What to Do with AT&T?[Fool on the Hill] June 13, 2000

An Investment Opinion

What to Do with AT&T?

By Richard McCaffery (TMF Gibson)
June 13, 2000

Flip through the pages of The Wall Street Journal and you'll see long lists of companies with strong partners, powerful brand names, solid market share, catalysts likely to push the stock higher, and other great assets.

Maybe you're looking at General Motors (NYSE: GM), the world's largest manufacturer of cars and trucks, or AT&T (NYSE: T), the 800-pound gorilla in the telecom industry.

What do these companies have in common. What characteristic do they share with dozens of other Fortune 500 corporations? Insufficient or shrinking returns for investors. The best brand name in the world, the strongest partners, indeed all that glitters on the pages of annual reports doesn't count for a thing -- from the long term investor's perspective -- if the company can't earn a high enough return on equity and invested capital to reward shareholders. Bottom line, end of game, all she wrote.

It was my interest in AT&T that brought me around to this. It's the country's largest phone company. It controls the cable lines into 30% of U.S. homes. It's pushing into local phone services and expects to be offering services to nearly 500,000 consumers by year end. It owns AT&T Wireless (NYSE: AWE), one of just six companies with a national wireless footprint, and one of probably three that has the financial strength to become a dominant player.

Is Ma Bell a good investment? I started researching the company in April, when the shares traded around $60 and the company had a market value of $189 billion. I got really interested in early May when it scaled back forecasts for 2000 because of weakness in its long distance business. Its shares fell 14% to $42 and kept sliding.

Now it's at $34 3/8, with a market value of $108 billion. It hasn't traded this low since fall of 1998, when the Asian currency crisis punished the markets. If there was ever an entry point to this stock, this is it. Its PE is less than 20 and it's trading at less than 1.5x book value. My thought when I started thinking about an investment was that the market overreacted. The transition AT&T is undertaking will take years, not months. If I bought shares of the company I wouldn't need to see 500,000 local phone subscribers by January, or even total revenue growth in the 8% to 9% range that Chairman Michael Armstrong has been promising, at least not this year.

Then I came across a conversation with Berkshire Hathaway's (NYSE: BRK.A) Warren Buffet and Charlie Munger in the December issue of Outstanding Investor Digest. A shareholder asked about AT&T and cited the strength of the company's assets. Were Buffet and Munger impressed? They replied that Ma Bell hasn't generated the kind of returns on equity they look for in investments, and that pretty much ended the conversation.

We've used a lot of ink at the Fool writing about return on equity (ROE), return on invested capital (ROIC), and the importance of profitability measures. I hadn't forgotten them. It's just that I'd gotten too focused on AT&T's brand name, collection of assets, and industry position.

So let's take a quick look. How does the company stack up? The answers surprised me.

      Return on    Return on
       Equity*   Total Capital**
1999     7%           8%
1998    26%          21%
1997    19%          26%
1996    31%          40%
1995     1%           1%
* ROE= Net income/average shareholders' equity
**ROIC= Net income+after tax interest expense/Average(total debt+owners' equity)

The returns in prior years were much better than I anticipated, but you can see how they've fallen off since the competitive effects of the Telecom Act of 1996 took hold. Now the company is faced with having to make over $100 billion in cable investments pay off, plus battle competitors from regional bell operating companies like Bell Atlantic (NYSE: BEL) , competitive local exchange carriers like Time Warner Telecom (Nasdaq: TWTC), long distance providers like MCI WorldCom (Nasdaq: WCOM), and data communications providers like Covad (Nasdaq: COVD).

AT&T had to make a move since its long distance business was fading fast, but it's probably a stretch to see the company earning returns above its cost of capital anytime soon, to say the least. As I said, I wouldn't demand instant results from the company. The AT&T turnaround is a long-term project. But I do like to see a more stable record of profitability and AT&T's declining returns woke me up to how fast the sands have shifted in the last five years. If it can boost returns in coming years, will they hit the threshold I want to see, say at least 15% ROE and 15% ROIC? I have no way of knowing and it's probably a long way off considering the size of the company's asset base.

Ratios like ROE and ROIC helped me put the qualitative aspects of AT&T into perspective. They certainly aren't silver bullets. There's not one handle you can grab to locate sure-fire investments, and all the ratios tell you is where a company has been, not where it's going. But for me, in this case at least, I've decided there's too much risk.

You may look and see something different

Have a great day.