Analyst Note| by Michael HodelUpdated Apr 20, 2023
We suspect two things are weighing on AT&T shares after the company released first-quarter results: weak free cash flow and slower wireless customer growth. We don’t believe either is a cause for concern, and we are maintaining our $25 fair value estimate.
AT&T generated $1 billion of free cash flow, per management’s definition, down from $2.8 billion in the year-ago quarter and well short of the pace needed to hit management’s $16 billion expectation for the year. In our view, the underlying business performed well during the first quarter, with services revenue increasing 2.6% and margins expanding in the wireless and consumer broadband businesses. However, a large repayment of payables and a modest uptick in capital spending hit cash flow. AT&T indicated last quarter that cash flow would be heavily weighted to the back half of 2023, which is normal for the firm, but the magnitude of the movement in working capital is unusual. Management remains resolute that working capital will even out over the course of the year and that it will hit or surpass its free cash flow target.
Net postpaid phone customer additions totaled 424,000 during the quarter, down from 691,000 a year ago and the slowest pace in nearly three years. Customer retention remains strong, with the rate of customer defections (churn) up very slightly versus a year ago. AT&T isn’t attracting new customers as quickly, likely reflecting a slowdown in industry growth, but we also suspect the firm is losing some ground to competitors, especially the cable companies.
After years of mismanagement of expectations around free cash flow, including a cut to management’s forecast last year, we understand investors' skepticism. However, we believe investors should focus more on AT&T's investments in its networks. We prefer the firm’s focus on building long-term customer relationships over offering deep service pricing discounts to attract accounts.
Business Strategy and Outlook| by Michael HodelUpdated Apr 20, 2023
We believe AT&T's strategy to invest heavily in its networks makes sense and will serve investors well over the long term. Aggressively extending fiber and 5G coverage to more locations builds on its core assets—its existing network and customer relationships—and should allow AT&T to gradually expand its share of telecom spending.
AT&T is the third-largest wireless carrier in the United States, 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 industry’s structure has improved in recent years, with three major players that have little incentive to price irrationally in search of short-term market share gains. We expect the industry will gradually reach competitive balance as each carrier deploys 5G technology on deep midband spectrum holdings and crafts pricing strategies that appeal to each market segment.
Upstart Dish Network could present challenges in some areas, but we don’t believe it presents a credible threat to the traditional wireless business. Also, AT&T and Dish have a wholesale relationship that should allow AT&T to participate in Dish's growth. 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 firm plans to extend fiber to 30 million homes and businesses by the end of 2025, up from 22 million today, and has formed a joint venture with BlackRock to expand into new areas. These efforts should allow the company to serve these locations extremely well while also enhancing wireless coverage in the surrounding areas. If the firm hits its targets, it would be the third-largest high-quality fixed-line network in the U.S. (behind Comcast and Charter) and the only of the three to also own a nationwide wireless network. 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 20, 2023
Wireless is AT&T's most important business. Returns on capital in wireless have eroded somewhat in recent years as the firm has spent heavily on wireless spectrum and invested to put that spectrum to use. We estimate the wireless business produced a return on capital in 2022 of roughly 8%, or about 10% excluding goodwill, modestly above our estimate of the firm’s cost of capital. These figures are down from about 10% and 12% in 2018. Over those four years, segment operating income is up 13% cumulatively while the invested capital base has expanded about 30%, primarily on $40 billion of spectrum purchases.
We expect that wireless returns will remain ahead of AT&T’s cost of capital. Verizon, AT&T, and 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 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 dividend 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 has 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.
Fixed-line enterprise services is AT&T’s next-largest 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% returns on invested capital 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 steadily declined in recent years, falling to less than $23 billion in 2022 from $29 billion five years earlier. Margins in this segment have held steady, but profits have also declined (EBITDA was less than $9 billion 2022 versus $11 billion in 2017). 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’s modest level has left returns on capital around 5%, by our estimate.
AT&T has upgraded about one third 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 20, 2023
Our $25 fair value estimate assumes that AT&T will deliver modest revenue growth and gradually expanding margins over the next several years as its wireless and fiber network investments pay off. Our fair value estimate implies an enterprise value of 8.0 times our 2023 EBITDA estimate and a 7% free cash flow yield.
In wireless, we expect AT&T will slowly gain market share over the next few years, though the near term could prove bumpy as the cable companies continue working to establish their wireless businesses. We believe postpaid revenue per phone customer will grow modestly amid a relatively stable competitive environment, hitting $60 per month in 2027 versus $55 in 2022. We estimate AT&T generates around $2 billion in revenue annually from connected devices, such as cars. We model this revenue roughly doubling 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 2027, with wireless EBITDA margins holding in the low 40s, as cost-efficiency efforts and benefits from slower customer growth offset rising network operating costs.
We expect the consumer broadband business will deliver steadily improving growth as the fiber network buildout matures. 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 35% segment EBITDA margin in 2027, 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. AT&T hasn’t provided much detail surrounding the enterprise business, making it more difficult to forecast future results. The firm has said previously that EBITDA in this segment will likely decline steadily until sometime in 2024. We suspect a large portion of the enterprise business will look similar to the consumer fixed-line business over the longer term, primarily providing basic connectivity and earning attractive margins. AT&T should benefit as fixed-line and wireless services converge, providing opportunities to create, deliver, and manage more complex offerings.
In total, we believe consolidated revenue can grow 2%-3% annually over the next five years. We expect capital spending will roughly match management’s current plan in 2023 (around $24 billion, including vendor financing payments) to support the fiber network upgrade and 5G deployment. The firm expects capital spending will decline sharply beyond 2023 but hasn’t provided a budget, likely to maintain flexibility to pursue growth opportunities. We expect that wireless network spending will decline in 2024 and beyond but that the firm will continue investing heavily in fiber, holding spending around $22 billion annually through 2027.
Risk and Uncertainty| by Michael HodelUpdated Apr 20, 2023
We have changed our Morningstar Uncertainty Rating to Medium from High to better reflect the volatility we expect AT&T investors will face relative to our global coverage. Regulation and technological change are the primary uncertainties facing AT&T. Wireless and broadband services are often considered necessary for social inclusion, 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 services to millions of homes across the U.S., including many in small towns and rural areas. It could be compelled to invest more in rural markets even if economic returns are insufficient.
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. Regulators around the world have used spectrum policies to foster additional competition, a strategy 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 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 20, 2023
We believe recent capital allocation decisions have destroyed shareholder value and the firm will pay the price for these missteps for some time to come. As a result, we assign AT&T a Morningstar Capital Allocation Rating of Poor. This assessment stems from our view that a relatively weak balance sheet has hindered AT&T's strategic flexibility and willingness 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 increasing the dividend even as leverage mounted. Management is moving in the right direction, using the Warner spinoff 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 doesn’t expect to get debt leverage below targeted levels until the end of 2023. With cash flow expectations coming down recently, we wouldn't be surprised if management pushes its targeted leverage date further out.
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-$30s, 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, it 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 of 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 than 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 returned only 2% annually over the 20 years leading up to the Warner spinoff and 3% over the previous 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's shares lagged those of nearly every major U.S. telecom peer over that prior decade, including Verizon (7% returns annually), Comcast (14%), Charter (23%), and T-Mobile (23%).