the stock thereafter, possibly after some sort of algo-driven panic sell-off, as uncertainty decreases and the focus returning to fundamentals.

Speaking of fundamentals the first quarter of 2018 was a big disappointment with revenue missing by a whopping $1.27B. Following the completion of the costly DirecTV deal AT&T has grown its top line by more than $30B over the last 8 years but organically growth has been virtually flat. In terms of profitability AT&T has been able to post the obligatory $0.01 to $0.03 EPS increases which helped raise its dividend by $0.04 per share. However, cord-cutting has been a major issue for the company. Its customer base is growing strongly every quarter but so far this growth has come at the expense of cannibalizing customers with a higher customer lifetime value. In Q1 187,000 in the higher-margin linear video business were lost whereas AT&T added 312,000 in the OTT video segment yet overall its margin still declined by roughly 1pp Y/Y or around $1B in sales.

You don’t have to be an expert to recognize this setup is losing money right now but whether it is still a “LOSE” or rather a “WIN” over the long-term is a completely different question. In an earlier earnings call from last year management stated the following on that:

Our wireless customers are really valuable in the extension of their life through the lowering of their churn, and the ability to get entire families or entire groups of phones is really important to us. And so we strongly believe that that is value-accretive to the total operations of the total organization, and we monitor it on a very regular basis.

Source: AT&T Earnings Call Transcript – Q3/2017

What could be even more value-accretive is how millions and millions of connected cars may lead to higher sales.

So we have millions and millions of connected cars out there, over 10 million connected cars out there. So we built this platform, and those are down in our Internet of Things in our connected device category.

But now what we’re finding is that 65% of the people who drive cars aren’t our wireless customers, so we’re finding a real opportunity to connect tens of thousands of those, almost 100,000 this quarter, with a prepaid offering to the connected car. And when they do that, they will pay us. It’s not a $4 or $5, it’s a $15 or $20 connection. And so it not only gives us a really great revenue opportunity and high margin, and that’s a lot better than a resale opportunity at a much lower, but it’s also an opportunity to show them what we can do and then potentially get the rest of their wireless business or get the rest of their video business.

Source: AT&T Earnings Call Transcript – Q3/2017

This is a tremendous opportunity that so far I believe has been more or less completely overlooked by the market which gets easily caught up on sequential and Y/Y comparisons. While that might be important for traders, for long-term investors, it is just noise to be ignored.

An Income Strategy Session

Now that the stock is trading at a 5.9% yield as of its close, long-term oriented investors should really welcome that opportunity to add to their position. In essence, if you are a long-term investor, this is exactly the kind of market reaction you would like to see. It allows you to lower your cost basis while the business is making the necessary transformation steps towards the future. The day-to-day noise with heavily followed stocks like AT&T is tough to ignore, and it may be one of the most difficult challenges to have the conviction to hold and add to your position in these times.

To help cope with these unrealized losses, investors should take a step back and concentrate on the bigger picture. Long-term investors know how powerful dividend reinvesting really is, but in the heat of the moment, it is only natural to temporarily blend this out. If we project the 5-year returns with reinvested dividends of an initial $5,000 investment in AT&T at $33.83, we end up with the following metrics:

  • Initial investment: $5,000 @5.9% yield assuming 2% dividend growth, 15% tax rate, quarterly reinvestment, 0% stock price appreciation, purchases of partial shares
  • Investment value after 10 years: $12,243 or an almost 144% gain with the respective yearly net dividends depicted below, thereof $3,624 in net dividends and $3,619 worth of additional stock from reinvested dividends.

After 5 years the net YoC has already risen to above 6% and after 10 years it has almost reached 10%. This is a very conservative scenario as it does not factor in any stock price appreciation and only minimal dividend growth. In that scenario CAGR would only be 10.5% and is basically a worst-case scenario given that it is unlikely that T’s stock price will remain flat over the next 10 years. And even if it does it is a great way to accumulate reliable and substantial income for long-term oriented dividend investors.

Assuming the stock appreciates by 5% every year over the next ten years with all other parameters being unchanged we would end up with the following metrics:

  • Investment value after 10 years: $15,899 or an almost 218% gain with the respective yearly net dividends depicted below. The total returns breaks down into $3,457 in net dividends received, $4,298 worth of additional stock from reinvested dividends and $3,145 worth of stock appreciation on initial investment. Naturally, as the stock prices rises the yield declines and as such quarterly reinvestment of dividends yields lower net YoC compared to the upper scenario. However, capital appreciation vastly overcompensates this effect.

If you want to easily run these calculations on your own, I’d be happy if you try out this Excel-based long-term dividend projection calculator.

Investor Takeaway

I am still bullish on the stock but as mentioned in a previous article have become a little bit more cautious as well as both the outcome of the Time Warner trial and AT&T’s ambitious 2018 FCF guidance have potential to further weaken the stock.

Still, over the long-run, as the two calculations above show, the prospects are very promising provided investors remain patient and not get overly obsessed about short-term fluctuations. You will probably not get rich with AT&T anymore but you can build up a growing stream of reliable and substantial income over time. Starting with an almost 6% yield appears to be a good opportunity to start and continue this journey.

For investors having been invested into the stock in the mid-to-high 30s patience is required even more but first one has to make up one’s mind as to what one expects from this investment. If you are expecting market-like or even market-beating returns in this environment you should definitely look elsewhere. If you treat the stock as one pillar of your portfolio targeted to generate reliable income this is the highest-yielding Blue Chip stock in America and based on market cap alone probably also around the world.

The 6% yield window of opportunity could close any time and if it does you may have to wait a very long time to get that opportunity again.

What do you think about AT&T and its prospects? Are you investing more on recent price weakness, holding your position or selling out and moving on to other investments?

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Disclosure: I am/we are long T, TWX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.