AT&T: Dividends and Buybacks Work Just Fine

NEW YORK (F.A.S.T. Graphs) -- Recently I happened upon the article of a fellow TheStreet.com contributor detailing Blackrock (BLK) CEO Larry Fink's ideas of the current state of the stock market. Within this commentary it detailed how Fink believes that dividends and buybacks are the catalyst for the recent stock market rally, rather than increased profitability and a strong economy. In turn, it would seem that this could indicate a seemingly unsustainable path forward.

However, I would like to make two points on this notion. First, instead of looking at the "stock market" I like to think of it as a "market of stocks." It's paramount to remember that stocks represent ownership stakes in the underlying businesses, which are analogous to owning your hometown restaurant. It follows that what the market is doing and what any individual company is doing can vary greatly. So while Fink's statements might carry weight in the aggregate, they are not necessarily representative of every enterprise.

The second point is -- depending on the company -- I would contend that relying almost solely on dividend and buybacks could actually work out quite well for some investors. To this regard, I would like to use telecom powerhouse AT&T ( T) as an example.

Based in Dallas, AT&T has nearly a quarter of a million employees who provide telecom service to virtually every country in the world. The AT&T name traces its roots all the way back to the beginning with Alexander Graham Bell and the invention of the telephone. However, the legacy company itself was forced to break up in 1984 through an agreement with the U.S. Department of Justice. From this arrangement, SBC Communications was formed along with a variety of smaller telephone companies. SBC began aggressively acquiring communication providers in the late 1990s, and in 2005 acquired AT&T Corp., shedding the SBC name in lieu of the iconic AT&T. This created the new AT&T and continues the storied history.

In viewing the past operating history of AT&T, it is prudent to view the company from the time of the SBC acquisition moving forward. Below I have included an Earnings and Price Correlated F.A.S.T. Graph for AT&T dating to 2006. Here we see that operating earnings (orange line) have been growing at just over 9% a year for the last eight years, while price has generally followed earnings. In addition, it's useful to recognize that the dividend (pink line) has been steadily increasing over this time period. Note that the payout ratio grew to over 100% recently due in large part to charges related to the failed T-Mobile acquisition.

Given the company's strong operating history, it would be expected that the performance results for investors were equally compelling. In viewing the eight-year Performance Result table below, one can see that AT&T provided investors with a 9% annualized total return for the period -- which was about 3% higher per year on average than the S&P 500 index over the same timeframe. Additionally, it's interesting to note that nearly half the returns were derived from AT&T's dividend. Even more impressive is the idea that the company's price-to-earnings ratio dropped from about 20 in 2006 to today's 15 and still provided investors with return results that matched the company's operating results. This was a direct result of the company's quarterly payout.

But of course a strong business past does not necessitate an equally compelling future. However, I would like to indicate that AT&T's dividend played an instrumental role in the company's return results over the last eight years. If one reinvested the dividends, the annualized yearly return would have jumped to 10.1%.

With this being said, it is my suggestion that even if AT&T isn't able to grow very much at all it still could be a compelling investment. Allow me to explain. Thirty-five analysts reporting to Standard & Poor's Capital IQ are predicting an intermediate-term growth rate for AT&T of 6.1%. Analysts reporting to Zack's provide a similar number.

If those numbers materialize as forecast, an investment in AT&T could be in the range of the Estimated Earnings and Return Calculator provided below. That is, with a 5.1% current dividend yield, expected earnings growth of 6.1% and an assumed P/E ratio of 15 in five years time, AT&T could provide annualized returns of 12.2%.

While it is important to underscore that this is simply a calculator that defaults to analysts' consensus, this is likely a reasonable approximation for how investors are viewing the company. However, the interesting aspect to me is that AT&T doesn't have to hit these numbers to be a worthwhile investment. Instead, if we scale back our expectations dramatically, the 5%+ current dividend yield provides a buoy of income support. For instance, if one believes that AT&T will grow at only 2% year, this still indicates a yearly rate of return of about 9%.

Interestingly, this assumption of 2% growth is effectively a "no growth" scenario when coupled with the company's share repurchase program. As depicted in the Fundamental Underlying Number graph below, AT&T has reduced common shares outstanding (csho) from about 6 billion shares in 2006 to today's number closer to 5.2 billion. If future buybacks are as successful as they have been in the past, this represents yearly EPS growth in the range of 1%-2% without having to grow total company earnings.

Overall Larry Fink assuredly provides some interesting points about investors being allured to dividends and buybacks rather than increasing profitability or a growing economy. However, his views demonstrate a market observation rather than a business specific view. In the case of AT&T it appears that the most important item moving forward is the sustainability of its dividend. Next, the company can achieve EPS growth via prudent share repurchases. Taken collectively, an investor could see 7%-9% annualized returns without the company actually growing total earnings. Additionally, as long as the dividend remains sustainable, this indicates that investors are able to collect a 5% dividend no matter what happens to the stock price. If the company happens to grow, that's just icing on the total performance cake.

At the time of publication, Carnevale was long T.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Charles (Chuck) C. Carnevale is the creator of FAST Graphs.

Chuck has over 43 years of financial experience and is the co-founder of the earnings and price correlated, powerful fundamentals analyzer software tool - FAST Graphs. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck's work stressing sound valuation has been widely published on numerous financial sites and blogs. Chuck is passionate about spreading the critical message of valuation and prudence in fundamental investing. So much so that regular readers have dubbed him "Mr. Valuation". Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Chuck believes that correctly assessing fair value is one of the primary keys of successful stock investing, and he has dedicated his more than 40 years of experience in finance to its pursuit. Chuck agrees with legendary investors such as Warren Buffett, who recognize how important it is for investors in common stocks to possess an intelligent framework for making sound decisions that can keep emotions out of the equation. With making smart stock selections, there is no room for fear and greed.

Chuck was fortunate to learn at an early age that earnings drive long-term stock prices, and that dividends, if any, will be paid out of a company's earnings. This led him to develop FAST Graphs, the fundamentals analyzer software tool that reveals the long-term relationship between a company's earnings and its stock price and dividends over time. Chuck is most interested in the business behind the stock.

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