Still No Love For AT&T

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About: AT&T Inc. (T)
by: Stefan Redlich
Summary

Despite a strong start to the year, AT&T's stock is still trading sideways.

The company has already reiterated its 2019 guidance multiple times and despite good progress in Q1, the markets are still not buying the story.

AT&T delivered on its promise to improve EBITDA for the Entertainment Group, made progress in terms of debt repayment, and generated strong FCF.

As AT&T continues to trade at rock-bottom valuations, it remains one of the best long-term opportunities for income generation.

AT&T (T) started pretty strongly into the year but despite being up 9% YTD vs. 13% for the S&P 500 (SPY) the stock remains dirt cheap. On a total return basis, the performance is much closer to the broad market but still nothing to cheer upon.

Chart Data by YCharts

For those investors having been able to snatch AT&T below $30 in December 2018, there is not much to complain but for investors having bought it in the mid-to-high 30s and beyond, the position remains deep in the red.

Chart Data by YCharts

AT&T has sold off various assets, it has perfectly delivered on its promises for the first quarter, its guidance has been reiterated multiple times but despite all these good news the markets are not buying the story. AT&T has not spooked investors like Vodafone (VOD) just did when it slashed its dividend 40% and based on what we know today, there is nothing to suggest a dividend cut for AT&T is even remotely possible.

(Source: AT&T Investor Relations)

Long-term-oriented investors can benefit from this misconception as they are offered AT&T at a sky-high 6.6% yield which offers a fair amount of downside protection and generates strong income. Let's see what is going on at AT&T.

What is going on at AT&T?

Financially, the company recorded but missed Q1/2019 sales of $44.83B (up 17.8% Y/Y, but missed by $270M), with EPS of $0.86 in line with expectations. It is guiding for adjusted EPS growth in the low-single digits and free cash flow in the $26B range.

Apart from those headline figures, the two most important aspects investors need to focus on right now are:

  1. Debt and Cash Flow Situation
  2. Performance of the Entertainment Group

Debt And Cash Flow Situation

Asset sales in 2019, most notably the Hudson Yards sale for $2.2B and the divestment of its 9.5% Hulu stake to Disney (NYSE:DIS) for $1.43B, have helped AT&T whittle down its debt. From a record-high of $190.1B reported as of June 2018, total debt has been reduced by over $25B and is expected to decline to around $150B by year-end which will bring down AT&T's net-debt-to-EBITDA ratio to at 2.6x.

Although I don't really like any of these asset sales, I certainly like where the proceeds are going. The reason I am opposed to these sales is I basically consider both assets as "silverware," i.e. something precious, despite for different reasons.

Hudson Yards is located in one of the best, most expensive and luxurious areas in Manhattan, which itself is one of the most expensive real estate markets worldwide. Although the transaction carries a hefty price tag, the exclusive area which was the last empty space in Manhattan will very likely appreciate significantly.

Source: architecturaldigest.com - all image courtesy remains

WarnerMedia is currently located at that office and it has been agreed to lease back the office until early 2034. Unfortunately, it is unclear as to what the current rent will be and how it will develop over the next 15 years, but I wouldn't be surprised if it rises dramatically. AT&T exchanged the luxury of not having to pay rent for a quick and substantial inflow of funds. Although this is needed to reduce debt levels only time will tell if that reduced leverage and lower interest costs will offset the additional rent expenses and increases.

Hulu is another example of that. AT&T only held a minority stake of 9.5% in the streaming service and although the reported valuation at which it sold its stake was significantly higher compared to previous valuation rounds ($15B vs. $9.3B in November 2018), it also means that AT&T will lose content and diversification in its portfolio. Additionally, it shows that AT&T will go all-in with its own streaming service which is expected to go in beta at the end of the year.

If that service meets or exceeds expectations, it was the right decision to sell this stake but if not, AT&T lost its only opportunity to implicitly benefit from Disney's streaming endeavors. For a company like AT&T, which is expected to generate $26B in FCF this year and with debt around $170B, the $1.4B it received to sell Hulu is not moving the needle at all. In my view, it should have waited with that sale at least another 2-3 quarters as the valuation for Hulu is unlikely to have decreased given that Disney wants total control of the service.

As far as the overall debt situation is concerned, AT&T will have to redeem almost 1/3rd (~$60 billion) of its total current debt amount from 2020 to 2023, which will notably exceed free cash flow after dividends in three out of four years.

Despite significant cash flows, such a massive debt load cannot be serviced without issuing new debt. Although this will slow down debt repayment, AT&T's total debt by end of 2023 will decline further to $136.5 billion, with full-year EBITDA expected to grow to $68 billion by year-end. Assuming its 2019 cash balance of $10.8 billion remains unchanged (i.e., any gaps between FCF after dividends and redeemable debt will be funded with new debt) gives us a net-debt-to-EBITDA ratio of just under 2 and, as such, represents a deleverage of more than 1/3rd from current heights and certainly demonstrates that AT&T is, in principle, more than capable of managing that debt risk.

If that holds true, the company will also have no problem to maintain and grow its alarmingly high dividend. In fact, despite almost doubling its total debt with the Time Warner acquisition, it has been accretive from day 1 and thus helped AT&T not only to maintain its safe dividend payout ratio but also actually improve it. By end of 2016 and 2017, the FCF dividend payout ratio stood around 70%, while in 2018, it came in at only 60% and is expected to decline into the high-50s as 2019 unfolds. This will ensure a very high degree of dividend safety, and while the current yield reflects the current level of risk as AT&T transforms from an "old economy-like telecom" to a well-diversified, content-driven media enterprise, it does not mean that the sky-high dividend is in danger.

AT&T's cash flow is very strong. Operating cash flow is up 24% Y/Y and TTM FCF has hit $25.4B and is thus well on track to meet full fiscal-year guidance of around $26B for 2019. The dividend is easily covered as well with an FCF dividend payout ratio of 63% for the last quarter.

Source: Company reports, author's illustration

This is a substantial improvement to Q1/2018, and given that the first quarter is usually the weakest, I wouldn't be surprised if AT&T even exceeds its annual FCF guidance.

Performance Of The Entertainment Group

The Entertainment Group is AT&T's Achilles tendon as it is facing the secular trend of people cutting the cord and expensive video subscriptions with the big carriers like AT&T (NYSE:T) in favor of cheaper and richly populated streaming services such as Netflix (NFLX), Hulu, Amazon Prime (AMZN) or YouTube Premium (GOOG) (NASDAQ:GOOGL). And with Disney having announced its own Disney+ streaming service at an ultra competitive price pressure on AT&T's most important business division will only increase.

However, despite these powerful competitors challenging AT&T, the division has been doing incredibly well which the markets so far have not acknowledged at all. But let's go step by step to depict what exactly is going on.

In Q1/2019, AT&T lost a total of 627,000 video customers of which the majority was not related to DirecTV Now and thus generally featured higher-priced offerings. That is undeniably a monstrous number but what is even more surprising is that despite such a huge loss EBITDA for entire segment actually increased by $200M to $2.8B following 1.8pp Y/Y margin expansion.

Apart from cutting down on expenses such as marketing cost and realizing cost efficiencies, AT&T has started to better monetize those customers that remain with the platform. Premium video ARPU came in at $114.98 and is up 2.2% Y/Y, and Broadband ARPU has reached $50.10 and is up 8.3% Y/Y.

Source: AT&T Earnings Call Slides 2019 Q1

As such, AT&T is exactly doing what it has been constantly reiterating during numerous calls:

That customer base that we burned off, if you will, in the third quarter (2018), and that we may or may not going forward chase in any given quarter, is always available. It's very promotionally-sensitive and price-sensitive, so you can always go get that business when you find the economics to do it so - or advantageous as a result of, for instance, what you can do on ad-supported models. - Source: AT&T Q3 2018 Earnings Call

With less subscribers left in the pool that are much more profitable, AT&T remains confident that it can hit its goal of stabilizing EBITDA for the segment in 2019 and is eyeing "real improvement in year-over-year EBITDA results starting in the first quarter."

During a recent conference in Dallas, AT&T again reiterated this statement. It still expects to "meet or beat its target for stable EBITDA of around $10B in both 2019 and 2020" as secular pressure on video subscribers will be offset by growing broadband revenues and ARPU growth for both Premium Video and broadband. Any model or expectation is only as good as its assumptions and while we do not know precisely how this is modeled, AT&T provided some useful color about the expected development:

The company expects elevated levels of linear video declines throughout 2019, noting that second-quarter subscriber losses in the past two years have averaged more than 100,000 higher sequentially than in the first quarter. In premium video, it expects that margins will improve as 2-year price locks expire. About 1.6 million video subscribers remained on these price locks at the end of the first quarter, which the company expects to decline to zero by year-end. In 2020, the company expects premium TV subscriber losses to improve as a result of no subscribers on two-year price locks, improved churn and additional subscribers from the launch of its thin-client video product.

Source: AT&T Press Release of JP Morgan Global Technology, Media and Communications Conference

Two things stand out here:

  1. Investors can already brace themselves for another ugly-looking earnings release with subscriber losses expected to accelerate due to seasonality.
  2. AT&T still has lots of customers on promotional pricing. These customers are generally viewed as more susceptible to switching once price locks expire and thus have higher churn and less ARPU. It will take some time for all of these promotions to expire and while probably not all of these customers will leave the platform a majority certainly will which will adversely affect revenue and margins.

As a result, this model does not appear to be optimistic. AT&T is not downplaying the risk of secular declines and in my view has made very plausible assumptions. With the company reiterating its expectations in May it looks as if it remains very well on track to meet its objectives.

More Catalysts For The Stock Price

While I personally favor AT&T's current price as it allows to load up on the stock at a dirt cheap valuation, there are many more catalysts for its stock price apart from an improving debt situation and stabilizing EBITDA segment than I can cover here such as wireless service revenue growth, FirstNet deployment which is ahead of schedule and the 5G expansion.

However, there is one thing which AT&T has mentioned during the conference that really caught my attention:

To the extent the company overachieves on cash generation this year, AT&T said it will look at using a portion of its free cash flow after dividends to retire some of the shares it issued in conjunction with acquiring Time Warner, particularly with shares at today’s levels.

Source: AT&T Press Release of JP Morgan Global Technology, Media and Communications Conference

Yes, you are not mistaken, AT&T has just mentioned stock buybacks although it has not specifically announced them. With the stock price at current levels this is a very smart move and depending on the extent of the buyback, this could be even more beneficial to the company and its investors than paying back more than expected debt provided AT&T can save more money on dividends that it needs to pay interest on its debt.

This does not mean AT&T should slow down with its debt repayment but if it overachieves its own target of around $26B in FCF, a stock buyback is the best thing it can do. It's been a very long time since AT&T retired a meaningful amount of shares.

Chart Data by YCharts

Investor Takeaway

There is still no love for AT&T. Now is the time not to be afraid of the stock's cheap valuation but instead to embrace it.

AT&T is on the right path:

  • It is cutting down on debt and delivering on its other key initiatives.
  • It is preparing its own streaming service and can meanwhile offset video subscriber losses with higher ARPU and growth in broadband.
  • It is a cash flow machine and if everything goes well could even start to buy back shares for the first time in several years.

Things are improving and the market's reaction to Disney unveiling its streaming service with the stock shooting up double digits shows at what could be waiting for AT&T as well. In the meantime, patient long-term investors can collect a juicy dividend.

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Disclosure: I am/we are long T, AMZN. 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.

Additional disclosure: I am not offering financial advice but only my personal opinion. Investors may take further aspects and their own due diligence into consideration before making a decision.