AT&T (NYSE:T) has hit a strong patch recently. LVMH (OTCPK:LVMUY), one of the world's leading purveyors of luxury goods, announced that it chose AT&T to connect 3,500 of its retail sites in a 5-year multi-million dollar deal.
Meanwhile, its decision to reduce subsidies on expensive handsets such as Apple's (NASDAQ:AAPL) iPhone and high-end smartphones running Google's (NASDAQ:GOOG) Android in favor of offering data plan "buckets" has been accepted as sound by Wall Street and is being emulated by its rivals Verizon (NYSE:VZ) and Sprint (NYSE:S).
As a result, AT&T's stock is up 13% in the year-to-date, which is superior to the performance of both Verizon and Sprint.
What lies ahead for the U.S.'s number one carrier? Can it successfully navigate the change in its operating paradigms and thrive even as wireless customer growth slows?
Can AT&T rely on subscriber growth to drive it forward? From a practical perspective, barring an acquisition of other carriers, it's going to be very difficult. As it stands, there are already more mobile subscriptions than people in United States (331 million to 311 million). Underscoring this is the fact that AT&T added just 736,000 subscribers in the first quarter - a growth rate of only seven-tenths of a percent.
Of course, if the fact that subscriptions exceed the number people tells us anything, it's this: a single customer can have multiple subscriptions. Consequently, if AT&T hopes to grow its number of subscriptions, it will find itself catering more and more to tablet users.
For all the media coverage, tablets are still relatively new devices with just 19% of Americans owning one. Indeed, tablets' best days may still be ahead: sales are expected to surpass that of PC's by next year. This opens wireless carriers like AT&T to the possibility of attracting new subscribers to "data only" plans for their tablets. Alternatively, it represents a way for AT&T to entice existing subscribers to top-up their data-plan bundles.
Similarly, Smartphones aren't exactly yesterday's news. As they grow in ubiquity - more than half of Americans already own one - network effects through agencies such as Social Networks, which are primarily accessed through mobile, could encourage others who don't to acquire one.
In turn, this creates a positive feedback loop: as the use of the mobile Internet is integrated more deeply into users' lifestyles, they invariably add other Internet-enabled devices such as tablets or notebook PCs to enrich their mobile experience. That means even more new subscriptions for carriers.
That said there's a limit to simply "providing a connection." AT&T is hoping to monetize its network further by offering value-added services such as AT&T Digital Life, which provides home security and automation through smartphones. This will complement its other services such as AT&T U-verse. It's too early to tell how successful these initiatives will be - for one thing, their more natural delivery channel, the tablet, is still a few years away from gaining very wide ubiquity.
In any case, I expect that Digital Life is just the first wave of AT&T's planned invasion of subscribers' homes. Gigabit Wi-Fi (a.k.a. Wireless ac), with its faster transmission speeds, represents another opportunity for AT&T since it should encourage users to move away from physical media such as Blu-ray discs and stream more content from the Internet.
Wherever it comes from, AT&T will need to generate as much value-added income as it can get its hands on. Based on 1st quarter financials, Verizon earns 25% more on its customers - at an annualized net income of $211 per wireless customer, compared to AT&T's $168.
Unfortunately, that will mean spending even more on its data services - and it's going to be expensive. As AT&T CEO Randall Stephenson noted: "every additional megabyte you use in this network, I have to invest capital." While Stephenson was referring to unlimited data plans when he said that - a product, incidentally, that AT&T no longer offers - his statement still holds true for the expanding use of data as connected devices like smartphones and tablets become more widespread.
Indeed, AT&T recently issued $2 billion of 32-year notes in part to fund its continued spending to expand and upgrade its LTE network. In the 1st quarter, it spent 1.2 times its Net Income on Capital Expenditures, mostly to fund its expansion. That was on top of the $56.2 billion it expended from 2009 to 2011 on its networks.
That's a staggering amount and is equivalent to $523 per wireless subscriber if we assume that 90% of AT&T's capex has been devoted to wireless. Considering that AT&T earns a net of $168 (annualized) per wireless subscriber, it won't break-even on its past expansion for another 3 years - unless it increases its average revenue per account. Of course, 3 years is not exactly a long payback period.
What's more, AT&T's fixed-line business remains robust with a 12% Net Income margin - and the deal with LVMH will only add to that. It's also worth pointing out that AT&T chief advantage over Verizon is that its Wireline business is 50% larger and that its segment income has a higher margin at 12% compared to just 2%.
The comparison notwithstanding, this gives it a financial buffer with which to fund its expansion and take chances on other valued-added services.
Value engineering its Wireless operations should also help - it earns nearly the same gross revenues per customer (around $620) as Verizon does, but as pointed out, Verizon earns more (25%) on a net basis per wireless account.
Given all this, it makes sense that AT&T is offering data plan bundles - it needs to balance its desire to increase its revenues per account with the high investment cost associated with providing the service.
Overall, AT&T is a solid carrier play, with robust earnings, revenue drivers in the form of smartphones and tablets, and the potential for higher per-customer spreads as it implements its data bundle plans.
That said it isn't a cheap stock, trading at a price-earnings (P/E) ratio of nearly 50 times earnings - that's nearly 3 times the Telecom Industry's 17 P/E and is also at a significant premium over the S&P 500.
AT&T does have a good dividend yield at 5.2%, which is actually more than it pays on its borrowings (4.875%) and is 10% above the Telecom space's 4.7%.
All things told, I don't see AT&T doing much more than performing in line with the market. Consequently, I expect the stock to trade with an upside of 10 to 15% -- anything more than that is a bonus.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.