Sell AT&T: Competition Hurts Results

Jul.23.14 | About: AT&T Inc. (T)


AT&T missed expectations as rising competition led to lower margins and earnings because AT&T was forced to cut prices.

Wireline continued to stabilize with U-verse showing strength, though the DirecTV acquisition will complicate the U-verse strategy.

Wireless service revenue fell as AT&T cut prices to keep customers from switching to T-Mobile, Sprint, or Verizon.

With weak operational results and a robust valuation, investors should sell T.

On Wednesday afternoon, AT&T (NYSE:T) reported its first set of quarterly results since announcing its bid for DirecTV (DTV), which regulators are currently reviewing. I am not a fan of this merger because of valuation and a lack of strategic value (more on my view here), which is why I eagerly awaited these results. I had been hoping AT&T's current operating units would continue their stellar performance and outweigh my concerns about its upcoming acquisition. The strong results from Verizon (NYSE:VZ) that included wireline revenue growth and accelerating wireless subscriber additions only raised my hopes. Unfortunately, AT&T failed to meet expectations, sending shares down 1%, and I would continue to avoid shares until they trade back towards $30-$32.

In the company's second quarter, AT&T earned $0.62 on revenue of $32.57 billion while analysts were looking for $0.63 on sales of $33.4 billion (all financial and operating data available here). While revenue was up 1.5% year over year, EPS fell from last year's $0.67 as increased competition from T-Mobile (NASDAQ:TMUS) has significantly impacted margins. This quarter was certainly no disaster, but it was underwhelming. Its wireline unit faces challenges from secular trends towards wireless while its wireless unit toils amid more price competition from TMUS and Sprint (NYSE:S) while Verizon maintains an edge in network quality. These problems are arriving just as management is forced to divert some focus to getting a merger approved and then integrating assets. With these problems and distractions, it is best to avoid T, and I would rather own VZ.

On the wireline side, the story continues to be stabilization as the worst revenue loss appears to be in the rear view mirror. Wireline revenues were only down 0.9% year over year and up 0.2% quarter over quarter. The legacy landline business is still a major drag with customer losses of 758,000. AT&T has also struggled mightily on the business side with some small businesses moving more to wireless and cloud offerings, which sent revenue down 2.9% compared to last year.

U-verse continues to be the stand-out performer in the unit with 190k new TV subscribers while adding 488k internet subscribers. These gains helped increase its revenue by 25% year over year. Internet ARPU (average revenue per user) also jumped 6%, and U-verse now accounts for 62% of wireline consumer revenue. The success of U-verse has helped AT&T diversify away from landlines, which is clearly a declining business and is the primary reason wireline has stabilized. The strength of U-verse is one reason the DTV makes little sense as T will have to mothball much of it to avoid competing with itself in some markets by offering two TV products.

Wireless was also a mixed picture. The bulls can point to two solid data points. First, it added 1 million postpaid subscribers, which is the best performance in over four years. Additionally, churn hit a record low of 0.87%, meaning fewer customers left for another carrier. On the face of it, these statistics would suggest AT&T is more than holding its own despite rising competitive pressures. Unfortunately, this is too simplistic as AT&T has been significantly cutting prices to avoid customer losses. Initiatives like the Mobile Share Plan have kept the customer base but decreased the profitability of each customer. Price cutting led to a 7.7% decline in phone-only ARPU.

In fact even though AT&T has added subscribers, wireless service revenue fell by 1.4% year over year. Subscriber gains are not brisk enough to offset price declines, which is an indication of how AT&T is struggling against stronger competition. This decline in revenue and prices led to appreciable margin deterioration. Operating income margin dropped 300bp to 24.1% while EBITDA margin fell 220bp to 35.5%. Both profit measures declined faster than revenue because the fixed costs of running a wireless network remain high with a growing customer base. Unfortunately, this customer base is less profitable due to lower pricing.

Finally, AT&T maintained its free cash flow guidance of $11 billion and cap-ex spending of $21 billion. AT&T is currently trading 16.9x free cash flow and 14x earnings, based on my expectations of $2.58. For a company whose core wireless business is under siege, this is a rich multiple while its expensive purchase of DirecTV will be another headwind. With margins declining and a muddled strategy, investors would do well to rotate out of AT&T. While the dividend is nice, capital appreciation is unlikely. Investors will do better in more focused companies with better operating performances like Verizon.

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