Warner Bros. Discovery Launches as a Media Powerhouse; AT&T Now Focused on Telecom
Warner Bros. Discovery Launches as a Media Powerhouse; AT&T Now Focused on Telecom
Senior Equity Analyst
Analyst Note| by Neil MackerUpdated Apr 10, 2022
The long-awaited merger between Discovery and WarnerMedia is complete. We are maintaining our narrow moat rating for the successor firm and lowering our fair value estimate to $40 from $42 as we have updated our model to fully incorporate the pro forma results and to forecast the combined firm. For AT&T, we also maintain our narrow moat rating on the standalone telecom firm, with a $25 fair value estimate.
Warner Bros. Discovery is now one of the largest media firms in the world with tremendous scale and reach. The merger has created a firm with tremendous content production and distribution capabilities along with a very deep and wide content library. The new company owns a number of well-known networks including HBO, Discovery, CNN, and TLC as well as a slew of major entertainment franchises like Superman, Rick and Morty, and Game of Thrones. We project that the new company, led by Discovery CEO David Zaslav, will use its combined programming library and production capabilities to drive further growth in its streaming services as it navigates the transition toward a more direct-to-consumer focused model, centered on combined HBO Max/Discovery+ services.
As for AT&T, we believe the firm is in a much stronger place, with renewed management focus and a stronger financial position. We remain optimistic about the wireless business and expect that AT&T and its rivals will compete rationally, allowing for steady, albeit slow, growth and solid cash flow. We also like the firm’s investment plans, which call for aggressive investment in wireless network capacity and the fiber network over the next several years. We expect AT&T will emerge from this period of investment in a unique place within the telecom industry, with the ability to use its combined wireless and fixed-line capabilities to grab market share across a large and growing portion of the U.S.
Business Strategy and Outlook| by Michael HodelUpdated Apr 10, 2022
With the closing of the Warner transaction, we believe AT&T is in a much stronger place within the core telecom business, with renewed management focus, a stronger balance sheet, and rightsized dividend, as well as a clear strategy to invest in its networks. Aggressively extending fiber and 5G coverage to more locations builds on the firm’s core assets—its existing network and customer base—and should allow it to gradually expand its share of telecom spending.
AT&T is the third-largest wireless carrier in the U.S., but we believe it has adequate scale, spectrum, and financial resources relative to both Verizon and T-Mobile to generate solid profitability. Also, we believe the T-Mobile/Sprint merger greatly improved the industry’s structure, leaving three players with little incentive to price irrationally in search of short-term market share gains. Upstart Dish Network could present challenges in some areas, but we don’t believe it presents a credible threat to the traditional wireless business. AT&T is 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. We expect Dish will focus on emerging wireless applications in the enterprise market, an area where AT&T also has a strong presence.
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. The plan to extend fiber to up to 4 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. AT&T expects to reach around 30 million total customer locations with fiber by 2025, covering about half its existing fixed-line footprint, making it the third-largest high-quality fixed-line network in the U.S. (behind Comcast and Charter). We expect AT&T will have the ability to use its combined wireless and fixed-line capabilities to grab market share in this large and growing territory over the next decade.
Economic Moat| by Michael HodelUpdated Apr 10, 2022
AT&T has slimmed down over the past two years, undoing the majority of the strategic moves made during the prior decade. At its peak, we estimate the firm had roughly $450 billion of invested capital employed in the business ($300 billion excluding goodwill). With the conversion of DirecTV into an equity investment and the spinoff of WarnerMedia, invested capital now stands around $330 billion ($250 billion excluding goodwill), with investment in wireless spectrum partially offsetting the divested assets.
We don’t believe AT&T enjoyed material synergies between its telecom and media operations, and we were happy to see these assets split into entities that will have greater strategic flexibility and focus. We award AT&T a narrow moat based primarily on cost advantages within the wireless business. Elements of efficient scale also benefit both the wireless and fixed-line businesses.
The wireless business remains AT&T's most important segment. Returns on capital in wireless have eroded somewhat in recent years as the firm has spent heavily on wireless spectrum. We estimate the wireless business produces a return on capital in 2021 of roughly 9%, or about 11% excluding goodwill, most of which was created through the 2006 consolidation of AT&T Mobility. These figures are down from about 10%/13% in 2018. Over those three years, segment operating income is up 7% cumulatively while the invested capital base has expanded about 20% on nearly $30 billion of spectrum purchases. AT&T spent another $9 billion on spectrum in early 2022, growing the capital base another 5%, and the firm expects to invest around $10 billion deploying that spectrum and licenses acquired in 2021.
We expect that wireless returns will remain ahead of AT&T’s cost of capital. Verizon, AT&T, and the 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 using their own networks provide evidence of efficient scale. Comcast relies on Verizon to support its wireless efforts while Dish will use both the AT&T and T-Mobile networks for several years as it attempts to build a nationwide network, more than a decade after it began assembling a spectrum portfolio.
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. Each of the three major carriers has pledged substantial capital returns to shareholders: AT&T’s new divided totals $8 billion annually, and Verizon’s nearly $11 billion, while T-Mobile has said it can repurchase up to $60 billion of its shares through 2025. To support these returns, each of the carriers as guided investors to expect modest, but steady, revenue growth over the next several years. These actions indicate that none of the carriers is looking to radically disrupt the current pricing structure in the industry and that each will increase prices as needed to offset any cost pressures that emerge.
The fixed-line business services segment is AT&T’s next largest. 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). Business services revenue has sharply and steadily declined in recent years, falling to $24 billion in 2021 from $31 billion five years earlier. Margins in this segment have expanded as AT&T has exited low margin businesses, but profits have also declined (EBITDA was $9 billion 2021 versus $11 billion in 2016). A significant, but undisclosed, amount of legacy business remains and will continue to exert pressure on growth over the next several years, but AT&T has begun to focus its efforts on core network connectivity and services where its assets allow it to deliver unique solutions. Management expects the segment will near stability in 2023 with growth returning thereafter.
AT&T’s last significant business, consumer fixed-line services, doesn’t possess a moat in our view. 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 profitability in the telecom business and AT&T modest level has left returns on capital in the 5% range, by our estimate.
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 versus cable. 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. We expect price competition will remain rational as AT&T’s fiber network grows, as neither AT&T or the cable companies are likely to risk earning less revenue across their existing customer bases over the long term to gain share.
The remainder of AT&T’s business includes the Mexican wireless 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 in the near future.
Fair Value and Profit Drivers| by Michael HodelUpdated Apr 10, 2022
Our AT&T fair value estimate following the Warner spinoff is $25 per share. We continue to expect several of the same trends that have hurt AT&T’s businesses recently will remain in place, yielding modest revenue growth and gradually expanding margins over the next several years.
In wireless, we expect AT&T will again gain market share through 2022 as it reestablishes its market position. We believe postpaid revenue per phone customer, which bottomed in 2018 with the transition to unsubsidized rate plans but has stagnated recently, will remain around $54 per month over the next couple years and then grow modestly thereafter amid a relatively stable competitive environment. We estimate AT&T generates around $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. In total, we expect wireless service revenue will increase 3%-4% annually on average through 2026, with wireless margins holding roughly flat at 2021 levels, as pricing rationalization offsets rising network operating costs.
We expect the consumer broadband business will deliver steadily improving growth as the fiber build gains momentum. We believe this business has an opportunity to sharply increase margins over the next five years as penetration rates increase and the old copper network is decommissioned. We model a 38% segment EBITDA margin in 2026, but this could prove conservative if legacy costs decline precipitously, especially given the absence of television content costs. Cable rivals that don’t have sizable television revenue, like Cable One, can generate EBITDA margins above 50%.
We expect the enterprise services business will gradually return to growth in the coming years with profitability holding steady as cost-cutting balances the loss of higher-margin legacy services. In total, we believe consolidated revenue can grow about 2% annually over the next five years, pro forma for the Warner spinoff. We expect capital spending will roughly match management’s current plan over the next two years (around $24 billion per year, including vendor financing payments) to support the fiber network upgrade and 5G deployment. We believe spending will remain elevated relative to management’s expectations beyond 2023 as the firm continues to expand its fiber network as aggressively as possible.
Risk and Uncertainty| by Michael HodelUpdated Apr 10, 2022
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. We also suspect when large spectrum blocks are made available, such as the 2021 C-band auction, the carriers have felt compelled to bid excessively to keep potential entrants out of the market, especially the cable companies. Alternatively, regulators around the world have used spectrum policies to foster additional competition, a policy the U.S. could follow.
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. Technology could quickly enhance these efforts. While unlikely, in our view, wireless technology could also remove the need for AT&T’s fixed-line networks, killing returns on its fiber investments.
Capital Allocation| by Michael HodelUpdated Apr 10, 2022
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. The state of the balance sheet is the result of several ill-considered acquisitions, poorly timed share repurchases, and an insistence on growing the dividend even as leverage mounted. Management is moving in the right direction, using the Warner 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. The firm then pursued the AWS-3 auction, the DirecTV deal, expansion into Mexico, the Time Warner acquisition, and the recent C-band auction. With leverage nearing 3.2 times EBITDA in early 2021, 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 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. AT&T has sold a stake in the television business, but still has exposure to this declining business. More importantly, as the firm was shifting its strategy, it didn’t invest as aggressively as it should have in its core business. Until recently, the firm had prioritized short-term 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 increased investment to retain customers and has made fiber construction a top priority, which should improve AT&T’s position but will also dent cash flow over at least the next couple years.
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 seemed odd given the territory’s strong ties to the U.S. and AT&T’s presence elsewhere in Latin America. Management has also been less then forthright, in our view, concerning the debt load, using preferred shares, receivables securitization, and vendor financing to cloud its financial picture.
Shareholders have suffered because of AT&T’s choices. The stock has returned only 2% annually over the past 20 years, 3% over the past decade, as a declining share price has partially offset dividends paid. While the telecom industry hasn’t delivered stellar returns in general, with several firms hitting bankruptcy in recent years, AT&T shares have lagged nearly every major U.S. telecom peer over the past decade, including Verizon (7% returns annually), Comcast (14%), Charter (23%), and T-Mobile (23%).