Raise your hand if you've heard that telecom giant AT&T (T -0.59%) stock has been cheap before. Shares have been getting cheaper for years -- Ma Bell's stock price is down 40% over the past decade.
But remember, price is what you pay, and value is what you get. So what do investors get with AT&T? Most know about the company's 6.5% dividend, giving shareholders a solid floor for investment returns.
Can AT&T's business muster the growth to move the share price in the right direction? Here is what you need to know.
Debt reduction could boost earnings growth
AT&T's years of slow and painful declines were warranted. The company spent years and more than $100 billion chasing a colossal shift into media content, a venture that ultimately never panned out. What investors have seen in the share price represents the waste of shareholder money that failed to generate value for the business and bloated its books with debt.
Debt has come down dramatically since management got serious about deleveraging by spinning off its remaining media segment and slashing the dividend to free up cash flow. More work to do is still ahead, but the company's balance sheet is the slimmest it's been in roughly five years.
T Total Long Term Debt (Quarterly) data by YCharts
The most important aspect of paying down debt is the massive amounts of interest AT&T owes yearly. More than $6 billion over the past year has gone to interest payments, nearly 10% of its gross profit. Paying down debt will help more of that $6 billion flow to earnings per share (EPS).
The bar is already low
Indeed, a stock can always go lower, but AT&T's valuation could become low enough that it begins setting a floor for the stock. Today, shares trade at a price-to-earnings ratio (P/E) of just 7, a fraction of the S&P 500's P/E of 18.
Analysts believe AT&T's EPS will average only 3.3% annual growth over the next three to five years, so a significant discount to the S&P 500, which has historically averaged about 10% growth, is warranted.
T PE Ratio (Forward) data by YCharts
But market sentiment could improve as AT&T sheds debt and becomes a healthier business. It's already showing it can still excel at its core business, continually growing its customer base (especially in the wireless segment). As a result, the stock only needs minor earnings growth and for the valuation to stabilize for solid investment returns from here.
In other words, a stagnant valuation and hitting analyst growth estimates could net nearly 10% annual returns when you factor in the stock's dividend. That would seem like a pretty realistic scenario and leave room for additional upside if Wall Street were to begin inching the stock's valuation higher.
One big catch...
No investment is risk-free. In this case, AT&T posted a shocking drop in free cash flow in the first quarter, just $1 billion, down from $2.8 billion last year. That's not even enough to cover its dividend, which costs roughly $2 billion each quarter.
On the earnings call, management chalked it up to seasonality and said it had expected the shortfall. More importantly, it reiterated its full-year guidance for at least $16 billion in free cash flow. Investors should look for cash flow to be much higher over the next few quarters, and it could be a red flag if AT&T doesn't meet this guidance.
As long as free cash flow hits targets, AT&T could finally have let enough air out of the stock to set investors up for a brighter future than its tumultuous past. Consider the stock to have a solid shot at 10% annual investment returns, with the potential for more.
