Written by Luke Poling (reach out to ryan@investingcity.org if interested in contacting Luke)
Thesis
AT&T pays investors to wait for upside. The company provides a safe, yet bountiful 7% yield while also having significant potential upside as the Time Warner acquisition begins a new era of growth.
History
Alexander Graham Bell invented the telephone in 1876. AT&T can trace its roots back to this incredible event as the American Telephone and Telegraph Company (AT&T) acquired the Bell Company on December 31, 1899. After a series of acquisitions, AT&T had a monopoly authorized by the government. The name for the new monopoly was Bell Systems. This lasted until 1982 when the antitrust division of the DOJ broke up the party. In essence, the company was divided from one massive national (and international) company into regional companies known as Baby Bells, and AT&T retained the long-distance portion of the business.
Through a sequence of acquisitions, AT&T grew to the company everyone knows today. It began in 2005 when a Baby Bell, SBC, acquired AT&T and rebranded under the AT&T name due to its brand recognition. In 2006 the new company completed its acquisition of Cingular Wireless and began the journey to wireless internet. In 2013 AT&T acquired cricket wireless to bring mobile internet to prepaid customers, and in 2015 the company bought lusacell and Nextel Mexico in order to bring their services to Mexico. 2015 was a busy year for the company as they also acquired DIRECTV putting AT&T in the lead worldwide for paid TV providers. Recently, on October 22, 2016, AT&T announced a deal to buy Time Warner that would undergo legal problems until the US justice department approved the merger on June 12, 2018. Three months later, the company was divided into four business segments discussed below.
Segments
AT&T has four segments: Communications, Warner Media, Latin America, and Xandr. It is important to note that although the numbers below are from the 2019 annual report, they may not add up to 100% due to rounding errors, corporate and other revenue, eliminations and consolidations. In order to understand the percentages below, note that total revenue for 2019 was $181 billion, and operating income was $28 billion.
Communications Segment
Communications is the largest segment and accounts for 78.6% of revenue. The division was down 0.9% in 2019 and contributed 76% of the 2019 operating income as compared to 84% in 2018. Clearly, this is the largest and most important segment of the company's business.
The communications segment has three significant subdivisions – Mobility, Entertainment Group, and Business Wireline. Mobility provides nationwide wireless service and equipment. This is the mobile phone part of the business. Entertainment Group provides video, including over-the-top (OTT) (over-the-top refers to video services that give consumers access via the internet such as Netflix or Hulu) services, broadband, and voice communications services to residential customers. Essentially, this segment is providing wired services to homes. This includes internet, TV, and home phones. Finally, Business Wireline provides advanced IP-based services, as well as traditional voice and data services to business customers.
When people think of AT&T, these three subdivisions are what they have in their minds. Cell coverage, business telephone lines, and other broadband TV and voice services. In recent years this business has seen a slight decline, which is why AT&T has been investing in other areas. Consumers have many more options to communicate with each other and get entertainment content today and are less reliant on traditional telecom options. This segment has seen declines in the last couple of years, but the 5G rollout is a bright spot that could lead to growth in the next three years.
Warner Media
Warner Media provided 18.5% of revenue and grew 76.9%. This growth is not very helpful because the most prominent factor here is simply the annualization of the segment. Annualization means that 2019 is the first year the acquisition is fully reflected in AT&T's financial numbers. The segment contributed 22% of the total 2019 total operating income compared to 15% in 2018 (again impacted by annualization). Warner Media also has three business units: Turner, Home Box Office, and Warner Bros. Turner is primarily a multichannel basic television network. Revenue is generated by selling advertising on these basic channels. Home Box Office (HBO) consists of premium pay television, OTT, and streaming services, as well as content licensing. This means that HBO earns money selling premium content themselves, and also licenses content to other distributors. The Warner Bros. business unit is responsible for the production, distribution, and licensing of television programming and feature films, the distribution of home entertainment products, and the production and distribution of games. Warner Bros is the true box office arm of Warner Media. Warner Brothers is responsible for six movies that have made over a billion dollars in the box office, including Joker, The Dark Knight Rises, and even a Harry Potter film.
This segment is the key to AT&T's future. They took a big bet on the importance of original content. Their communications segment was losing to the OTT model, and this acquisition puts them in the heart of the OTT battle. Investors need to consider two key questions. How much synergy is there between AT&T's primary business and this segment? Will AT&T customers successfully be converted into paying HBO customers and vice versa? If AT&T is to see organic growth in the next five years, this will be the key to watch.
Latin America and Xander
Revenue from the Latin America segment comprised 3.8% of revenue and shrank 9%.
Xandr's share of Operating Revenue was 1.1% and had revenue growth of 16.2%. In both 2018 and 2019, Xandr contributed about 3% to operating income. Xandr's primary function is to provide advertising services. Their services utilize data insights to develop and deliver targeted advertising across video and digital platforms. This is important because it complements the Warner Media acquisition quite well. If Xander can be used on a free or discounted version of HBO Max, it could grow further and become a more substantial and incredibly profitable part of AT&T's business in the future.
Moat
The key to AT&T's future is how they leverage their different business segments. While the company has an incredible debt load due to the acquisitions, they also have an incredible opportunity. Wireless carriers have seen slowing upgrade cycles the last couple of years and are expecting that to change with the rollout of 5G. AT&T is positioned to capitalize on this and increase the revenue of its other business units as well.
AT&T is playing the long game. This is seen by their decision to reduce HBO content that is available in 2019 and early 2020. While this caused Warner Media to miss out on an estimated 11% of revenue, it is viewed by the company as an investment in HBO max – their new service, which was released on May 27, 2020. Warner Media is combing all of their HBO resources into one service, HBO Max. They launched with hit shows like Friends, Rick and Morty, and Game of Thrones. HBO Max had 1,300 movies and over 10,000 hours' worth of programming at its launch, and this is expected to grow. The newcomer will premier 21 brand new original series by the end of August. HBO Max is joining a crowded field of streaming services, but its content puts it in position to shine.
As for traditional AT&T businesses, there are new growth areas as well as declining old businesses. First, we will look at the segment with the largest percentage of revenue: Wireless. According to Pew Research, 96% of Americans have a cell phone, and 81% have a smartphone. In 2011, the first year Pew tracked this data, only 35% of Americans had a smartphone. Wireless data has gone from a luxury to a necessity. Who is capitalizing on this fundamental switch? Below is a chart with data from Statista and two graphs illustrating the market share for wireless subscriptions. Notice the consolidation from 2011 to 2019. It is important to note that some American's have multiple cell phones, so the total cell phone subscriptions are slightly higher than the US population number of around 330 million.
Over the last decade, AT&T and T-Mobile have eaten up market share. This is expected to continue. The moat for AT&T's wireless segment is pretty much insurmountable for a newcomer. The competition has been reduced to a three-way battle between AT&T, Verizon, and T Mobile. To read more about this, see the Competitive Dynamics section below. While the wireless moat is vast, Broadband is a different story. There are over 60 million broadband customers in the US, and AT&T has a small percentage of that. The positive here is fiber. When AT&T talks about fiber, what they mean is the same broadband services, but with fiber optic cables instead of the traditional copper ones. Fiber optic cable provides a more reliable, secure, and significantly faster connection. The number of Fiber customers is growing by approximately 200k customers a quarter, and the total is up to 4.3 million.
Similarly, AT&T TV is growing, which helps offset the lost revenue from decreasing premium video customers. AT&T realizes that two of their business units are declining, and this is why they have launched new and innovative products to recapture the lost revenue. AT&T TV is especially important because it has a 90% attach rate to broadband services. Wherever AT&T sees declines, the company has invested to make sure they are prepared for the future.
Warner Media faces increasing competition but also enjoys a moat. While the barriers of entry are lower than the wireless business, creating quality content is not cheap. No matter how the economy is disrupted from Covid, people are going to want media to consume. As distribution models change, content is king. Warner Media has not only launched a top tier streaming service with HBO Max, but they also have invested heavily in quality content for this service. This can be seen in massive box office hits such as 2019 hit Joker, which brought in over a billion dollars, or the choice to forgo revenue in Q1 2020 to save content for the launch of HBO Max. This backlog of content is quite timely, considering that all studios have been put on pause due to Covid. The streaming battle is intensifying, and HBO Max is a bit late to the market, but Warner Media has been quite strategic with the launch. When theaters reopen and sports resume, HBO Max will be a welcome catalyst to a strong business. Subscriber growth is essential, but investors should pay more attention to content. Content is what drives subscriber growth and keeps current customers paying. AT&T has made it clear they are going to continue to invest heavily in creating the best content, and this will translate into a strong moat.
Growth Opportunity
AT&T has the largest market share in wireless and several legacy businesses that are declining. How can such a mature company continue to grow? AT&T has launched HBO Max at the perfect time. AT&T TV growth paired with the HBO Max launch and the completion of the nationwide 5G network provide multiple catalysts for the future. In fact, in areas where the company faces headwinds, they have a new product that is growing. Over the next couple of years, HBO Max will be the key. Not only will this provide revenue growth and eventually turn into a new cash cow with subscribers paying monthly (a model AT&T is quite used to) but also contribute to other business segments. AT&T has launched a new plan named Elite that bundles unlimited data, 30GB of hotspot data, and HBO Max. The incremental costs of giving customers the premium version of all of these services are low, yet AT&T can charge $50 per line (for 4+ lines). This is still an incredible value. Due to the acquisitions AT&T has made, they can provide a differentiated value proposition to their customers. This bundling of services is the perfect way to take advantage of the 5G upgrade cycle and grow recurring revenue streams. It also makes them quite sticky. It has been suggested that people will switch between different streaming services as there is too much content to watch all of it at once anyway. If HBO Max is lumped into a phone bill, it will not be the one that gets canceled when consumers want to cut their entertainment spending.
Business' Economics
AT&T made an incredible $41 billion in revenue in Q2 2020, but how much cash and profit is the telecom giant making? Gross profit was $23 billion, but operating income was $3.5 billion. This means that the gross margin was 56%, and the EBIT margin was 8.5%. The profit was $1.3 billion, meaning that the profit margin is only 3%. While these numbers are substantially lower than they would have been without Covid, one thing is clear. AT&T is a cash-intensive business. This is demonstrated by looking at the cash flow statement. It would be a mistake to see somewhat lackluster earnings and determine that AT&T is not a solid business.
AT&T generated $7.6 billion in free cash flow (FCF) despite spending $4.5 billion in Capital Expenditures. To get a sense of the strength of AT&T's business, investors need to look at FCF. FCF is vital for the company as they have a high dividend. The company pays $3.737 billion to its shareholders currently and has raised the dividend 35 years straight. The leadership team is committed to keeping this streak active, and as such, it is important to look at the payout ratio. In Q2, it was 49% (3.737/7.6), and management expects 2020 to end in the low 60% range. While AT&T is in a capital intensive business and pays massive amounts of money to its shareholders, it is maintaining a sustainable payout ratio indicating that the dividend is safe.
All right, so we know that AT&T generates massive amounts of cash, but how sticky is the business. Despite a weak macro environment and the inability of customers to go to stores, service revenue remains strong even though there are serious headwinds investors may not have considered. For example, in normal times, people travel abroad and pay roaming fees. This has all but dried up. Typically AT&T charges late fees, but as part of their Keep American Connected pledge, this has been forgone. Additionally, 340k postpaid subscribers were counted as disconnects even though they are still using the network. Despite all of these COVID consequences, the mobility segment generated $7.8 billion of EBITDA on $17.1 billion in revenue. Despite a global pandemic, the mobility business unit of the communications segment provides strength and stability that gives AT&T the confidence to invest in growth areas. This is the beauty of the business model.
Competitive Dynamics
First, let's compare the new elite plan offered by AT&T to T-Mobile and Verizon's plans. AT&T Unlimited Elite is $50 per month per line and includes unlimited minutes, texting, and data, although if a customer somehow uses 100GB in a month, it will be reduced to slower speeds. The plan also includes 30 GB of Hotspot data and HBO Max. Many American's whose schools or employers partner with AT&T can get this plan for $40 per month per line. Verizon's premium plan is $55 per month per line for unlimited minutes, texting and data, and 75 GB of 5G and 4G LTE. The plan also includes Apple Music and Disney + instead of HBO Max and the same 30 GB per month of Mobile Hotspot at 4G LTE with speeds declining after that is used. T – Mobile's Magenta Plus plan comes in at $43 per month per line. It includes unlimited talking, texting, and 4G LTE data, as well as Netflix (2 screen plan) or Quibi. It will be interesting to see how T – Mobile changes their pricing once they get further into their 5G rollout. All of these are for the premium plan for a family of 4. The options get more nuanced on the way down, but as fewer features are included, prices go down. To learn more about competitors' business, check out the Verizon and T-Mobile business breakdowns.
The days where AT&T's competitors are primarily wireless companies are gone. Disney, Comcast, and Netflix are also major competitors to Warner Media. HBO Max is $14.99 per month and only has one premium option. It includes multiple profiles for multiple devices and allows users to download content so they can view it offline. It does not offer 4K right now, but according to Andy Forsell, who is the Product Chief at HBO Max, launching 4K HDR is "a huge priority." Content for many HBO favorites such as Game of Thrones has already been released in 4k for Blu-ray, so it has to just be a matter of getting it onto the streaming platform rather than remastering the content.
HBO Max has a great library, but many competitors. The most comparable platform with content for people of all ages is Netflix. Instead of one price, Netflix has tiered its pricing. Premium is $15.99 and allows users to stream 4K on four screens at a time. Standard reduces the quality to HD, and the screens to two and basic reduces the quality to SD for one device. All four plans allow users to download content. Standard is $12.99 per month, and Basic is $8.99 per month. Disney + offers a bundle that includes ESPN + and Hulu (ad-supported) for $12.99 per month, or Disney + by itself for $6.99 per month. Both options include 4K and allow subscribers to view content on multiple devices. Hulu is $5.99 per month with advertisements or $11.99 without. Hulu also has options to add live TV and sports, but this is more comparable to a cable plan or AT&T TV. Clearly there are lots of options. These are some of the closet competitors to HBO Max, but others such as Peacock, Apple TV, and even Amazon Prime are out there as well. Competition has intensified, but if HBO Max can continue to stay ahead of its estimates, it will be an incredible catalyst for Warner Media as it opens up a great distribution path to use alongside the traditional theater route.
To take a look at two of the closest competitors in more detail, check out the Netflix and Disney business breakdowns.
Key Risks
AT&T faces several key risks over the next ten years. The largest ones are inability to pay back their debt, network vulnerabilities, movement away from 5G, and failed cannibalization. AT&T has nearly $170 billion of debt and only $17 billion of cash. The good news though, is that hardly any of this debt is due in the next three years. In Q2, the company issued an additional $17 billion in long term debt (at a rate much lower than their average cost of debt) and paid down some of the shorter term obligations. While the debt level is high, the FCF generation and long term nature of the debt means investors should not be too worried. AT&T has suspended its share buyback and made paying down the debt a priority.
A huge risk for AT&T is hacking and network failure. Recently Twitter was hacked, and this caused concern about other US companies being vulnerable. Any issues with the network will not only set customer loyalty and trust back; it could be disastrous for the company and the nation. Lawsuits could be crippling, and the company might never recover if they are at fault. This is why the enormous amount of money being invested into the network is so important. While AT&T seems too big to fail, and the government would likely get involved in a scenario with widespread network issues, the financial repercussions for the company could be devastating.
The strategy launched by AT&T regarding HBO, Warner Media, and their TV business as a whole is one many executive teams have shied away from. The fact is, if you are not willing to eat your own lunch, someone will eat it for you. There are tons of examples of companies that held onto the old way of doing things and watched in disbelief as consumers shifted to the new way. Just ask Blockbuster and Kodak. AT&T is refusing to join this list. Rather than protect their dying legacy businesses, they have gone the route of cannibalization. They are contributing to the loss of premium video subscribers, but are betting on the shift to streaming. This is why they launched HBO Max and AT&T TV. This strategy can go wrong though. If the company fails to covert old customers canceling premium TV services into new HBO Max and AT&T TV customers, they will not grow their business, but shrink it. There also is risk as the streaming market place is full. AT&T will have to compete with many competitors who have been in the business for years.
Management
In July 2020 the planned CEO transition from Randle Stephenson to John Stankey took place. Stephens is leaving the company with a $64 million pension account and also owns AT&T stock and options worth $20 million. In his 13 year tenure as CEO, the stock price has gone from $39 to $30, but dividend payments have more than made up for that decline. In fact, if they were reinvested, shareholders enjoyed a 55% return under Stephenson's leadership, but Stankey will be looking to do much better.
CEO: John Stankey, MBA
John Stankey took over the role from Randle Stephenson in July 2020. Stankey has had a long career at AT&T. He was working for SBC before the merger with AT&T and has held various executive positions in his 35 years at the company. Recently he was the CEO of Warner Media and COO of AT&T. Making him the CEO shows the importance of Warner Media to the overall strategy. Stankey also has been a key player in Xander, and it seems like the incorporation of Xander in Warner Media is his doing. Xander could continue to grow and could become a large part of Warner Media's business down the road. Stankey made $22.5 million in 2019 and owned at least 76,755 shares worth over $2 million. This is a negligible percentage of the company.
CFO: John Stephens, JD
Stephens also is a long time member of the company as he joined back in 1992. He became the Managing Director of taxes in 1995 and the Vice President of taxes in 2000. He has served as controller and VP of several different parts of the Finance team since then and has been CFO of the entire company since 2011. Stephens made $16.7 million in 2019 and owns at least 556,092 shares worth approximately $17 million. While this is a lot of money, it is not a large amount of the company on a percentage basis. In fact, all insiders together own only .35% of the company.
Work Culture:
Overall, AT&T receives 3.4/5 stars on glassdoor.com. According to the website, 58% of employees say they would recommend it to a friend, and 65% approve of the CEO. This compares to 3.8/5 with a 72% recommendation rate and 72% CEO approval rating for Verizon. T-Mobile comes in at 4.1 stars, 83% saying they would recommend the company to a friend and 87% approving of the CEO. According to Glassdoor, AT&T has had the worst company culture among its major competitors under Randle Stephenson, but this just means that there is lots of room to approve under Stankey. The company won the top position of all companies from DiversityInc in 2019 and placed #100 on Fortune's 100 Best Companies To Work For list in 2018 and 93rd in 2017, but was not included since then. While AT&T has not been a leader in work culture, the bar is low and little improvements will go a long way.
Valuation
AT&T stock has come down substantially in price. Does this make it a buy? The current P/E is 18 with forward P/E around 12. This compares pretty well to historic levels. The typical P/E for AT&T the last 15 years is slightly under 20. The range is quite significant though from under 8 to over 49. Verizon has P/E of 13, and T–Mobile is sitting at 26 for comparison. Here is the problem though: AT&T has an incredible debt burden as discussed in the Key Risk section. The company's total debt burden is quite close to the market cap. This makes typical valuation metrics such as P/E a bit tricky to use. Especially when the large dividend is considered. FCF is much more important than earnings. AT&T has pulled guidance for 2020, but if comments made on the Q2 earnings call are extrapolated, it can easily be calculated that FCF will land somewhere near $24.5 billion in 2020. This is a 16% decline from 2019 FCF, which was $29.23 billion. Pre-COVID, the stock traded at ~$38. This means that it has declined by around 22%. As far as FCF is concerned, the selling has gone too far and the stock is undervalued compared to its pre-COVID price.
To look at the valuation for all three carriers as well as a segmented version for AT&T, check out these models and feel free to play with the assumptions. Check the notes for guidance on the assumptions.
Conclusion
AT&T provides a safe and growing dividend with the potential for significant stock price appreciation. While investors should not expect the stock to triple in the next three years, AT&T will likely increase the dividend by 2% per year as they have done in the past, and the stock price will probably recover from losses due to COVID and the CEO change. If AT&T maintains the 2% increase to the dividend, in 10 years, the annual payout will jump from $2.08 to $2.54. this means that if bought at current levels, the dividend will be paying 7% today and 8.7% in 10 years. In 10 years, an investor will have received $22.77 in dividend payments (7.7% return). This does not even include dividend reinvestment or the potential increased share price. The value offered by this safe dividend is an incredible opportunity to invest in a dividend aristocrat created by an overreaction to the current macroeconomic environment. AT&T has demonstrated that margins will be strong enough to maintain a reasonable payout ratio despite falling revenue. Especially for investors looking to reduce their risk and move from high growth to value, AT&T offers a great opportunity.
Once again, written by Luke Poling (reach out to ryan@investingcity.org if interested in contacting Luke)
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