AT&T: Upside Past $38

| About: AT&T Inc. (T)

Summary

AT&T reported relatively in-line quarterly results, sending shares slightly lower after hours.

Strong U-verse growth and subscriber additions helped to stabilize wireline revenue in the quarter.

Wireless performed well with low churn and strong margins despite concerns about increasing competition.

With a strong operating performance and cash flow, shares should trade at 14-15x earnings or $38-$40.

On Wednesday, AT&T (NYSE:T) reported its first quarter results, and the quarter was relatively in-line with expectations. Shares have rallied somewhat into the quarter, so some investors took profits on the news, sending shares down about 2% after-hours. Still, AT&T has a bit more upside to fair value. I would be willing to pay upwards of 14-15x earnings or around $38-40. Shares also sport a solid 5.15% dividend, making AT&T a stable investment for income oriented investors. After this quarter, investors can stay long T.

AT&T earned $0.71 in the quarter, which bested estimates by $0.01 (all financial and operating data available here). Revenue grew 3.5% year over year to $32.5 billion, which was roughly in-line with analyst expectations. AT&T's revenue growth was the fastest it has been in the past two years, and it now expects to grow revenue by at least 4% this year. AT&T generated $8.8 billion in cash and $3 billion in free cash flow. For the full year, free cash flow should be at least $11 billion this year. With strong cash flow and a rock solid balance sheet, T can maintain its dividend, buy back shares, and even make accretive acquisitions when possible. We continue to see stabilization in AT&T's legacy wireline business while its wireless business showed solid growth, which suggests the threat from T-Mobile (NASDAQ:TMUS) has been overstated.

Let's first examine the wireline business. It is well-documented that this has been a tough business over the past decade. Cell phones have made landlines less important, and some consumers have dropped landlines all together. To deal with this drop in landlines, AT&T has been pushing into high speed broadband and TV. We are beginning to see the fruits of this investment with U-verse (AT&T's broadband and TV offering) showing substantial growth. In fact, consumer revenue growth was 4.3% this quarter, the best it has been since 2006. Business revenue is still a bit weak, so total wireline revenue was down 0.4%. Operating profits did fall 10.5% to $1.5 billion as content price increases pinched margins.

Still, U-verse showed substantial growth. AT&T added 201,000 TV subscribers and a robust 634,000 broadband subscribers. U-verse continues to gain share from traditional cable providers, and AT&T now has a combined 11.3 million TV and broadband subscribers. As a consequence of strong subscriber growth, U-verse revenue was up 29% year over year, and it generated an annualized $14 billion in revenue. U-verse is becoming an increasingly important piece of AT&T's wireline business. With continued growth, it should help AT&T keep wireline revenue flat in 2014 and potentially grow 0-1% in 2015.

AT&T also continues to show strong results at its wireless unit despite fears that T-Mobile was taking share. AT&T has responded forcefully to any threats by offering new plans that offer more data, and this strategy seems to be working. Wireless revenue jumped 7% in the quarter, and service revenue was up 2.2% to $15.4 billion. Total churn was stable at 1.39%, which suggests AT&T has not seen notable customer losses. It also added 625,000 postpaid subscribers, the best first quarter performance in five years. AT&T continues to benefit from the shift to smartphones, which generate more revenue thanks to lucrative data connections. 78% of AT&T subscribers are now using smartphones, which is up from 72% a year ago. 92% of phone sales during the quarter were smartphones, so this figure should continue to increase in coming quarters.

AT&T grew wireless revenue thanks to low churn and continued subscriber growth. Importantly, AT&T is not cutting prices too much to keep customers. In fact, the company reported stronger margins in the quarter. EBITDA service margin was 45.4% compared to 43.2% a year ago. Wireless operating income margin came in at 28.3%, better than last year's 28%. If competitors were really gaining share from AT&T, we would be seeing either customer losses or shrinking margins. Instead, we are seeing customer additions and solid margins. While not as strong as Verizon's (NYSE:VZ), AT&T's wireless unit continues to perform well. Competitive pressures have been overstated, and its business has proven to be exceptionally resilient.

Overall, investors should be impressed by AT&T's quarter. Management has done a good job modernizing the legacy wireline unit. U-verse is showing exceptional growth and should power wireline revenue growth by next year. While wireline is stabilizing, wireless is showing continued growth. AT&T continues to grow subscribers while growing margins. While the wireless market is definitely very competitive, AT&T is not ceding shares. Thanks to strong operations, AT&T is generating a significant amount of free cash flow, allowing for an aggressive buyback policy, including the repurchase of $1.2 billion in stock last quarter. With improving results and strong cash generation, AT&T is a stable company paying a great dividend it can continue to slowly growth. T continues to be a great fit for income investors. Shares are attractive here.

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.