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2 Dividend Blue Chips Worth Owning And 1 I’ll Avoid No Matter How Cheap It Gets

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(Source: imgflip)

AT&T (T) is a beloved name for many high-yield investors and it’s easy to understand why. The company’s core wireless business is a recession-resistant cash cow that has helped this blue chip deliver generous, safe and rising income in all economic, market, and interest rate environments.

(Source: Simply Safe Dividends)

In fact, with 35 consecutive years of dividend hikes under its belt, AT&T is a member of the legendary dividend aristocrats, S&P 500 companies that have grown their payouts for 25+ consecutive years. This is why so many high-yield investors consider Ma Bell a “no brainer” investment, especially recently when the yield hit a yield of over 7%, the highest since the Financial Crisis.

(Source: Ycharts)

With my love of high-yield blue chips, and deep value, contrarian investing, many readers asked me why I didn’t buy AT&T for any of my portfolios, including my retirement portfolio, where I keep 100% of my life savings.

Given that AT&T recently hit a seven-year low, that’s a fair question. A big reason that I’m unwilling to own AT&T comes down to one simple difference between it and most aristocrats.

(Source: Ploutos Research)

Owning an aristocrat, which represent the bluest of blue chips, is about making high probability, lower-risk investments that have historically delivered market-beating returns and also (and because of) lower volatility, superior total returns, especially during bear markets.

(Source: Ycharts)

Personally, I’m not just looking for maximum high yield, but rather have a goal of achieving great total returns by a combination of maximum safe yield (portfolio-wide), fast dividend growth, and buying top quality blue chips at strong discounts to fair value (high margin of safety and long-term valuation boost).

That’s why my retirement portfolio has the following fundamental stats

  • yield on cost: 5.1%
  • 1-year organic dividend growth: 16.8%
  • 5-year organic dividend growth: 13.8% CAGR
  • 10-year organic dividend growth: 11.3% (vs 6.5% S&P 500)

The reason for owning blue chips in the first place is that, according to JPMorgan Asset management, since 1980 2/3 of companies have underperformed the market and a shocking 40% have delivered permanent 70+% share price declines. In fact, over the last three decades, the median return for most US companies has been negative.

A key feature of my “fat pitch” deep value blue chip approach is determining whether the market is right or wrong to be bearish on a company, and thus whether the thesis is truly broken, or a company is set to revert to historical valuations within 5 years, and deliver high-risk style total returns, but in a low-risk blue chip package. While all blue chips can fail (no stock is “risk-free”) blue chips are less likely to suffer fast and catastrophic business failures that can wipe out your investment.

While the market is notorious for infinite stupidity in the short-term, over 10+ years, the fundamentals, not sentiment, determines share prices, and unfortunately, AT&T’s poor fundamentals, most notably sub-par management, are a key reason that it’s delivered such horrible returns over the decades, especially compared to superior rivals like Verizon (VZ) and Disney (DIS).

That’s why I wanted to highlight the reason why, no matter what sector you’re looking to gain exposure to, I consider Verizon and Disney to be far better telecom, and media dividend blue chips, respectively.

However, with the stock market now experiencing its best Q1 rally in a decade that doesn’t necessarily mean Verizon and Disney are great buys today. That’s because, like all companies, both face their share of risks. At today’s valuations, investors aren’t getting much in terms of margin of safety with either company. Verizon is slightly overvalued and Disney is slightly undervalued or at fair value.

So let’s find out why Verizon and Disney are potentially great watchlist blue chip stocks, far superior to AT&T, and what valuations make sense for you to put your hard earned money to work by buying shares.

Why Verizon Is A Far Better High-Yield Telecom Choice

Never forget that buying stock means buying a part of a real company, so the most important thing to look at with any investing decision is the quality of the company. For dividend growth investors that often means making sure the dividend is safe since we’re looking to avoid payout cuts like the plague. That’s both because dividends are like royalties that allow us to recoup our investments over time (thus minimizing the risk of a permanent loss of capital), plus can be used to fund expenses, such as during retirement.

Company Yield TTM FCF Payout Ratio Simply Safe Dividend Score (Out Of 100) Sensei Quality Score (Out Of 11)
AT&T 6.3% 61% 55 (Borderline) 7 (“Dirty Value”)
Verizon 4.1% 61% 84 (Very Safe) 9 (SWAN Stocks)
Disney 1.5% 27% 99 (Very Safe) 11 (SWAN Stock)

(Source: Simply Safe Dividends)

Simply Safe’s dividend safety scores have helped predict 98% of dividend cuts since 2015. The algorithm that SSD (where I’m an analyst covering over 200 companies per year) uses is designed to be ultra-conservative, which is why it’s success rate is so high. I sometimes disagree with its assessment’s (I consider AT&T’s dividend safe) but for ultra-conservative income investors, it’s a great tool to ensure their dividend income is safe in any economic/market environment.

My proprietary Sensei Quality Score, or SQS, which I use to rank all my watchlist stocks and make retirement portfolio decisions, is based on three things, dividend safety, business model, and management quality. I only consider recommending level 7 or above companies (8 are blue chips and 9+ are SWANs) and personally only own level 8 or higher companies in my retirement portfolio.

AT&T offers the most attractive yield by far, over three times that of the S&P 500. And while it’s well covered by recession-resistant cash flow, AT&T has by far the worst dividend safety of these three companies. SSD ranks its safety a 55, while my quality score a 4/5. In contrast, Verizon and Disney, while lower yielding, have very safe dividends, both according to SSD, and my quality score (5/5).

That partially explains why AT&T has a much lower SQS than Verizon or Disney (the biggest reason is the poor quality management, which I’ll get to in a moment).

Why is AT&T’s dividend safety rating so much lower when its FCF payout ratio is equal to Verizon’s? Because in addition to payout ratio the other half of the safe dividend equation is the balance sheet.

Company Net Debt/EBITDA Interest Coverage Ratio S&P Credit Rating Average Borrowing Cost Return On Invested Capital
AT&T 3.5 4.0 BBB 4.7% 7%
Verizon 2.6 7.3 BBB+ 4.2% 17%
Disney 1.4 21.8 A 3.1% 18%

(Sources: Simply Safe Dividends, Gurufocus, F.A.S.T Graphs)

Thanks to the $85 billion Time Warner acquisition last year (which I consider overvalued), AT&T today has $176.5 billion in total debt and just $5.2 billion in cash on its balance sheet. Note that on February 26th the merger was upheld by the D.C Circuit Court, putting to bed fears that the merger might be overturned. For good or ill (only time will tell) AT&T now owns Time Warner, lock stock and barrel.

(Source: earnings presentation)

$48 billion of that debt is maturing through 2022, and management has made very clear that deleveraging quickly is the company’s top priority. In fact, here’s what CEO Randall Stephenson told analysts at a recent investor conference.

“If you hear nothing else this afternoon, I want you to hear me on this. Our discretionary cash flow is going to go to one place. It’s going to be paying down debt. We took on debt to do the Time Warner deal. We told you when we announced the deal, it would take a little over a year to get the debt back to more comfortable levels.” – AT&T CEO (emphasis added)

And in March 2019 Stephenson once more reiterated that deleveraging, not further M&A is what the company is laser-focused on.

(Source: investor presentation)

According to management, AT&T plans to reduce its leverage ratio to 2.5 by the end of 2019 which it considers a comfortable level. While that’s true, based on its core business model, even with $26 billion in annual free cash flow by the end of 2019 ($12 billion in post-dividend cash flow), and $6 to $8 billion in planned non-core asset sales it will likely be until 2022 until AT&T approaches its historical net leverage ratio of 1.5. And that’s only if management doesn’t decide that a higher leverage ratio is appropriate and decide to overpay for another big, needle-moving deal.

(Source: investor presentation)

And keep in mind that management’s deleveraging time table is based on $2.5 billion in assumed synergies, both in terms of cost and revenues. Those are not guaranteed to happen. The failure to achieve planned synergies, (as well as overpaying with lots of debt) are key reasons why, according to The Harvard Business Review, 70% to 90% of mergers fail to deliver long-term shareholder value.

And I happen to agree with Morningstar that AT&T has been guilty of ill-conceived and overpriced M&A.

We believe AT&T’s recent capital-allocation decisions have destroyed shareholder value, resulting in our Poor stewardship rating.” – Morningstar’s Michael Hodel (emphasis added)

AT&T has proven it loves to overpay for big deals, such as paying $48.5 billion to buy DirecTV in 2014. While cable and satellite have both been hammered by cord cutting, it now appears Cable subscriber losses might be stabilizing, while satellite losses are not. But DirecTV is hardly the only example of AT&T making questionable acquisitions.

  • $85.4 billion for Time Warner (highly risky diversification play)
  • $48.5 billion ($67 billion including debt) for DirecTV in 2015 (overpaying for a business that was peaking in the face of cord cutting)
  • $1.9 billion for Nextel Mexico in 2015
  • $1.9 billion for Lusacell (Mexican wireless operator) in 2015

The company has been investing heavily into Mexican wireless, where it has yet to turn a profit. While it believes it will eventually gain enough scale to become free cash flow positive, AT&T’s core strength is US wireless, where it commands a relatively wide moat due to having spent decades and hundreds of billions ($140 billion just in the last five years) building out a nationwide network and gaining 77 million postpaid monthly subscribers (30% market share).

AT&T will never enjoy that kind of dominance in Mexico, and thanks to the capital intensive nature of the telecom business, free cash flow generation from its international operations is never likely to be particularly large. Since free cash flow is what funds the dividend, and the only reason to own the stock is the dividend, anything that doesn’t boost free cash flow is something dividend lovers should be skeptical of.

But even in US wireless, the company has overpaid, including paying $18 billion for AWS-3 spectrum in 2015 when it got into a bidding war with Dish.

That’s not to say that AT&T is a horrible company, because the wireless business is a cash cow and management has been able to deliver relatively steady margins and returns on capital over time (thus a 2/3 business model rating on my quality score).

AT&T Revenues and Adjusted EBITDA by Segment

(Source: AT&T Annual Report)

Wireless generates half of adjusted EBITDA dwarfing all other segments (note that international accounts for just 1% indicating it’s an expensive distraction).

(Source: Simply Safe Dividends)

Sadly, returns on invested capital, while stable over time, are below the 9% that is a good proxy for average management in this industry. Since management is the one allocating shareholder capital, I personally refuse to invest in any poorly run company, whose returns on invested capital are sub-par and have fallen over the last decade.

But while I may not be a fan of the company, due to my dislike of management’s capital allocation over the years, if the company can live up to 2019 guidance then AT&T will remain at least a decent (if slow growing) high-yield dividend stock.

2019 Guidance

  • Free cash flow in the $26 billion range
  • Dividend payout ratio in the high 50s% range
  • End-of-year net debt-to-EBITDA ratio, on an adjusted basis, in the 2.5x range
  • Gross capital investment in the $23 billion range
  • Adjusted EPS growth in the low single digits

Investors will want to make sure that AT&T lives up to those relatively low expectations because if they don’t the stock could remain in the toiler for the foreseeable future.

Why am I skeptical that management can clear that low hurdle? Because the fact that its all-important wireless business is struggling against major rivals like Verizon and T-Mobile (TMUS).

(Source: 10-K)

You can see that in the fact that top-line revenue in mobility barely grew in 2018 after declining in 2016.

(Source: 10-K)

AT&T is gaining low margin subscribers in connected devices, but its postpaid customers, the most profitable and the source of the stable and recession-resistant cash flow that supports the dividend, actually declined by 621,000 last year.

Now let’s compare that to Verizon and T-Mobile.

  • Verizon: added 1.2 million net postpaid subs…in Q4 2018 alone
  • T-Mobile: added 1.4 million net postpaid subs…in Q4 2018 alone

T-Mobile CEO John Legere, who I consider hands down the best US telecom CEO (the Bezos of his industry) has managed to shake up the US wireless market. His “un-carrier” initiatives have brought back unlimited data, lowered costs, and put the screws to weaker telecom giants like Spring and AT&T.

The good news is that unlike Sprint, who probably would fail given enough time, as a standalone company, AT&T could survive, but not likely thrive. Verizon, while certainly seeing its bottom line growth challenged by T-Mobile’s rise, has adapted and continues to grow at roughly the same rate as the upstart rival.

In other words, Verizon and T-Mobile are stealing market share from Spring and AT&T, and remember that AT&T’s mobile business is its crown jewel. What explains Verizon’s ability to be more nimble and adaptive? Well, I personally credit the industry’s second-best management team (behind T-Mobile).

(Source: Simply Safe Dividends)

A company’s profitability profile can tell you a lot about the quality of the management, in one glance. Verizon has consistently delivered the industry’s highest margins and returns on capital, which have been trending higher over the past decade. That’s definitely what dividend investors want to see in their blue chip investments.

While Verizon is hardly without sin when it comes to stupid acquisitions, it’s made far less of them and has mainly remained within its circle of competence (less empire building M&A). The company did spend over $9.2 billion on media companies (like AOL and Yahoo), creating Oath Media, which it recently took a $4.6 billion write-down on (96% of its goodwill), and renamed Verizon Media.

The idea was Verizon was going to compete with marketing giants like Facebook (FB), Alphabet (GOOG) and Amazon (AMZN) for the large and rapidly growing online ad market. It’s now pretty much given up on that dream as unattainable.

I consider such an admission to be smart when facing virtually impossible odds against the industry’s top giants (FB, GOOG, and AMZN control about 2/3 of the digital ad market and are gaining market share). AT&T continues to tilt at windmills with its XANDR online ad platform, indicating management continues to pursue pie in the sky dreams, which are a potentially costly distraction from its core business.

But the thing that I like about Verizon is that over the past decade it’s made just two major acquisitions.

  • 2009’s $28.1 billion acquisition of Alltell, which increased its subscriber count 20% and made it the country’s largest wireless carrier (40% market share and holding stable)
  • 2014’s $130 billion buyout of Vodafone’s (VOD) 45% stake in Verizon Wireless

Both of those mega-deals were within Verizon’s wheelhouse and allowed it to focus almost all its capital investments into building out the nation’s largest and highest quality wireless network. It’s succeeded with no less than seven of the top network raters giving it the crown for several consecutive years now.

Those Rating Verizon #1 In Overall Wireless Network

(Source: Verizon Investor Presentation)

Basically, when it comes to making smarter capital allocation decisions, I like that Verizon has remained mostly in its circle of competence and focused on operational excellence that AT&T hasn’t come close to matching.

Morningstar’s Michael Hodel agrees with this, saying

We like Verizon’s telecom focus, which should maximize its strengths in the areas it can control while limiting exposure to the rapid changes across the media landscape.” – Morningstar (emphasis added

Verizon’s plan for future growth lies in 5G, which will have economy changing implications.

(Source: Verizon investor presentation)

That includes 10 to 100 times faster download speeds, up to 10 times shorter latency (how fast devices communicate) and allow for 1,000 times the device density (1 million per square KM). It will also allow for 10 times less energy use allowing for the internet of things or IOT to take off, revolutionizing pretty much every industry via the real-time collection and analysis of data.

(Source: Verizon investor presentation)

It’s also going to allow for Verizon to go after hundreds of millions of new subscribers, though mostly through lower margin IOT devices.

But Verizon has said (though it recently hedged this) it plans to become a dominant name in 5G enabled wireless internet, trying to take a big cut of the $115 billion ISP market. It’s already rolled out limited home internet service in four cities where it’s offering 1 GP speed internet via 5G, for $50/$70 per month (discount for VZ wireless subs).

Using just 40% of available spectrum in those test markets Verizon is offering $10/month cheaper internet that’s 10 times faster than the national average. That kind of value proposition is why management says it wants to eventually get to 30 million 5G internet customers.

US ISPs by Subscribers

(Source: Statista)

While that may be an overly ambitious and unrealistic goal (see risk section) if Verizon does attain it then it will become the largest internet service provider in the country, as well as the biggest wireless provider.

If you want to own a high-yield dividend blue chip, then owning the one that dominates all aspect of American telecom would certainly be a good starting point. But as much as I’m a fan of Verizon’s management, operational excellence, and ambitious long-term plans, there are still plenty of risks to consider.

Verizon Risks To Keep In Mind

Let’s not sugar coat it, Verizon is never going to be a fast-growing company. Analysts expect long-term US telecom revenue growth (industry wide) to be just 2% to 3% CAGR. Even if Verizon achieves total domination in all things wireless and 5G ISP, it’s not likely to be able to grow its bottom line faster than 2% to 3% per year (which is the 20-year average dividend growth rate as well).

This means that Verizon, like AT&T, is effectively a corporate bond alternative, with inflation adjustments courtesy of token annual dividend hikes.

And it’s far from certain that Verizon will be able to achieve 30 million 5G internet customers. For one thing Comcast (CMCSA) and Charter (CHTR) control 77% of the US ISP market. Verizon’s early attempts at disrupting this space is truly a David vs Goliath struggle and I don’t give it a high probability of success.

If anyone is going to potentially disrupt home internet with 5G it’s more likely to be T-Mobile who says it wants 9.5 million wireless 5G internet subscribers by 2024, making it the 4th largest ISP in the country. T-Mobile has a proven track record of innovation (and a beloved brand) that neither AT&T, Verizon, Comcast or Charter can match (Comcast is frequently on the list of most hated companies in America when it comes to customer service).

Does that mean that Verizon is a bad stock to buy? Not if your primary goal is safe, generous and inflation-adjusted income. But make sure to only buy the company when it’s deeply on sale, to earn decent total returns as well as maximum yield on cost (see valuation/total return section).

Why Disney Is A Much Better Media Company

Don’t get me wrong WarnerMedia is indeed a strong collection of quality assets with great IP. And its studio segment can indeed make great films, that are both critical and box office successes (as Shazam! just proved).

(Source: AT&T investor profile)

And I’ll give management credit for the bold vision to take on Disney to become a global media giant, operating in over 65 countries with direct consumer relationships with over 170 million customers. There is no doubt that buying Time Warner means AT&T has better growth POTENTIAL than Verizon, who is sticking to its knitting now that its media ambitions have proven a costly folly.

But I’m with Morningstar’s Michael Hodel in being skeptical of whether AT&T’s huge bet on breaking into media is going to work out.

We doubt that AT&T’s transformation into a diversified media and telecom company will deliver significant strategic benefits, as we don’t believe these industries complement each other well, despite their close association. We expect AT&T will need to reach as wide an audience as possible at WarnerMedia to maintain relationships with content creators and fend off rivals, limiting opportunities to create unique experiences for its telecom customers.” – Michael Hodel, Morningstar (emphasis added)

The reason that I and Morningstar are skeptical of AT&T’s grand plan to bundle their new content as a way of achieving market dominance and profit is that the media world has shifted towards real-time offerings that provide maximum convenience (thus the rise of streaming).

(Source: AT&T 10-K)

As you can see, AT&T has seen its video subscriber base steadily erode, and at an accelerating pace. In fact, since buying DirecTV, the sub count is down 9%. DirecTV Now is AT&T’s answer to streaming and it has seen rapid growth since being introduced in 2016.

However, a recent UBS survey found that of those looking for a live TV streaming offering DirecTV Now came in third behind YouTube TV and Hulu Live (number one and now 60% owned by Disney). By the way, Hulu Live has now crossed 2 million subscribers and is now well ahead of DirectTV Now. Hulu itself has over 25 million subscribers and is the 3rd largest streamer in America.

Even worse? In Q4 2018 DirecTV Now lost 267,000 subscribers after growth slowed to 49,000 in Q3 2018. This shows that AT&T has little customer loyalty with streaming customers and very high price elasticity (meaning no pricing power). How do I know that?

Because DirecTV Now’s growth fell off a cliff and then turned negative after AT&T hiked its price by $5 per month (it’s hiking them $5 more in Q1) and reducing the number of channels in the standard package. Management thesis was it could reduce expenses while boosting revenue. Instead, its customers are leaving in droves to lower cost alternatives and that trend is likely to accelerate now that AT&T is doubling down in its most recent mistake.

In essence, AT&T bought DirecTV because it thought that by maximizing content distribution scale, it could lower content costs and maximize profitability. Instead, the industry continued to shift under its feet, and buying Time Warner is a defacto admission by management that DirectTV failed and now it has to make a bet that’s about 50% larger to try to become a streaming giant.

But what about AT&T’s new plans for streaming with WarnerMedia, coming in late 2019? Here’s the reason I’m skeptical this will work. DirectTV Now is a good example of AT&T’s big mistake, which is thinking that bundling is its way to success. DirecTV Now customers are leaving because AT&T made the base package less appealing and more expensive.

In 2019, it plans on launching no less than three-tiered streaming services focused on:

  • HBO licensed films (cheapest tier)
  • HBO Originals
  • Warner Bros. and Turner content (most expensive tier)

This risks breaking HBO NOW, which already has over 5 million subscribers. And because the company is still licensing Time Warner content (Friends to Netflix for $100 million) I’m skeptical that many people will sign up for the highest priced offering (likely $50 to $60 per month).

Not when Apple (AAPL) and Disney (DIS) are launching their own streaming offerings to join the long list of choices already available. Netflix (NFLX), Hulu (60% owned by Disney) and Amazon (AMZN) Prime Video are the top three streamers and are plowing billions into exclusive content.

Essentially, AT&T troubles with streaming are like its issues in all parts of its business. Management has made the wrong calls, spent a lot of money doing it, and then when the market indicated that a change was needed it either doubled down on its earlier mistakes or made all new ones. That’s the hallmark of poor management that you don’t want to entrust your hard earned money to.

Disney has the world’s largest collection of content, thanks to the $70 billion Fox merger which closed in March 2019. But let’s talk about that huge deal. Didn’t I just explain that big M&A is hard to do well? Indeed it is.

CEO Bob Iger, in the top job for 14 years now, is scheduled to retire June 2021. Iger has proven a master of great strategic M&A including

  • 2006: Pixar ($7.4 billion deal)
  • 2009: Marvel ($4 billion)
  • 2012: Lucasfilm ($4 billion)

Thanks to these acquisitions, Disney dominates the global movie industry with key franchises that it now owns 21 of the 38 movies that have ever grossed $1 billion+ at the global box office.

(Sources: Boxoffice mojo, Motley Fool)

What’s more, Disney’s world-class content, which it has proven it can grind out with clockwork-like precision (executional excellence) then gets leveraged via its massive media distribution channels, such as the Disney Cable channels which are super profitable because it pays nothing for its own content.

It also is a master at merchandising and licensing its brands around the world, creating further revenue streams. That includes royalties where other companies peddling shoes, hats, and even sunglasses, take all the marketing and production risks for using Disney’s known and beloved brands. Disney collects a 6% to 10% royalty check each month for doing absolutely nothing.

And let’s not forget the theme parks. Disney owns seven of the 12 most visited theme parks on earth and is leveraging its brands to open new rides to keep attendance virtually maxed out, despite steadily rising ticket prices and absurdly priced merchandise, food, and drink costs.

I know many readers are outraged by Disney’s constant price hikes, arguing that Walt Disney must be spinning in his grave that the average family can’t afford to visit his parks. But guess what? Disney’s job is to maximize profits for shareholders. In any capacity constrained business, the smart move is to charge as much as the market will bear while keeping capacity (attendance) running near 100%.

(Source: Simply Safe Dividends)

Here’s the result of Disney’s brilliant management team, which is able to run one of the world’s largest conglomerates with precision, strong execution, and adapt to challenges that are unavoidable in every business segment and industry. Specifically, sky-high margins and returns on capital that are more than double what the average good companies generate and that have been trending higher over the past decade.

If you want to see what a wide moat company, run by excellent management looks like Disney is it, and the mirror image of AT&T, who keeps misfiring and making costly mistakes with shareholders money.

What about AT&T’s big dreams of becoming the next NetFlix? Well there too Disney is far more likely to succeed. For one thing, they now own 60% of Hulu, the 3rd largest US streaming company.

In 2018 Hulu’s advertising customer base grew 50% and its ad revenues 45% (to $1.5 billion) compared to AT&T’s answer to advertising, Xandr, were revenue grew 27%. In other words, AT&T is trying to compete in all segments of media, including high margin advertising, but once again failing against larger rivals or those with superior management, who are able to adapt to this fast-changing market much better.

Disney plans to launch two streaming services, the first being a $5 per month offering called ESPN plus that’s been up and running for a year. The House of Mouse is being smart, trying to build market share with a low initial price while offering

  • One MLB and NHL game during each day of their respective seasons.
  • Over 250 MLS games, including the exclusive rights to the Chicago Fire.
  • Various boxing matches.
  • Coverage of 31 PGA tour events.
  • Thousands of college sports events.
  • Wimbledon, U.S. Open, and Australian Open tennis.
  • Hundreds of international rugby and cricket matches.

Recently ESPN+ inked an exclusive deal with UFC to air its pay-per-view events, with Disney getting 25% of sales. When the deal was announced the company reported a 600,000 subscriber boost in January 2019 ahead of a major fight.

Thanks to that kind of smart deal-making ESPN+ now has over 2 million subscribers despite launching less than a year ago. For context HBO Now gained just 800,000 subs in its first year. CBS All Access took three years to get to 2.5 million subscribers and has a much richer content library than ESPN+.

In the last 5 months alone Disney has doubled the subscriber base of this service and has been steadily adding about 200,000 subs per month since launch. Helping make such fast growth possible is Disney’s acquisition of 75% of Bamtech Media, which gives it the streaming infrastructure to make possible its ambitious growth plans. One of those ambitions includes potentially expanding Hulu to Europe (it’s currently 100% US focused).

This highlights Disney’s great track record of not overpaying for bolt-ons that don’t add value but are important parts of its master plan (much like Marvel movies are part of a grander money minting whole).

That bodes well for Disney+, the streaming service coming in late 2019. The bottom line is that when it comes to breaking into and actually doing well in streaming, I have far more confidence in Disney’s chances than AT&T’s. But while Disney is unquestionably a superior media company it also has risks to consider.

Disney Risks To Keep In Mind

While streaming is a fast growing market, it’s also extremely expensive and won’t make Disney any positive free cash flow for many years. In 2018 Disney’s various streaming operations (Hulu, Vice, and Bamtech) generating $1 billion in operating losses. $580 million of that loss (on a 30% stake) was from Hulu, meaning that the entire company lost nearly $2 billion. And that loss was 38% larger than in 2017 despite faster subscriber growth than Netflix.

So let’s sum up Hulu (who AT&T can’t hope to replicate quickly)

  • 25 million subscribers
  • 2 million paying $45/month
  • $1.5 billion in ad revenue
  • $2 billion operating loss that rose 38% YOY

There is a reason that Netflix, despite having 139 million global subs, is expected to burn $3 billion in cash this year ($7.5 billion in content costs). In fact, Moody’s doesn’t think Netflix, the largest streaming giant on earth, can become free cash flow positive until 2023.

Now there is good news in that Disney owning its own content means lower costs and better economics than Netflix and most other streamers (including Hulu). Analysts currently expect Disney Plus to launch at $8 per month, and have about $350 million per quarter in operating costs (factoring in $150 million in lost licensing revenue from Netflix). This implies it will take 14 million subscribers to hit breakeven.

But given that the company plans a lot of exclusive content for the service, it might be much more than that. The good news is that Disney has deep pockets and is generating billions in cash flow to subsidize Disney Plus, which is really a strategic move to defend or even deepen its moat.

But the point is that Disney investors need to keep in mind that streaming, while it’s sure to gain headlines if Disney Plus explodes out of the gate as ESPN+ has, won’t actually be driving FCF/share growth for a long time (if ever).

And at a fundamental level, we can’t forget that most of the company’s segments are cyclical and economically sensitive. Park attendance is especially like to crash in a recession, as will operating park profits due to high fixed costs.

In February the New York Federal Reserve estimated that as of January the risk of a recession beginning within the next 12 months was 50%, based on two of the most accurate yield curves (historically speaking). That’s the highest level in a decade. The Cleveland Fed’s model puts the odds at 33%, but the risk has been rising at 3% per month in 2019.

12 Month Recession Probability

(Source: Cleveland Federal Reserve)

Which brings me to the issue of valuation, which is crucial to both achieving good long-term returns with any stock, as well as managing your portfolio’s risk.

Valuation/Return Profile: Disney Is The Best Buy Right Now

(Source: Ycharts)

Disney and Verizon have been hot this year, and AT&T, while underperforming badly over the past 12 months, has rallied nicely off December’s lows.

Since 1994 45% of the stock market’s returns have come from starting valuation, in this case, the forward PE ratio.

And going back all the way to 1881, Yale researchers found that starting valuation (trailing PE) was highly correlated to total returns as far out as 30 years. A low valuation imparts a “margin of safety” because as you’ve seen in the risk sections, every company faces challenges they must overcome in order to achieve their growth potential and for the bullish thesis to play out.

So let’s start out with the forward PE ratio, which has been shown to be a good valuation approach and which is endorsed by Chuck Carnevale (SA’s valuation guru and in the top 1.4% of all analysts in America) approach.

Chuck’s rule of thumb is that paying 15 times forward earnings or less is a great way to avoid grossly overpaying for a company and not being compensated for the risks you’re taking on as an equity investor.

Company Forward PE 5-Year Average Forward PE Growth Baked Into Share Price

Expected Growth Rate (Analyst Consensus)
AT&T 9.1 13.0 0.8% 2.9%
Verizon 12.7 12.6 2.7% 6.8%
Disney 16.5 17.2 4.8% 2.5%

(Sources: Simply Safe Dividends, Fast Graphs, Benjamin Graham, Yahoo Finance)

AT&T and Verizon are not just trading at under that 15X rule of thumb but AT&T is also trading at a big discount to its five-year average. The lower the PE the less growth is baked into a stock, and the easier it is for management to clear a low expectations hurdle. Of these companies, Disney is the only one trading above Chuck’s 15X rule of thumb (but below historical average) and has an implied growth rate above the current 5 year forward EPS growth consensus.

However, that’s likely due to analysts baking in a future recession, and not an indication that Disney’s long term growth potential is actually impaired (it’s a cyclical stock).

My personal favorite valuation method is dividend yield theory or DYT. Asset manager/newsletter publisher Investment Quality Trends popularized this in 1966 when it became the only approach they used (on blue chip dividend stocks based on six quality criteria) to deliver decades of market-beating returns and with 10% lower volatility.

(Source: Investment Quality Trends)

According to Hulbert Financial Digest, over the past 30 years, IQT’s DYT blue chip approach has delivered the best risk-adjusted returns of any investing newsletter in America.

DYT assumes that a company’s business model remains relatively stable (wheels don’t fall off) and the yield reverts back to a historical norm that approximates fair value.

Company Yield 5-Year Average Yield Estimated Discount To Fair Value Upside To Fair Value

10-Year CAGR Valuation Boost
AT&T 6.3% 5.4% 15% 17% 1.6%
Verizon 4.1% 4.5% -9% -10% -1.1%
Disney 1.5% 1.5% 0% 0% 0%

(Sources: Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, Moneychimp)

DYT current estimates that AT&T is the most undervalued of these companies, but not obscenely so, especially given the terrible track record on M&A and poor ability to adapt to shifting industry conditions. Verizon appears modestly overvalued while Disney looks fairly valued.

Note this scale only applies to level 8 quality companies or above, meaning Verizon and Disney. AT&T, as a level 7 dirty value company, requires a significant discount to fair value to compensate for the risk of poor management. While I personally don’t ever buy companies with sub-par management I’d recommend a 20% discount to fair value before putting new money into AT&T (6.8% yield or better).

Based on DYT and my personal valuation scale (which is inspired by Buffett’s rule about buying wonderful companies at a fair price or better) I can only recommend buying Disney at this time.

To confirm what historical PE and yield comparisons are telling us I also look at the three-stage, discounted cash flow valuation models prepared by Morningstar’s conservative fundamentals focused analysts. I consider them a trustworthy source of fair value estimates that are far superior to the 12-month price target spouting sell-side analysts the media likes to trot out (who are guessing at where a stock’s earnings multiple will be in a year).

Company Morningstar Fair Value Estimate Current Price Discount To Fair Value Moat

Management Quality
AT&T $37 (uncertainty medium) $32.39 12% Narrow (stable) Poor
Verizon $58 (uncertainty medium) $59.13 -2% Narrow (stable) Standard (average to good)
Disney $130 (uncertainty medium) $114.96 12% Wide (stable) Standard

(Sources: Morningstar)

Morningstar agrees with DYT about AT&T but actually thinks Verizon is a potentially decent buy right now (under the Buffett rule) and that Disney is a buy due to being 12% below intrinsic value.

When it comes to my own retirement portfolio, only Disney meets my goals of long-term dividend growth potential and double-digit total returns, but at a much steeper discount than it currently offers (under either DYT or Morningstar’s DCF based estimate).

I’ve set a limit to buy a starter position in Disney at $102.56 (about 11% below the current price), and will potentially keep adding at $1 increments up to a 5% position in my portfolio. That would require Disney to fall to $96.56 (7 limit orders worth of buying totaling $14,000).

I’m not predicting that will actually happen, but I’m patient enough to set my limits and let the market determine what “fat pitches” I swing at.

Bottom Line: AT&T Is Fine As A High-Yield Income Source, But Is Likely To Struggle With Perpetual Slow Growth Due To Poor Management

Don’t get me wrong, in no way am I saying that AT&T is a sell. If you own it purely for the generous dividend, that’s growing at the rate of inflation, and bought it years ago at a great price, by all means, holding onto your shares might be right for you.

Just make sure you realize that AT&T is effectively an inflation-adjusted corporate bond whose high debt levels, poor management, and history of questionable and overvalued M&A likely means that this company will never make an especially good growth investment.

Verizon is hands down the better US telecom high-yield blue chip, thanks to superior management that mostly sticks to its circle of competence, and focuses on its cash-rich, wide moat wireless business. That’s not to say that Verizon is going to deliver sensational growth over time, given the saturated and mature nature of the US telecom industry. Analysts do expect that Verizon will benefit more from 5G, thanks to its ISP pivot, which I consider a lower-risk approach to restarting growth than AT&T’s high-risk splashy M&A strategy.

However, T-Mobile, unquestionably the most innovative and well run US telecom, also has its sights set on the ISP market, and if the Sprint merger is approved, could prove a powerful force that keeps both AT&T’s and Verizon’s long-term growth stuck in the low single digits.

Disney is unquestionably my favorite media company, thanks to what I consider a great management team’s ability to put together a string of brilliant strategic acquisitions that have given it the world’s best content library.

While there is a lot of risk in Disney’s going after the crowded and competitive streaming space, Disney’s deep pockets, patient management, and a mountain of beloved content give it a much better chance at becoming a leading streamer in my opinion. While AT&T’s content library is also large and high quality, it can’t hold a candle to Disney’s and I’m skeptical that its management’s approach to a three-tiered, higher priced bundle package will actually gain traction.

In terms of my retirement portfolio, I am only looking to own Disney but at a lower price. For the average investor looking to buy a wonderful company at a fair price, Disney is probably fairly valued if not slightly undervalued making it a potentially good buy. But for deep value investors looking for “shark tank” like good deals (and long-term total returns of 15+%) I recommend watchlisting Disney and patiently waiting for a much better price, such as occurs during corrections or bear markets. My personal price target on Disney (where I set my first limit order) is $102.56, which would represent a 12% to 23% discount to fair value.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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