AT&T: Stock or Bonds?

Jeremy Glaser: AT&T, stock or bonds? I'm Jeremy Glaser with Morningstar.com. I'm here with Associate Director, Mike Hodel, to talk about the relative attractiveness of AT&T's bonds and their equity. Mike, thanks for joining me today.

Michael Hodel: Thanks for having me.

Glaser: So let's start off by talking a little bit about AT&T as a debt issuer. They're one of the most prolific issuers out in the marketplace. What do you think about AT&T's credit quality?

Hodel: As you said, AT&T is a very large debt issuer. They've got about $70 billion worth of debt outstanding. But, that said, we think they're also one of the strongest credits in the telecom universe. We've given them an A- rating, and that really reflects the strength of the company's balance sheet. Their debt load total is about 1.7 times operating income, excluding depreciation, or amortization, or EBITDA. And management has explicitly said that they'll bring that ratio down to about 1.5 times, over the next year or so, using cash flow above and beyond their dividend to repay debt, again over the next year or so.

In addition to that, they're one of the largest, most diversified, telecom carriers out there. They've got a 120 billion plus top line. They serve pretty much every market within telecom, from wireless service to consumer fixed line, and business services as well. In the wireless business, we think they're extremely well positioned as one of the two largest carriers in the US. More than half of their profit comes from their wireless business, which is somewhat little known, because the fixed line business has traditionally gotten more attention, especially the consumer fixed line business.

We don't think the consumer fixed line business is all that well positioned, competitively, but it's also a fairly small business. It's around 17 percent of total revenue, these days. So, again, it really is mostly about wireless, the strength of the wireless business. And the strength of the company's balance sheet, we think that they're a solid credit.

Glaser: What do you think about the pricing of their bonds right now?

Hodel: We think the bonds are pretty fairly valued. If we look at their 2019 maturity notes, which is roughly equivalent to the duration of Morningstar Corporate Bond Index, they're trading right in line with what we'd expect from an A- issuer. If we look a little bit shorter dated than the 2019 bond, like say the 2013, spreads are a little bit tighter, relative to the longer dated maturities.

If we go out further on the maturity curve, their spreads are a little bit wider relative to the treasuries, than those 2019s. And we think that makes a lot of sense. The odds of distress with a company like AT&T, over the next two or three years, are pretty low we think. Again, just given the stability of cash flows and the competitive position that the company enjoys.

Over the longer term, though, we think that a debt holder is taking on more risk. The company has a fairly sizable pension, and other post retirement benefit obligation, that's unfunded. In addition, just predicting the future of telecom is difficult over a 10 or 15 year period. Consumer habits change. Technologies change. And really, again, predicting how consumers and businesses are going to interact with telecom services, and what the competitive landscape will look like a decade down the road, is pretty difficult.

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Glaser: Maybe not a huge opportunity for bond investors in AT&T right now, but if you were looking to get exposure to AT&T, what does the equity look like?

Hodel: We do think that the equity is relatively more attractive than the company debt. It's currently a four star rated stock by us. And we also think that the dividend is attractive. The dividend yield's actually six and half percent, which is higher than you're going to get on any AT&T debt, in terms of yield to maturity. So you actually get paid more to own the common stock than you do investing in the company's bonds.

In addition, you get a stock that we think is undervalued. The shares have underperformed relative to the market over the last year or so. And we don't think that that's necessarily warranted, and we think that the shares are in fact a little bit undervalued here.

Glaser: It sounds like for investors, who aren't necessarily looking for fixed income, the equity might be a better place for them to be.

Hodel: I think so. With the equity, you get some income, as you'd expect with a fixed-income security, and you also have some upside potential, as well, we think.

Glaser: Mike, thanks so much for joining me today.

Hodel: Thank you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.