U.S. telecommunications company AT&T (T -0.60%) has had an eventful year. It shed its entertainment assets to become a pure telecom business and reduced its dividend to help right the financial ship. Wall Street hasn't appreciated the company's efforts yet; the stock is down 10% since January and a painful 40% over the past decade.
Understandably, you might look at such a long streak of poor performance and quickly move on to something else. But if you're willing to put some patience and diligence into this lump of coal, you could get a diamond in 2023 and beyond. Here's why that could happen.
1. Admitting a mistake and moving on
Anyone who's owned AT&T or looked into the stock is probably aware of its disastrous decade throughout the 2010s. The company swung hard on entertainment, spending billions of dollars on DIRECTV and Time Warner and loading itself with debt. Look at how much debt AT&T had accumulated -- it peaked at more than $200 billion with virtually nothing to show for it today!
That's why AT&T's decision to admit its mistakes and return to being a pure telecom company was probably wise. The company sold off DIRECTV, spun off its remaining entertainment assets, and used the proceeds to pay down a chunk of its debt. Furthermore, the company reduced its dividend to free up more cash flow to continue rebuilding its balance sheet. AT&T will do roughly $14 billion in free cash flow this year, which should leave about $6 billion after the dividend to continue paying down debt. AT&T's balance sheet still has a ways to go, but it seems there's a clear path back to long-term financial health.
2. Showing competence in its core business
AT&T's focus on the telecom business means it must successfully position itself in a U.S. wireless market that AT&T, Verizon, and T-Mobile dominate, but competition is fierce between the three. So far, AT&T seems to be doing a good job -- the company has added 1.6 million net postpaid phone additions through the first six months of 2022.
To compare, chief rival Verizon lost 24,000, while T-Mobile added 1.3 million net postpaid phone additions over the same period. AT&T is leading the way in growth and put up a 0.75% churn in the second quarter, the lowest of all three companies.
The success has resulted in management raising wireless revenue guidance for 2022, from 3%+ growth to 4.5% to 5% growth. Two strong quarters are nice, but investors will want to see this trend continue over the back half of 2022 and into 2023. Still, it's nice seeing AT&T's core business perform well soon after making it the company's primary focus.
3. The valuation has become a bargain
Investors probably shouldn't expect much growth out of AT&T. It has historically been an outstanding dividend stock, but the U.S. telecom market is saturated -- just about every American has a smartphone these days, which means that you're competing to steal customers from your peers. Analysts believe the business will grow earnings per share by an average of 3% annually over the next three to five years.
But a cheap stock can be a good value, even if you're not getting much growth from the business. AT&T has traded at a median price-to-earnings ratio (P/E) of 13 over the past decade, which includes the tumultuous years noted earlier. Today, the stock trades at a forward P/E of 6.5, half its long-term norm.
One might argue that AT&T's business fundamentals are the strongest in several years. Its debt load is the lowest since 2017, and its wireless business is performing well. But you don't even need a higher valuation to get a solid return -- if the stock's valuation remains the same indefinitely, 3% earnings growth plus a 6.6% dividend yield can get you almost 10% annual returns. Any boost to the stock's valuation is just icing on the cake. Nobody can guarantee anything, but that seems like a good setup heading into next year.