Selling Put Options On AT&T Could Produce Substantial Yields With Reduced Risk (NYSE:T)

Last October, we wrote an article titled “AT&T: Pay Yourself 11% With This Bond-Like Exposure“.

In that piece, we talked about AT&T’s (NYSE:T) improving financial picture and attractive valuation, and highlighted a put option trade idea that yielded substantially more (on an annualized basis) than the stock’s dividend at the time.

Since then, our idea has finished at Max Profit, with the stock closing well above our suggested strike price of $14 by mid-December:

This would have netted investors a 1.5% return over the 57 days between our suggestion and the trade’s expiry. While not a particularly substantial return, the trade was designed to deliver that return on capital in a short space of time with a very low level of volatility, which was achieved.

Today, it seems as though T is in a similar position to last October. The company continues to execute on multiple fronts, which makes us generally bullish on the underlying stock, and shares are still trading beneath our Fair Value estimates, which gives us a valuation edge to the upside.

Tactically, we believe selling puts on T once again offers the best balance of risk and reward for investors.

This options strategy has the potential to earn a solid return on capital, and if the stock price dips, it presents the opportunity to buy shares at an improved cost basis.

If you’re looking to boost your income, lower portfolio volatility, or add T stock to your holdings with a better margin of safety, then this might be the perfect fit for you.

Let’s dive in.

AT&T’s Financials

Before we get to the trade idea, let’s first do a quick review of AT&T’s financials, as we haven’t covered them since last October.

In short, the company continues to execute on all fronts. If you remember, AT&T was a sprawling media, tech, and telecom company pre-breakup, but following the WBD spinoff, margins, debt, and growth all appear to be trending in the right direction due to increased focus on the remaining communications segment:

For some context, FY 2019 was the year of peak AT&T ‘gluttony’. In that year, the company produced $181 billion in revenue, $27 billion in operating income, and carried ~$150 billion of long-term debt on its balance sheet.

Over the last twelve months, AT&T has produced $122 billion in revenue, with $31 billion in operating income while carrying ~$126 billion in long term debt.

Since we wrote this, things have only continued to improve.

In the two quarters reported since, EPS and revenues have remained largely stable, with flat EPS and only a slight drop in revenue, which can largely be attributed to regular cyclicality in T’s underlying business:

Revenue growth on the whole has remained stuck in the low-single digit range, but gross profits seem to have stabilized around 60%, which is structurally higher than what T was able to achieve pre-breakup.

On the bottom line, FCF generation has been strong, and TTM FCF continues to trend higher following the trough that was due to the aforementioned corporate action:

Looking ahead, analysts expect AOEPS to grow slightly to $2.44 by the end of 2026, which appears highly achievable to us, due to T’s leaner operating structure, lower net debt, and improving margins:

For their part, management are also bullish on T’s prospects, due to the company’s strong market position, low churn, and straightforward value proposition:

When you look under the hood, it’s clear that our largest and most powerful EBITDA growth engine – mobile – is running well. Our strength and value proposition help us deliver 349,000 postpaid phone net adds in the first quarter. We now have about 71.6 million high value postpaid phone subscribers, which is up 1.5 million from a year ago.

Our results reflect the quality of our customer growth with higher ARPU, higher adjusted operating income, improved margins and lower postpaid churn. We’re also growing efficiently, thanks to our consistent and simple go-to market strategy.

Our postpaid phone churn of 0.72% was our lowest first quarter churn ever on record.

Finally, T’s balance sheet also continues to improve as a result of accelerating delta between the amount of debt issued and the amount of debt repaid on an ongoing basis:

These increased repayments have been covered by T’s improving cash flow.

Overall, T appears to be executing well, and we expect marginal improvements to organic growth and margins over time.

AT&T’s Valuation

But what should AT&T be worth? Are shares a good deal?

Right now, T is trading at roughly 1x sales and 9.3x net income, which are both nominally cheap vs. the S&P 500 as a whole. No doubt this is due to T’s meager growth profile:

That said, when compared with T’s historical valuation, as well as when compared with the sector, the company does appear to be trading at a relative discount.

Zooming out, when you project T’s forward growth and apply historical & model multiples to future results, you get a Fair Value range between $20 and $24 per share, which is above T’s closing price yesterday of $17.24:

We think this is a fair way to value T because it bakes in both the company’s history with the market, as well as a more traditional pricing model that reveals where T ‘should’ be trading (Graham Dodd Formula). When combining these middle points and then projecting them out a year and averaging them, it gives a clear idea of where prices may mean-revert to.

This range indicates that the stock could see material upside in the medium term, should the market continue to re-value the company alongside historical norms. One could also make the case that T deserves an even higher multiple than it has enjoyed historically, due to the increased margins and potential for returns to shareholders.

Overall, we think that getting involved in T at the present moment includes a strong margin of safety.

The Trade

That said, given that the main portion of return for T investors will likely come from T’s generous 6.4% dividend yield, we think that selling put options on the stock is the best way to balance risk and reward.

In case you’re unfamiliar, selling a put option is essentially like selling insurance on the stock.

When you sell a put option, you reserve buying power in your brokerage account, and trade upside appreciation potential for an immediate cash return.

If the stock stays above the put option’s strike price, then you keep the cash premium and get your reserved buying power back.

If the stock drops below the put option’s strike price, then you keep the cash premium, but are forced to use reserved cash to buy the stock.

Either way, you keep the cash premium, which can represent an enticing yield / return on capital for investors.

In this case, we like the October 18th, $17 strike put options:

These options are currently trading for $0.74, which results in a $74 per contract payout to sellers.

Given that each contract requires $1,700 to be ‘fully backed’, this cash represents a 4.55% return over 149 days, which annualizes to roughly 11%.

This is substantially higher than T’s 6.4% dividend payout.

If T’s stock drops beneath $17 by expiry, then an option seller would need to buy shares at $17 in order to satisfy the trade.

However, given that $17 is beneath where shares are currently trading, and that the $74 could be put towards the purchase price (which results in an effective cost basis of $16.26 per share) selling these options could also lead to a ~6% discount on shares vs. where they currently trade in the market, which could be of interest to those seeking to improve their margin of safety.

Finally, because the put is a low-delta option, a swing in T’s share price should lead to a corresponding, but smaller, move in the option price, which should serve to dramatically dampen position volatility within a portfolio.

Between this volatility dampening effect, the potential cost basis improvement, and the strong, annualized ~11% Return on capital, this trade appears to be a win-win for those willing to sacrifice appreciation potential in T.

Risks

There are some risks associated with getting involved in a stock like T.

First, T carries a lot of debt, and while the company’s total debt situation is moving in the right direction, $126 billion in long-term debt will prove to be a hamper on cash flow.

For the longest time, issuing debt to finance Capex made sense, as debt capital costs were lower than equity ones. However, with rates increasing, T’s borrowing and refinancing costs will increase, which could hurt earnings significantly. This is currently ameliorated somewhat by T’s maturity calendar, which has maturities laddered out over the next decade+, but it’s a risk to earnings nonetheless.

Additionally, there are some risks around the option trade we highlighted. If shares collapse overnight for any reason, then option sellers may still be assigned shares at $17, which could lead to a large unrealized loss. This happens even if the stock goes to zero. While this isn’t any different to the risk profile of buying and holding the stock, it deserves to be mentioned.

Summary

With a strong cash return on capital, a fundamentally sound underlying company, and an attractive looking multiple, we think that selling put options on T is a fantastic way to generate income with a low level of risk.

There are some risks to be aware of, but we think that on balance, this trade appears to be a win-win for value and income oriented investors.

Thus, we re-iterate our ‘Buy’ rating on the stock.

Good luck out there!