AT&T - Investing In The Future But At What Cost?

| About: AT&T Inc. (T)

AT&T Inc. (NYSE:T), the biggest telecommunications company in the US behind Verizon Communications Inc. (NYSE:VZ), recently unveiled its investment plan project velocity IP (VIP), which is aimed at the expansion of its 4G LTE network, availability of high speed broadband in remote areas as well as improvement of its capability to manage the high data demands of its wireless customers. Even though the increased $22 billion investment for each of the next three years will bring operational and financial benefits for the company in the long run, I believe the investment plan will pressurize its cash flows, top line and earnings in the short to medium term. Moreover, AT&T's decision to utilize the debt market for its investment as well as share buyback program does not send the right signals as far as dividend sustainability through cash flows is concerned. As such, I give a neutral rating for the stock and that investors should wait for a pull back to initiate a long position to take advantage of its lucrative dividend yield of 5.3% and capital appreciation.

Wireless Strategy

AT&T announced that it will spend approximately $8 billion on overhauling its wireless infrastructure for the next three years to densify its network. This $8 billion will largely serve to further maximize speed, and improve call quality as well as capacity in the areas of its operations. The company already has 4G LTE coverage in more than 250 markets, however through the revised overhaul program, it is now expecting to expand its 4G network to cover over 300 million people in the US by the year-end 2014.

Through these investments in its wireless network, the management is expecting a revenue growth of mid single digits which I think is achievable considering its upcoming products like Mobile Wallet and Connected Car. Moreover, apart from the aforementioned products, its recently launched shared data plans will continue to be the main growth driver in the coming days as they have performed exceptionally well in Q3 2012. In the quarter recently ended, the company reported a healthy improvement in ARPU largely due to its shared data plans.

The graph above indicates that the company has successfully brought about a consistent drop in churn, which even though rose slightly in Q3 2012, was lower than what the company reported in the third quarter of the previous year. Going forward, as network quality further improves and smartphone penetration rises, further improvement in churn can be expected. As of the recent quarter end, smartphone penetration stood at 81% of the company's total postpaid sales, which even though is higher than the smartphone penetration at Verizon , still provides the company with opportunities for further growth.

It seems like most of the telecom companies are now focusing more on how much they spend to overhaul their networks as well as high speeds rather than just prices. This shift in strategy by carriers is largely due to a shift in consumer preferences which are more data centric now than ever before. As a result of the changed consumer behavior, telecoms like AT&T and Sprint Nextel Corp. (NYSE:S) are in the process of upgrading their respective networks to offer 4G services. These network upgrades will, no doubt, lead to improving metrics for these telecoms, eventually leading to subscriber gains.

Smartphone sales forecasts revised

AT&T is the leader in the telecom industry when it comes to selling smartphones. In Q3 2012, it sold 6.1 million smartphones, out of which 4.7 million were iPhones. Interesting to note is that smartphone penetration at AT&T is much higher (80%) than it is at Verizon, which basically leaves relatively less room for growth for AT&T as opposed to Verizon, which reported a 53% smartphone penetration by the end of Q3.

Moreover, AT&T also sells the highest number of iPhones and according to a news report, the company has raised its 2012 smartphone sales forecast to 26 million from the previous forecast of 25 million. This revision has come after the company sold 6.4 million smartphones in the first two months of Q4, which is more than what it sold in the entire third quarter. However, the downside to the increased smartphone sales is margin erosion caused by increased subsidies. In the last quarter, EBITDA service margins shrank to 40.8% compared to 44% reported in Q3 of 2011. With the recently announced figures for smartphone sales and especially the higher iPhone penetration at the company, further margin erosion can be expected in the last quarter of the year.

Wireline Strategy

AT&T now plans to expand its U-verse product by approximately 8.5 million additional locations for a total potential U-verse market of 33 million, which will enable the company to provide pay TV services to approximately one third more subscribers.

The company has been experiencing a consistent decline in net additions for U-Verse video. AT&T added 920,000 customers in FY 2010 which dropped to 800,000 customers in 2011. As far as broadband is concerned, it is very likely that the company will post net customer losses in FY2012 as it only added 118,000 broadband customers in 2011 compared to 520,000 gains in 2010. However, with the company's VIP program, its payTV reach will expand and its video adds are likely to stabilize for U-verse.

Key catalysts

Looking forward, a full quarter of iPhone 5 sales, shared data plans as well as the last quarter seasonality factor can be identified as key catalysts for growth, and will likely contribute towards growth in the company's revenue base.


T offers an attractive 5.3% dividend yield which is higher than what Verizon offers. The company has brought about a modest but consistent growth in its dividends year over year. Currently, AT&T is paying a quarterly dividend of $0.45 per share. However, to maximize total returns, investors should wait for a better entry point.

T is trading at 13 times its forward earnings which is a 13% discount to the said multiple of its bigger rival, Verizon, that is trading at 15 times it earnings. The stock does look undervalued on a PE basis, however earnings growth expectations over the next five years are much lower for AT&T. Based on expected 2014 EPS of $2.70, I arrive at a target price of $35. The stock is currently trading near $34 and based on the limited upside at this point on the current share price, I give T a neutral rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.