Although we have Sprint Nextel (S) in our portfolio and it is our most covered telecom company for our published research, we have been recently pondering whether to add one of its two top peers AT&T (T) and Verizon Communications (VZ) to our portfolio. In our previous reports on AT&T and Verizon, we have analyzed and evaluated these two firms to see which telecom titan offers investors a better investment opportunity. AT&T may be fairly valued, but it pays a strong 5.3% Dividend Yield ($1.80/Share) and generates plenty of free cash flows to pay it and boost it by 2-3% annually. However, AT&T stakeholders have to be gritting their teeth at AT&T Wireless's underperformance over the last two years relative to Verizon Wireless. We attribute this to AT&T Wireless having to share the right to sell Apple's (AAPL) iPhone smartphone device with Verizon Wireless and also Sprint. This explains why Verizon Wireless's revenue growth rate has exceeded AT&T Wireless's over the last two years even though AT&T had a higher growth rate in 2010.
Source: Bloomberg LP
AT&T Wireless continues to be the star-performer and workhorse for AT&T shareholders. AT&T Wireless grew its Q4 2012 revenues by 5.7% versus Q4 2011 levels. Wireless service revenues grew by 4.2%, aided by 14.7% growth in data revenues. Equipment revenues grew by $344M (14.6%) due to a full quarter of contribution from Apple's widely anticipated iPhone 5 smartphone device and were $2.7B. AT&T Wireless's data revenues grew by $870M year-over-year and now represent 45.6% of its service revenues, up from 41.2% in Q4 2011. As AT&T Wireless only grew its total service revenues by $602M and total division revenues by $946M, we can see beyond a reasonable doubt that AT&T is benefiting from carrying Apple's iPhone and iPad and the lucrative data plans that AT&T Wireless can sell to customers. Without the growth in data revenues, AT&T Wireless would have seen a revenue decline.
AT&T also tightened its grip on retaining customers with its solid 1.19% contract customer churn rate, which improved by 2bp versus the prior year period. AT&T's total retail customer churn rate was 1.42%, which regressed by 3bp versus the prior year period. AT&T sold 10.2M new smartphones during the quarter, 8.6M of which were Apple's iPhone smartphone devices. Despite the ballyhooed promotional campaign for Nokia's new Lumia smartphones with Microsoft's Windows Phone operating system, we can see that Lumia sales were statistically insignificant as Nokia's total North America Lumia sales were about 700K. AT&T also had its best quarter ever for Android powered smartphones. 16% of iPhone sales were to new AT&T customers and nearly 70% (47.1M) of AT&T's postpaid subscriber base had a smartphone in Q4 2012, up from 58.5% (39.4M) in the comparable quarter last year. The good news for AT&T Wireless is that its smartphone sales increased by 800K and its iPhone activations increased by 1M (13%) in Q4 2012 versus Q4 2011. The bad news is that Verizon Wireless saw its iPhone activations increase by 1.9M (44%) during this same period.
AT&T Wireless's segment operating income declined by 1.4% year-over-year in Q4 2012 versus the comparable period as gains in operational execution were offset by increased demand for new iPhones. Segment operating slipped from 15.5% in Q4 2011 to 14.5% in Q4 2012. AT&T's smartphone sales represented 89% of postpaid devices sold (up from 82% in Q4 2011 and 77% in Q2 2012) and provide a lucrative $20/per month and up revenue stream for data service. ARPU for retail postpaid customers increased by 1.9% year-over-year and reached $64.98 for the quarter, which represented the 16th straight quarter that AT&T's retail postpaid ARPU increased on a year-over-year basis.
AT&T and Verizon have been migrating smartphone customers towards "Mobile Sharing Plans" in which customers can share one pre-allotted data subscription across multiple devices. More than 6.6M of AT&T's customers are on AT&T's Mobile Share Plan and this represents 9% of its postpaid customer base. The number of Mobile Share accounts reached 2.2 million in the fourth quarter for an average of about three devices per account. AT&T has also been able to migrate a significant portion of its customer base away from its grandfathered unlimited plans and more than two-thirds, or 31.7 million, of all smartphone subscribers, are on usage-based data plans. This compares to 56 percent, or 22.1 million, a year ago and 31 percent two years ago. Although AT&T Wireless added 780K postpaid customers for the quarter and 1.4M for the year, this pales in comparison to Verizon Wireless's net customer additions for Q4 2012 and FY 2012 (2.1M in Q4 2012 and 5M in FY 2012). Verizon Wireless's prepaid customer additions of 893K for 2012 were sharply higher than AT&T Wireless's 128K.
VZW does not itemize its subscriber figures for its reseller and connected devices product lines during the quarter, only during the annual financial reports, so we can't really compare AT&T versus VZW in this segment until the end of the year. AT&T added 234K reseller customers during the quarter, which was down from 592K added in Q4 2011. Although AT&T Wireless added 246K connected devices customers during the quarter, this was sharply lower than the 1.029M added in Q4 2011. Now that Sprint is joining the iPad party, we expect to see further headwinds to growth and performance in this segment. At least AT&T Wireless's branded computing subscriber base (tablets, tethering plans, aircards, mobile Wi-Fi hot spots and other data-only devices.) increased by 25.9% from 5.1M as of 2011 to 6.43M in 2012.
Source: AT&T's 2010-2012 Annual Reports
We previously believed that this division was maturing as AT&T's corporate-wide capital expenditures have declined by nearly 7% year-over-year for the first nine months of 2012 versus the first nine months of 2011. We also believed this because AT&T transferred a $9.5B preferred equity stake in AT&T Wireless to its defined benefits trust and pension fund in order to eliminate a pension plan funding shortfall. In addition to paying $10.2B in dividends for 2012, AT&T also spent $12.3B net of employee stock issuance to repurchase shares during the year. While we still see the wireless market as a maturing market, we believe that AT&T is looking to win back market share it ceded to Verizon and that explains its $14B network upgrade program. This will result in AT&T's total capital expenditures exceeding $21B for 2013, which represents an increase of nearly 8% versus 2012 levels. AT&T is still expected to generate $14B of free cash flow and $35B of operating cash flows in 2013 though.
Source: Morningstar Direct and AT&T's FY 2013 Management Guidance
AT&T Wireline is certainly not going to be confused for AT&T Wireless anytime soon. However, the division is mitigating the decline of its traditional wireline business with strategic communications services such as Digital TV, High Speed Internet and Video services to residential and business customers. AT&T U-Verse's subscriber base increased from 4.4M in Q2 2011 to 8M in Q4 2012, which represented an increase of 82% over the last 6 quarters. Wireline data revenues grew by 6.9% versus last year's quarter and 7.6% in 2012 versus 2011 and almost offset the revenue declines from voice and other wireline services. AT&T Wireline boasts a significantly higher profit margin than Verizon Wireline even though it has a higher cost unionized workforce versus VZ Wireline. AT&T Wireline actually grew its business segment income by 1.8% as reduced operating expenses and depreciation more than offset the decline in wireline revenues. In fact, AT&T Wireline's Depreciation and Amortization allowance of $2.8B exceeded VZ Wireline's $2.1B in adjusted EBITDA.
Sources: Q4 Conference Call for AT&T
In conclusion, we can't argue with yield hungry investors who are interested in the AT&T-Verizon duopoly, as those companies sport a 5% and 4.7% dividend yield respectively. We can see why AT&T is transferring a $9.5B preferred equity stake in AT&T Wireless to its union plans, as the handwriting on the wall says that AT&T Wireless is no longer a growth engine. We can determine this because AT&T is tendering a minority stake in AT&T Wireless to the pension plan and it is cutting its capital expenditures. We believe that AT&T is a strong cash cow as it has a 2-1 dividend coverage ratio based on its 2012 YTD free cash flow of $15.6B and its $7.7B in dividend payments. Based on the strong market presence for AT&T and Verizon, we can feel confident that each company will maintain and steadily expand its dividend by 2-3% annually. In our professional opinion, we think that both Verizon and AT&T are suitable candidates for a dividend-rich portfolio. Verizon still leads AT&T in the Wireless communications business (except for its 45% Minority Interest Tribute to Vodafone) and AT&T still performs better in the wireline communications segment than Verizon. We maintain that both companies would be more suitable to income-oriented investors than blue-chip growth investors because we believe that both companies are underestimating Sprint's transformation efforts and this was before Sprint partnered up with SoftBank. That thesis was proven by the fact that Sprint's shares have increased by over 60% since the middle of July, vs. flat performance for AT&T and Verizon.
Source: AT&T/SBC Dividend History
Additional disclosure: Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.