AT&T: Wireless Growth Drivers Still Appear Strong

| About: AT&T Inc. (T)


Smartphone penetration levels, while approaching saturation, still have room for growth.

AT&T's device financing initiatives appear to be resonating with subscribers and should improve margins.

Growth in Mobile Share plans and connected devices augers well for long term increases in data consumption.

I am a self directed dividend investor who manages my own portfolio. The portfolio is currently on track to deliver close to $27,000 in dividend income for 2013. AT&T (NYSE:T) remains a potential investment of interest for me, not least of which for its strong yield. High yielders can provide significant benefits to a dividend investor. I currently have a substantial investment in Telstra (OTCPK:TLSYY), an Australian telecommunications company that I acquired for a yield close to 10%.

AT&T is one of the dominant US telecom carriers along with Verizon (NYSE:VZ), Sprint Nextel (NYSE:S) and T Mobile (NASDAQ:TMUS). AT&T offers both wireline and wireless services to consumer and enterprise customers.

AT&T has a market capitalization of $180B with revenues of $130B and a gross margin in excess of 60%. AT&T generates a net income of almost $18B. AT&T currently trades at a forward PE of 13 and a dividend yield of 5.3%.

With smartphone penetration approaching saturation, the question has been asked whether significant wireless growth drivers remain to support the AT&T investment case. While growth may eventually slow, AT& T still has a number of natural growth drivers that appear to support the investment case and dividend stream of the company moving forward.

Smartphone penetration

The last five years were a period of golden growth for US telecom as subscribers essentially doubled down on their data plans. The results were significant growth in revenues and profits that AT&T and Verizon lapped up. AT&T smartphone penetration hovers around close to 80% of its postpaid base. While this suggests that there are still 20% of the base that can still be upgraded from basic phones and feature phones to higher value smartphones, most of the easy pickings as far as conversion to smartphones have already occurred. The balance of the population who are still on basic phones will likely require some additional incentives to get them there, with these users also unlikely to be heavy users of wireless data. Nevertheless, AT&T smartphone penetration isn't yet at saturation, and there is still likely a 2-3 year benefit from the conversion of remaining basic phone and feature phone users to higher value smartphone users.

Device Financing

AT&T's device financing plan, AT&T Next, promises AT&T significant margin improvement over time, as the company transitions the burden of the smartphone subsidy away from its balance sheet to customers. This program appears to be resonating well with the AT&T base, with the Next program having a take rate of close to 35% of AT&T's base and a penetration rate of 50% in Q2 alone on new device sales. AT& T should initially experience a small revenue improvement due to a change in accounting which will mean that the previously subsidized portion of the phone sale now gets treated as revenue. Eventually more and more of the subsidy burden that AT&T incurs today for smartphones will be shifted toward customers, producing a cost saving also. To illustrate just how much of a cost impact this is for carriers today, typical subsidy amounts for high end smartphones range from $200-$450. AT&T will gradually be able to shift this cost burden away from its own balance sheet over to its customers. This will eventually result in a nice margin improvement for AT&T as a significant cost item is removed from the business.

Wireless Pricing stability

AT&T and Verizon have a combined wireless market share of almost 63% between them, with a number of small competitors including Sprint and T Mobile battling for the remaining market.

This concentrated market structure results in very rational price behavior and limited price competition between the two market leaders. It was notable that both AT&T and Verizon maintained unlimited pricing plans for approximately the same duration of time. Both moved to family plans and tiered pricing at approximately the same time. The absence of price competition is likely to lead to favorable economics and positive profitability for the medium term.

The wildcard here as far as long term pricing stability is what the impact of recent price discounting by Sprint and T-Mobile is likely to be. Both Sprint and TMobile are battling it out for the remaining 37% market share, along with a host of other minor players. The failure of a desired Sprint and TMobile consolidation means that both companies are now reliant of desperate pricing tactics to try and win share.

Neither Sprint, nor TMobile are likely to have sufficient capacity in the tank to keep aggressive pricing measures in play for a sustained period of time. Sprint has not been able to generate any meaningful free cash flow since 2012, and continues to lose subscribers. It is also faced with massive network upgrades that will occur over the next few years that will see cash flow bleed further. T Mobile's aggressive pricing and subsidization of early termination fees has only had the effect of reducing the company's already marginal cash flow. Large deficits in free cash flow were incurred by T Mobile in 2013, with 2014 also displaying a similar pattern.

This is suggestive of the fact that neither Sprint, nor TMobile will be able to keep discounting up for a significant period, while still investing to make necessary capital upgrades. Provided neither AT&T nor Verizon blink first and respond with similar discounting, both should be able to withstand this period and see rationality in pricing prevail.

Mobile Video traffic

Video traffic accounts for close to 50% of traffic going across mobile networks today among US operators and this rate of video consumption is only expected to increase.

Cisco's VNI (Visual Networking Index) suggests a strong continuation of IP traffic growth, much of which will be driven by increasing consumption of video traffic. Global IP traffic is expected to triple over the next 5 years, driven by more global internet users, more devices and connections and increased use of video services and applications.

The VNI study also suggests there will be strong growth in IP traffic over mobile operator core networks with wifi and mobile connected devices generating almost 70% of IP traffic by 2017. For AT&T, that suggests more wireless subscribers likely upgrading to progressively bigger data tiers over time.

Connected Devices

AT&T has made particularly good progress in driving Machine to Machine connections, which include such things as wireless vending machines and wireless connected cars. Estimates indicate that AT&T likely has about 17 M machine to machine connections. Customers are embracing the company's Mobile Share plans. These plans more than tripled year over year to reach 11.3 million in Q2 2014.

Mobile Share plans make it easier for subscribers to add multiple connected devices which can all share data, driving data buckets higher. While there are concerns that customers may just be running these connected devices over wifi, this doesn't seem to be playing itself out. AT&T reported in Q2 that these Mobile share plans continue to drive higher data usage, with 46 percent of accounts on data plans of 10 gigabytes or higher.

There remains a clear opportunity for AT&T to drive the remainder of its postpaid base to these Mobile Share plans, as these customers seem to be higher data users on average, compared to the rest of AT&T base. That means better opportunities for AT&T to drive ARPA increases from its user base. Offering subscribers a wide range of connected devices from tablets to watches to fitness gear will only accelerate the interest of more subscribers to move to Mobile Share plans.

Conclusions & Implications

While smartphone penetration is approaching saturation levels, there still a remain a significant proportion of AT&T's embedded base that are still yet to convert to smartphones, which should continue to provide a modest boost to revenues over the next few years. Nevertheless, AT&T still appears to have additional growth drivers that should assist profitability over the medium term. Device financing initiatives will improve gross margins, while video and connected devices will power higher data usage amongst subscribers.

Even though AT&T isn't a growth stock by any stretch, with a solid 5.3% yield, and continuing drivers of wireless revenue growth in place, it should be considered a serious candidate for investors in search of strong current income.

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.