July 2, 2022

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AT&T: New Standalone Company, Same Structural Risks; Avoid (NYSE:T)

AT&T: New Standalone Company, Same Structural Risks; Avoid (NYSE:T)

Morsa Images/DigitalVision via Getty Images

Introduction

We review AT&T Inc. (NYSE:T) based on developments in the last few months. Since our last update in January, AT&T has spun off Warner Media, set out new guidance for the standalone company, and released Q1 2022 results. The macro environment has worsened significantly, with record inflation and fears about consumer spending.

We initiated a Hold rating on AT&T in July 2021, expressing our view that shares should be avoided. Since then, including the value of dividends and Warner Brother Discovery (WBD) shares received, T shares have lost either 2.7% or 10.6%, depending on whether an investor has sold the WBD shares immediately or kept them:

AT&T Share Performance (Since 02-Jul-21)

Source: Google Finance and company websites.

AT&T Share Performance (Since 02-Jul-21)

Librarian Capital Rating History vs. AT&T Share Price (Last Year)

Librarian Capital Rating History vs. AT&T Share Price (Last Year)

Source: Seeking Alpha (11-Jun-22).

AT&T’s share price has risen 14% since the spin-off on April 8, and are currently trading at a P/E of 8.5x, a Free Cash Flow (“FCF”) Yield of 10.2% and a Dividend Yield of 5.4%. However, we continue to be cautious about the long-term structural challenges in the business, and reiterate our Hold rating.

New AT&T & Financial Outlook

The new AT&T today generates more than two-thirds of its segmental EBITDA from its Mobility segment, while Business Wireline and Consumer Wireline contributed 21% and 9% of segmental EBITDA, respectively.

AT&T Revenues & EBITDA by Segment (2021)

AT&T Revenues & EBITDA by Segment (2021)

Source: AT&T company filings.

NB. Negative EBITDA figures in corporate & other not shown.

In addition, AT&T holds a 70% economic interest in DirecTV (with the other 30% held by private equity firm TPG) and receives cash dividends each year (including approx. $4bn expected in 2022).

Management has set up their outlook for the next two years at AT&T’s investor day in March. Adjusted EBITDA is expected to grow by approx. 10% between 2021 and 2023, driven by a low-single-digit growth in Wireless Service revenue and a mid-to-high-single-digit growth in Broadband revenue. FCF is expected to first fall to $16bn in 2022 before rebounding to $20bn in 2023, compared to $19.2bn in 2020:

AT&T Revenues & EBITDA by Segment (2021)

AT&T Revenues & EBITDA by Segment (2021)

Source: AT&T investor day presentation (Mar-22).

2022 and 2023 FCF expectations are after $24bn of CapEx each year, which is expected to “begin tapering down to around $20bn” “starting in 2024”. 2022 EBITDA is expected to be burdened by a $600m hit from peak 3G shutdown costs and the absence of Connect America Fund Phase II (“CAF II”) credits.

AT&T expects EBITDA growth to be positive in Mobility and Consumer Wireline, but negative in Business Wireline:

2022

2023

Mobility

growth

low-single-digit growth

Consumer Wireline

mid-single-digit growth

Business Wireline

mid-single-digit decline

low-single-digit growth

Revenue growth is expected to contribute a minority of AT&T’s FCF growth in 2022-23. Approx. one-third of gross FCF growth (and half of EBITDA growth) is expected to come from cost savings (to start flowing to the bottom line in H2 2022), while lower cash interest (from deleveraging) and working capital together will contribute more than organic growth:

AT&T FCF Bridges (2021-23)

AT&T FCF Bridges (2021-23)

Source: AT&T investor day presentation (Mar-22).

While the deleveraging and cost savings parts of AT&T’s expected FCF growth are likely achievable, we are much more cautious about its ability to sustain organic growth, beyond 2023 or even during 2022-23 itself.

AT&T’s Structural Problems

Our longstanding caution on AT&T stems from what we consider structural problems in its businesses:

  • Mobility operates in a commoditizing market, with low revenue and EBITDA growth, despite large volume growth, and faces an increasing threat from Mobile Virtual Network Operator (“MVNO”) businesses at U.S. Cable players
  • Consumer Wireline is only partially upgraded to fiber and is still losing subscribers to U.S. Cable; EBITDA has hit a lower plateau in 2021 after an effective price cut, when AT&T added HBO Max to its Internet bundle
  • Business Wireline is in structural decline, due to losses in legacy services as well as market share gains by U.S. Cable among SMB customers

Evidence for these were again visible in Q1 2022 results released in April.

Q1 2022 Saw Another EBITDA Decline

In Q1 2022, AT&T’s Communications group, which is substantially the new AT&T today, reported a year-on-year EBITDA decline of 2.9%, or 0.3% excluding one-offs (comparison with Q4 is not meaningful due to seasonality):

AT&T EBITDA by Segment (Q1 2022 vs. Prior Periods)

AT&T EBITDA by Segment (Q1 2022 vs. Prior Periods)

Source: AT&T results supplement (Q1 2022).

NB. Q1 2022 other one-offs included absence of FirstNet and CAF II reimbursements.

We review each business in Communications in more detail below.

Mobility: Chasing Volume Before Profits

The Mobility segment reported a year-on-year EBITDA decline of 1.8%, or growth of 1.9% excluding one-offs:

AT&T Mobility P&L and KPIs (Q1 2022 vs. Prior Periods)

AT&T Mobility P&L and KPIs (Q1 2022 vs. Prior Periods)

Source: AT&T results supplement (Q1 2022).

(The EBITDA growth from Q4 2021 was seasonal; Q2 Mobility EBITDA also grew sequentially by 11.9% in 2021 and by 5.4% in 2020, in both cases followed by sequential declines in the two quarters after.)

AT&T appeared to have again prioritized volume over profit. Total Subscribers & Connections rose 5.6% year-on-year, and Postpaid Phone subscribers rose 4.8%, the latter being AT&T’s best Q1 in more than a decade. However, Average Revenue Per User (“ARPU”) fell 0.2% year-on-year (and 0.1% sequentially), and Operations & Support costs rose much faster than revenues, resulting in a mediocre 1.9% EBITDA growth (excluding one-offs).

While AT&T’s Postpaid Phone net adds of 691k in Q1 2022 were approx. 100k better year-on-year, Verizon (VZ) and its two MVNO partners (Comcast (CMCSA) and Charter (CHTR)) together had net adds of 655k, 255k better year-on-year. (Total net adds among the top 5 players were basically flat year-on-year, with T-Mobile (TMUS) losing share.)

Wireless Postpaid Phone Net Adds – Key Players (Since 2019)

Wireless Postpaid Phone Net Adds - Key Players (Since 2019)

Source: Company filings.

NB. AT&T Q1 2022 figure excludes 400k loss from 3G shutdown.

AT&T also acknowledged that 300k of its Q1 net adds came from FirstNet, the network it runs for first responders, and that it benefited from T-Mobile’s shutdown of its legacy Sprint CDMA network.

AT&T’s ARPU has been trending down since Q1 2020, unlike Verizon, which has kept its APRU growing/stable. Verizon’s ARPU rose slightly (by 0.4%) year-on-year this quarter, with a 2.2% increase in Average Revenue Per Account being offset by a similar increase in average connections per accounts.

Verizon’s ARPU has continued to grow since early 2020, while AT&T has intentionally sacrificed ARPU to gain volume:

Wireless Retail Postpaid ARPU – AT&T vs. Verizon (Since 2019)

Wireless Retail Postpaid ARPU - AT&T vs. Verizon

Source: Company filings.

Management stated (at the time of Q1 2022 results) they expect Mobility EBITDA’s trajectory “to improve through the course of the year” as one-off costs moderate. We remain sceptical about the business.

AT&T has reportedly stopped offering free HBO Max subscriptions to new subscribers of its premium unlimited packages in June. HBO Max bundling has been cited as a key attraction of such packages, as well as a material factor behind EBITDA margin decline, since H2 2020. This is a sensible move in our view but may mean slower future growth.

Consumer Wireline: Improving Only Slowly

The Consumer Wireline segment reported year-on-year growth of 2.0% in revenues and 1.3% in EBITDA:

AT&T Consumer Wireline P&L and KPIs (Q1 2022 vs. Prior Periods)

AT&T Consumer Wireline P&L and KPIs (Q1 2022 vs. Prior Periods)

Source: AT&T results supplement (Q1 2022).

The 9.3% jump in EBITDA from Q4 2021 is not necessarily meaningful, as Q4 was impacted by one-off network costs from storms. (Sequentially, revenues only grew 0.1% but costs fell.)

AT&T has stopped disclosing DSL subscriber losses (they were 19k in Q4 2021). Excluding DSL, total connections grew 5k sequentially, with fiber net adds almost entirely offset by non-fiber net losses, continuing a longstanding pattern:

AT&T Consumer Wireline Net Adds (Since 2019)

AT&T Consumer Wireline Net Adds (Since 2019)

Source: AT&T company filings.

NB. Q2 2020 net adds include 104k (28k fiber) “Keep Americans Connected” accounts.

While replacing non-fiber connections with fiber will have a positive impact, this has so far only produced a marginal benefit for Consumer Wireline EBITDA (which were anyway only 9% of group segment EBITDA).

One reason is that a substantial part of the customer base remains to be upgraded – fiber revenues were just “nearly half” of Consumer Wireline broadband revenues in Q1; non-fiber connections (excluding DSL) still outnumbered fiber connections by 20%.

Another reason is strong competition from U.S. Cable operators, who have continued to see positive broadband net adds. AT&T’s penetration across its entire fiber footprint (including new build) was 37% at 2021 year-end, including average 1-year penetration rate of “almost 24%”. (Total fiber connections were at 16.2m at 2021 year-end and 14.4m at 2020 year-end.). By comparison, Charter and Comcast had broadband penetrations of 55% and 53% respectively in their footprints at 2021 year-end.

AT&T has also lowered the competitive intensity of its fiber pricing in Q1, removing discounted introductory pricing. Management stated that “in many cases” AT&T fiber is now “at a minimum of $10 higher” than promotional prices offered by U.S. Cable or other broadband providers.

We expect Consumer Wireline EBITDA growth to remain modest in the future.

Business Wireline: EBITDA Still Falling

Business Wireline EBITDA fell 1.6% sequentially and 8.5% year-on-year in Q1 2022, continuing its long-term decline, made worse by the impact on public sector demand from the delay in Congress passing the U.S. federal budget:

AT&T Business Wireline EBITDA (Since 2019)

AT&T Business Wireline EBITDA (Since 2019)

Source: AT&T company filings.

Management expects Business Wireline EBITDA to fall by mid-single-digits in 2022 and low-single-digits in 2021.

Worsening Macro Environment

The macro environment has worsened significantly since Russia invaded Ukraine on February 24, with record inflation and fears about consumer spending.

AT&T CEO John Stankey, appearing at a J.P. Morgan (JPM) investor conference on May 23, observed early signs of consumer spending weakness and predicted a “pressured economy in 2023”

“In the demand side, I’m not seeing any softening right now … But we are seeing … [bad debt] collection levels get back to pre-pandemic levels … I would say that the consumer in the low end of the market is definitely stressed in making choices … And I think that’s an early sign [of] … what’s probably going to be a pressured economy in 2023”

Stankey declared that AT&T may need a revised 2023 plan that “relooked on investment levels in certain places”, with the parts of the business “driven by customer activity in volume and growth” perhaps “to be “tempered a bit”. He also expected management to have to look at further cost savings.

Poor Capital Allocation (Again)

AT&T management has a poor record in capital allocation, with value-destroying acquisitions such as DirecTV ($67bn) and TimeWarner ($109bn). This may happen again.

For the moment, AT&T is focused on lowering its Net Debt / EBITDA to 2.5x by 2023 year-end. However, management also wants to compete with other companies on AT&T’s Dividend Yield:

“I want the dividend to remain at a competitive level relative to others out in the market, which means I’ll pay attention to the yield of the dividend.”

John Stankey, AT&T CEO (Q1 2022 earnings call)

This is misguided. The Dividend Yield would automatically fall if the share price were to rise – to target it implies management would either try to stop the shares from rising, or raise the dividend irrespective of circumstances to offset any share price increases. The focus on dividends itself is also misguided, given the supposed high Return on Capital for AT&T’s fiber expansion.

We believe share repurchases may be a much better use of capital, but these will just be one of the choices the AT&T will consider.

Management has started signalling that AT&T will be investing in assets outside its core connectivity competency, perhaps even returning to the acquisition trail:

“While we like the durability of our asset-intensive products, we desire a better balance of revenues and profits that are generated from more flexible and asset-light approaches that software brings … We’re not talking about transformative M&A here.”

John Stankey, AT&T CEO (2022 investor day)

Decisions are expected to be made in 2023, after AT&T has completed its planned deleveraging and with CapEx expected to fall back to a more normal level.

AT&T Dividend Yield and Valuation

With shares at $20.69, relative to the mid-point of management 2022 guidance, AT&T stock is trading at an 8.5x P/E and a 10.2% FCF Yield:

AT&T Valuation Metrics (2022E)

AT&T Valuation Metrics (2022E)

Source: AT&T company filings.

The dividend is $0.2775 per quarter ($1.11 annualized), implying a Dividend Yield of 5.4%.

While these metrics appear superficially attractive, we believe they are outweighed by the risks from the long-term challenges in AT&T’s businesses.

Is AT&T Stock A Buy Now? Conclusion

AT&T’s risks outweigh its superficially cheap valuation, and we reiterate our Holding rating.