AT&T's Restructuring Plans Put It on the Right Path Forward
AT&T's Restructuring Plans Put It on the Right Path Forward
Business Strategy and Outlook| by Michael HodelUpdated Aug 05, 2021
We believe AT&T management is now putting the firm on the right path, shedding assets and teaming WarnerMedia with Discovery in a structure that makes strategic sense. The remainder of AT&T will refocus on the telecom business, investing aggressively to extend its fiber and 5G networks to more locations, which we believe will build on the firm’s core strengths.
AT&T is now the third largest wireless carrier in the U.S., but we believe it has adequate scale relative to Verizon and T-Mobile to generate solid profitability. AT&T also benefits from its ownership of deep network infrastructure across much of the U.S. and its ability to provide a range of telecom services, particularly among enterprise customers. The plan to extend fiber to 3 million homes and businesses annually through at least 2025 builds on this position and should allow it to serve those locations directly and enhance wireless coverage in the surrounding areas.
Also, we believe the T-Mobile merger greatly improved the industry’s structure, leaving three players with little incentive to price irrationally in search of short-term market share gains. We don’t believe Dish Network presents a credible threat to the traditional wireless business. AT&T is also positioned to benefit as Dish builds out a wireless network as the firms recently signed a 10-year wholesale agreement that generates revenue for AT&T and gives it access to Dish spectrum.
AT&T shareholders will own 71% of the new Warner Bros. Discovery. Warner remains a media powerhouse in its own right, with a deep content library and the ability to reach audiences across a wide variety of platforms. The firm’s direct-to-consumer plans around HBO Max are gaining momentum, which should nicely augment and eventually supplant traditional distribution channels like cable TV. Adding Discovery’s nonscripted prowess and international presence should give the new firm wider options to craft service offerings. Placing Warner under Discovery management as a stand-alone firm brings focus and the flexibility to pursue a wide array of distribution partnerships.
Economic Moat| by Michael HodelUpdated Aug 05, 2021
AT&T has grown into a behemoth over the past decade through acquisitions and heavy investment in wireless spectrum and other assets. Excluding the impact of recent write-offs, we estimate the firm has roughly $450 billion of invested capital employed in the business, or about $300 billion excluding goodwill. The firm is in the process of restructuring, which will break these assets into several standalone entities, with this effort likely to conclude in 2022. We don’t believe AT&T enjoyed material synergies between its telecom and media operations, and we’re happy to see these assets split into entities that will have greater strategic flexibility and focus.
Looking at AT&T as it currently exists, we award the firm a narrow moat based on the strengths of its individual businesses, based primarily on cost advantages within the wireless business and intangible assets at WarnerMedia. These advantages should enable the firm to maintain relationships with customers and increase free cash flow.
The wireless business remains AT&T's most important segment. We estimate the wireless business produces a return on capital of roughly 10%, or about 12% excluding goodwill, most of which was created through the 2006 consolidation of AT&T Mobility. Returns have dropped steadily over the past five years as investments in wireless spectrum have bloated the capital base. With the cost of C-band spectrum added to the capital base, we estimate wireless ROICs will drop a bit more than one percentage point in 2021, remaining ahead of AT&T's cost of capital.
Verizon, AT&T, and the new T-Mobile dominate the U.S. wireless market, collectively claiming nearly 90% of retail postpaid and prepaid phone customers between them and supplying the network capacity to support most other players. Providing solid nationwide coverage requires heavy fixed investments in wireless spectrum and network infrastructure. While a larger customer base does require incremental investment in network capacity, a significant portion of costs are either fixed or more efficiently absorbed as network utilization reaches optimal levels in more locations.
The benefits of fixed-cost leverage and the difficulty of providing a differentiated wireless offering create an efficient scale advantage in the wireless industry. The massive consolidation across the industry over the past 15 years and the inability of several interested parties, including Dish Network and Comcast, to effectively enter the market thus far using their own networks provide evidence of efficient scale. In addition, we believe the merger between T-Mobile and Sprint reflects both firms' belief that they needed to gain share to earn acceptable returns on capital. T-Mobile's turnaround over the past few years has been impressive, but the firm's share gains on its own were relatively modest. We estimate T-Mobile held 18% of the postpaid phone market immediately prior to the Sprint merger, up from 15% three years prior but still far smaller than AT&T or Verizon (nearly 30% and 40%, respectively). With Sprint in the fold, T-Mobile’s postpaid market share now exceed AT&T’s.
With three sizable players, we don’t expect the carriers will have an incentive to aggressively poach each other’s customers given how painfully slow market share shifts occur in the business. We also expect the high cost of maintaining nationwide coverage and its diminutive size will limit Dish’s ability to compete on a large scale in the traditional wireless business over the long term. AT&T recently inked an agreement with Dish that allows Dish to use the AT&T network and indicates the two firms will work together on network deployments in the future.
While video distribution continues to evolve, WarnerMedia holds a strong competitive position, in our view. The firm owns a deep television and film content library, with a plethora of well-known characters and franchises. With wide distribution globally, this library creates a virtuous cycle: video platforms like traditional cable companies, online distributors, and theater chains have an incentive to work with WarnerMedia, which attracts strong content creators seeking as large an audience as possible.
Prior to its acquisition, Time Warner earned very strong returns on capital, around 30% excluding goodwill. While we expect WarnerMedia will remain a strong competitor well into the future, the issue for AT&T shareholders is the price paid to acquire the business, which totaled more than four times Time Warner’s invested capital base, again excluding goodwill. All else equal, we’d expect AT&T to earn roughly its cost of capital on this acquisition, with future growth offset in part by the increase in competition for content resulting from the rise of Netflix and other new platforms. The decision to spin this business off and merge it with Discovery adds additional content breadth and international distribution capabilities to WarnerMedia, which should strengthen its market position.
With the decision to sell a stake in the traditional television business (DirecTV), AT&T has split its entertainment segment into two parts: television and consumer broadband. We don’t believe either segment possesses a moat. The majority of the television business stems from the $63 billion DirecTV acquisition. Before the 2015 acquisition, DirecTV was an exceptionally profitable company with a challenging long-term future. The firm's collection of satellites is exceptionally efficient at delivering linear television service. ROICs were typically around 40% in the years leading up to the deal (high 20s with goodwill).
An increasing number of consumers are choosing Internet-based alternatives to traditional television services. In the years since the deal closed, AT&T has lost nearly 40% of its traditional television customer base (DirecTV satellite customers and AT&T’s own U-verse subscribers). AT&T has sharply curtailed promotions and increased pricing on its television offerings, which has accelerated customer losses in the face of stiff competition from online players like YouTube TV and Hulu with Live TV. With TPG taking a 30% stake in the television business, we suspect the private equity firm has a strong incentive to quickly find a strategic alternative for DirecTV. In the meantime, the TPG deal was structured to ensure AT&T is able to wring cash out of DirecTV over the next few years.
We estimate AT&T’s consumer fixed-line networks reach around 55 million homes, or a bit less than half of the U.S. population. This business is challenged competitively across most of this footprint thanks to inferior networks relative to cable competitors. About 25% of the homes in this service territory subscribe to AT&T’s Internet access service, around half the penetration level Comcast claims. The gap between AT&T and its cable rivals has steadily widened over the past several years. Customer penetration is critical to driving returns on capital in the telecom business. AT&T has upgraded about a quarter of its residential footprint to a fiber-to-the-premises network, which provides a much stronger competitive position. The firm plans to expand the FTTP network aggressively over the next few years, but it has a long way to go on this effort.
Fixed-line business services is AT&T’s remaining significant segment. We believe this operation holds a solid competitive position in a consolidating market. AT&T is one of only a handful of companies capable of providing complex communications services to business customers with geographically diverse needs. We roughly estimate this segment earns 10%-15% ROICs excluding goodwill. AT&T’s most recent major acquisition in this area was the 2005 purchase of the legacy AT&T long-distance business.
The remainder of AT&T’s business includes the Mexican wireless business and the Latin American satellite television operation. The firm has agreed to sell the satellite television business. We don’t believe the Mexican business has a moat, operating at a fraction of the scale of market leader America Movil. We wouldn’t be surprised if AT&T sold the Mexican wireless business as well.
Fair Value and Profit Drivers| by Michael HodelUpdated Aug 05, 2021
Our $36 fair value estimate excludes DirecTV results beyond 2021, instead including the cash we expect AT&T will realize from its venture with TPG. We continue to include WarnerMedia in its current form. We expect several of the same trends that have hit AT&T’s businesses recently will remain in place, yielding modest wireless revenue growth, despite increased network capacity, while heavy content investment pressures WarnerMedia’s profitability.
In wireless, we expect AT&T will modestly gain market share over the next two years as it reestablishes its market position with heavy promotions that will gradually subside. We believe postpaid revenue per phone customer, which bottomed in 2018 with the transition to unsubsidized rate plans wrapping up, will grow modestly over the next several years amid a relatively stable competitive environment. We estimate AT&T generates a bit less than $1 billion in revenue annually from connected devices, such as cars. We model this revenue roughly tripling over the next five years as things like edge computing gain adoption, but this estimate is highly uncertain. We expect wireless service revenue will increase 4% annually on average through 2025, with wireless margins declining modestly over this period, as pricing rationalization partially offsets rising network operating costs.
At WarnerMedia, we expect a 14% rebound in revenue during 2021 with 4% average annual growth through 2025 after that. We model growth, absent the rebound from the pandemic, holding fairly steady as HBO Max gains acceptance and offsets weakness in the traditional television business. We don’t have high expectations for the advertising business over the long term, as consumer behavior shifts away from ad-supported formats reduces inventory, offset only in part by stronger pricing. We also expect that increased investments in content required to fend off newer entrants will pressure margins.
We expect the consumer broadband business will deliver steadily improving growth as the fiber build gains momentum. We also expect the enterprise services business can gradually return to growth in the coming years. In total, we believe consolidated revenue can grow about 3% annually over the next five years, excluding the impact of the partially divested television business. We expect AT&T will produce modest consolidated EBITDA margin expansion, with capital spending increasing to support the fiber network upgrade and 5G expansion.
Risk and Uncertainty| by Michael HodelUpdated Aug 05, 2021
The primary uncertainties facing AT&T center around regulation and technological change. Regulatory scrutiny reflects the major ESG risk facing the firm. Wireless and broadband services are often considered necessary for social inclusion, both in terms of employment and education. If AT&T’s services are deemed insufficient or overpriced, especially if in response to weak competition, regulators or politicians could step in. The firm is also still responsible for providing fixed-line phone service to millions of homes across the U.S., including many in small towns and rural areas. The firm could be compelled to invest more in rural markets even if economic returns are insufficient. Wireless technology may enable the firm to serve small-market customers more efficiently, but it would also open the doors to greater competition.
Regulators also control the flow of wireless spectrum into the industry, which has created scarcity in the past, pushing carriers to pay high prices for licenses. Alternatively, regulators around the world have used spectrum policies to foster additional competition.
AT&T’s plan to divest WarnerMedia and merge the business with Discovery creates additional uncertainty. We believe the proposed transaction alleviates an ESG risk in that it eliminates the vertical integration between AT&T’s core telecom business and the media business, particularly CNN. Regulators could still reject the deal on the grounds that it increases media concentration overall, though.
On the technology front, wireless standards continue to evolve, putting more spectrum to use more efficiently. The cost to deploy wireless networks could come down to the point where numerous new firms are able to enter the market. The cable companies are already making serious attempts to leverage their existing networks to provide limited wireless coverage using Wi-Fi. Technology could quickly enhance these efforts. Technology has also dramatically altered the media and television industry.
Capital Allocation| by Michael HodelUpdated Aug 05, 2021
We believe recent capital-allocation decisions have destroyed shareholder value and that the firm will pay the price for these missteps for some time to come. As a result, we rate the firm’s capital allocation as poor. This assessment stems from our view that a relatively weak balance sheet has hindered AT&T's strategic flexibility and wiliness to invest aggressively in the business when needed. Management is moving in the right direction, using the planned WarnerMedia spin off to shift to a dividend policy that better supports needed investment, but AT&T is still playing catch up. It will need to invest aggressively for the next several years to make its fixed-line network competitive and it still doesn’t expect to get debt leverage below targeted levels until the end of 2023.
The firm’s run of heavy capital deployment began in 2012 with a massive share-repurchase program that, at the time, was billed as a temporary move away from AT&T’s 1.5 times net debt/EBITDA leverage target. The firm repurchased $27 billion of its shares through 2014 at prices per share in the mid-$30 range, pushing leverage to 1.8 times. That activity reduced balance sheet flexibility as the firm subsequently pursued the AWS-3 auction, the DirecTV deal, expansion into Mexico, the Time Warner acquisition, and the recent C-band auction. With leverage now around 3.2 times EBITDA, AT&T’s capital structure simply didn’t line up well with a large dividend payout. Yet management explicitly expressed support for the prior dividend until immediately before changing direction, catching long-suffering investors off guard.
These capital forays have not only left AT&T with a weaker balance sheet, they also left the firm in a weaker competitive position overall, in our view. With 2015’s DirecTV purchase, AT&T acquired a satellite TV business that was, at best, peaking in maturity. The firm also hasn’t invested as aggressively as it should have in its business. Until recently, the firm had prioritized margins over maintaining wireless market share, allowing T-Mobile to steadily steal customers. In addition, AT&T has only begrudgingly invested to expand its fiber optic network in the past. New CEO John Stankey has made fiber construction a top priority, but AT&T only plans to upgrade around 3 million locations per year, equal to about 5% of its footprint. Expanding fiber is key to not only stabilizing the consumer broadband business but also providing a network edge in wireless and bringing high quality service to more business customers as they adopt 5G.
In 2015, the firm spent $18 billion at the AWS-3 auction, equating to an unprecedented price/MHz-POP (a common measure of spectrum capacity and usefulness). Dish Network was a heavy bidder in that auction, and AT&T may have pushed prices higher to stall this would-be competitor. However, we don’t believe AT&T has anything to fear from Dish, and we think this capital would have been better spent elsewhere. While valuations in the C-band auction were more reasonable, with a much larger amount of spectrum up for sale, AT&T likely could have secured spectrum more cheaply prior to the auction if it hadn’t been tied up with other initiatives and debt repayment.
AT&T has placed a priority on debt reduction since the Time Warner merger closed, using asset sales as a part of this effort. Not all these sales have made strategic sense, in our view. For example, the sale of its wireless assets in Puerto Rico seems odd given the territory’s strong ties to the U.S. and AT&T’s presence elsewhere in Latin America. Management’s continued emphasis on debt reduction could push the firm to make additional questionable assets sales.