Patience in AT&T May Be Rewarded

AT&T (T) reported 3Q2008 EPS @ $0.67 vs. $0.71 consensus. Revenues met expectations and were up 4% @ $31.4bn. The $900mm subsidy paid for Apple (AAPL) iPhones shaved 10 cents per share off its bottom line.

Exclusive U.S. distribution rights for the iPhone came at a price, but the tradeoff produced a 2mm or 40% increase in new wireless customers for the quarter. T’s wireless accounts now almost total 75mm and is coming at the expense of Verizon (VZ). Some of these subscriber gains were offset by 990k cancellations in landline accounts which switched to VOIP service offered by cable companies. 

T’s wireless revenue rose 15% to $12.6bn while the landline business fell 2% to $17.6bn. To offset the lost landline revenue, T intends to reduce headcount by 4k.

If forced to bet on consumers’ future preference for telecom services, the 3G superfast wireless network and its freedom of mobility trumps landlines and VOIP anyday. T realizes this and is strategically positioning itself to exclusively distribute smartphones from Apple’s iPhone and Research In Motion 's (RIMM) Blackberry Bold, and distinguish itself as best of breed with consumer and business wireless customers.

The average customer generates $58.99 in revenue while iPhone customers produce 1.6x (i.e. $94.38) this amount. The strategy is something of a long-term gamble contingent upon the makers of these smartphones to maintain their "better mouse trap" competitive edge. Yet, T has the right idea to focus on higher margin and revenue generating customers.

Financially, T is sound despite tough economic times. Its annual operating cash flow derived from just its core business activity throws off @ $5.51 per share. This is sufficient to cover the $1.60 dividend and confirms that it is focused on its business. Compared to its industry, debt to equity ratio stands @ 0.68 vs. the average of 1.37. CFO Lindner recognizes the tenuous economic conditions and wisely intends to use some of the company’s cash flow to pay down debt. 

AT&T is still geared to growth and reinventing itself. ROE (return on equity) is a respectable 12%. Compared to its peers, sales grew @ 5.4% vs. the 5.2% industry average, but income grew @ 25.7% vs. the 11.6% industry average. The decision to focus on higher margin telecom services appears to be working.

Another ace up its sleeve is U-Verse, its TV and broadband data service, which added 232k subscribers for the quarter to reach 781k and ultimately on track for 1mm year end.

However, what really makes T attractive is its low PEG ratio @ 1.26 and forward PE @ 7.65. Assuming that T can meet FY2009 estimates @ $2.91 per share and trade for 12.5x earnings like its industry peers, the stock would be worth @ $36 or 40% upside potential.

Meanwhile, the 6.7% dividend yield should keep investors happy while waiting for the company’s strategy to bear fruit. Not to mention, the stock is also a great candidate for a DRIP (dividend reinvestment program): a $25k investment in 1000 shares with reinvestment of dividends over a 10 year period could theoretically grow to 1848 shares and throw off almost $3k in cash dividends annually for @ 11.7% cash yield on original investment (excluding any potential appreciation and value of accumulated shares). 

Telecom stocks usually lag the economy and this economy probably has at least another 2 or 3 quarters before any signs of revival. Tight credit and economic weakness is forcing businesses to reduce spending.

Although existing market conditions are frightening, investors who rise above the myopic sentiment of being obsessed with just the current quarter and the financial crisis may find that delaying immediate gratification has its rewards. (For those skeptics and others who like to sleep well at night, consider hedging this position with option collars.) 

Disclosures: None

Comments

[Tom B:]

I like T. They will indeed reap revenue for more expensive calling plans because of theri investment in the iphone. But, It's not clear to me T is superior to FTE or TEF.

I am long on all three.

2008 Oct 27 08:41 AM