AT&T Rhetoric Suffers From A Major Bias
Summary
- Poor capital allocation decisions made in the past do not mean that recent deals will produce the same results.
- Fixing the past mistakes will not happen overnight, but recent developments are encouraging for the long-term future of AT&T.
- There are more challenges lying ahead for AT&T's Communications division as competition intensifies.
AT&T (NYSE:NYSE:T) has been making the news quite often recently as the company's new CEO is making a rapid U-turn on many of the major capital allocation decisions made in the company over the recent years.
Needless to say, performance relative to Verizon (NYSE:VZ) and T-Mobile (NYSE:TMUS) has been disastrous due to AT&T's failed attempts to expand into the satellite TV business and content creation.
With the recent deals, AT&T's management has literally admitted, even though it has been already obvious, that the company has destroyed a massive amount of shareholder value. On top of that, the company's wireless division has been faced with increasing competition and the need for more capital investments. All that inevitably led to a major downward multiple repricing for AT&T and an opening of a wide gap between those of the other two major carriers.
As recent events unfolded the narrative around the company grew even more extreme in both believers and skeptics camps. Believers in AT&T business model expressed their support for the company's long-term potential even more strongly as the company's valuation reached new lows. Skeptics, on the other hand, are rightfully so pointing out to the massive shareholder value destruction and poor capital allocation policy, through the DirecTV and Time Warner acquisitions.
While both theses have merits, the latter seems to be increasingly influenced by the recency bias and assuming that since AT&T has done mistakes under its previous CEO, it will necessarily continue to make wrong moves.
The Recency Bias
Judging performance in hindsight is easy. It is not hard to judge past decisions, especially in the case of AT&T when the result of DirecTV and Time Warner mega deals is quite clear at this point.
Certain media outlets have also been quite vocal about the poor capital allocation decisions made by AT&T's management a few years ago and that's fair when judging past performance. However, it seems that the narrative is slowly falling into the bias of fighting the last war or recency bias. In other words, people tend to judge future performance based on the most recent data they have.
The capital allocation mistakes done a couple of years ago have already played their role in AT&T's share price and low valuation multiples relative to peers. The terms under the spin-off deals, however, appear as the best solution possible at this point and in my view are a step in the right direction towards turning around the telecom carrier.
Fixing Past Mistakes
Fixing strategy mistakes and reversing course, following two major M&A deals is not an easy task for a company the size of AT&T. On top of all that, the carrier also faces increasing competition and the need for increased capital spend in the wireless space which necessitates bold management decisions.
Reversing course in satellite TV
Going through the figures of the DirecTV deal was indeed painful. Although it is nearly impossible to calculate the exact figures on just how much value was destroyed in the process of acquiring, trying to integrate and now spinning off the DirecTV business, the high level figures show the following.
In 2015, AT&T paid $49bn to acquire DirecTV which valued the satellite business at $67bn (including the long-term debt). The purchase price allocation also shows that almost all of that amount was related to Goodwill, which is rarely a good sign and a smaller proportion to customer lists.
Source: AT&T Annual Report 2015
Fast forward to 2021 and the new spun-off entity is valued at only $16.3bn (see below). Of course, we should recognize that part of DirecTV assets, such as regional cable sports channels and DirecTV's Latin America, were not subject to the spin-off deal.
Source: AT&T and TPG to Form New Premium Video Entity
Even though DirecTV's fate remains uncertain due to its rapidly shrinking customer base, the deal has a number of important implications for AT&T:
- the sizable cash proceeds of $7.6bn could be used to finance AT&T's spend on 5G spectrum;
- bringing in a partner, such as TPG Capital, would help in transitioning the DirecTV business as a standalone entity.
Reversing course in content
The deal to spin-off WarnerMedia came only months after the announcement of DirecTV deal and appears to be another step in the right direction for AT&T. HBO and Warner Bros are among the crown jewels in media and combining them with the undisputed leader in the non-scripted space creates a large enough Direct-to-Consumer player that will be able to compete with Netflix (NFLX) and Disney's (DIS) Disney+, ESPN and Hulu offerings.
First and foremost, the deal will reduce churn rates as the two offerings complement each other while the larger scale is also crucial for any DTC offering. In addition Discovery's (DISCA) significant international exposure will also help in advertising new content from HBO and Warner Bros.
The combined offering of WarnerMedia and Discovery could still be seen as inferior to those of Disney and Netflix in certain areas, however combining blockbuster movies, tons of unscripted content, sports, news channels and kids networks would create a more well-rounded player.
Source: Discovery and WarnerMedia to Combine Presentation
The new company will also lead in annual content spending, which given the legacy of HBO, WarnerBros and Discovery of creating the world's best content will create a significant competitive advantage.
* High end estimate of the $14bn to $16bn estimate for 2024
Source: prepared by the author, using data from CNBC
The deal will also give AT&T a breath of fresh air by reducing its massive debt load by $43bn and allowing it to shift its focus on 5G wireless and fiber.
Source: Discovery and WarnerMedia to Combine Presentation
Finally, the newly created media company will also have significant free cash flow conversion rate and although leverage will be elevated in the beginning, the CEO David Zaslav and John Malone have proven track record of using debt for productive purposes and consequent deleveraging.
Source: Discovery and WarnerMedia to Combine Presentation
It should also be mentioned here that WarnerMedia is also selling its mobile games studio to Electronic Arts (EA) in a push to streamline the business and focus solely on content creation.
Wireless Wars
As I said, DirecTV and WarnerMedia deals will allow A&T to shift its focus on its Communications business and dial-up its investments in 5G and fiber. The telecoms business of AT&T is where its core competency lies and expanding into media seems to have been a mistake that will soon be taken care of.
However, that does not automatically make AT&T a compelling investment opportunity and does not mean that the problems in wireless will suddenly go away. Spending on 5G is in its early stages and will continue well into the coming years.
Source: GSMA
Based on the graph above, in 2020 the Capex to revenue spend for telecom operators came at around 17%. This is significantly higher than AT&T's Capex to Revenue ratio in its Communications segment of 10% for the same year.
As a matter of fact, the whole fiasco of going into media and cable has resulted in AT&T significantly lowering its Capex to Sales ratio when compared to Verizon.
* Based on Communications segment for AT&T
Source: prepared by the author, using data from annual reports
Verizon has also solidified its leading position in 5G airwave bidding wars by spending $45bn, compared to $23bn spent by AT&T in the recent auction.
Source: fortune.com
While that should not be interpreted as a definite sign on who will lead the way in 5G connectivity, it highlights the importance of midband frequency assets and the amount of capital needed for wireless airwaves auctions only.
AT&T has also been suffering from increased competition by T-Mobile, which recently acquired Sprint and thus consolidated the industry to only 3 major wireless carriers in the United States. Following the deal, it appears that customers of AT&T are more likely than those of Verizon to switch to T-Mobile.
Source: telecompetitor.com
Contrary to all that, so far the business momentum behind AT&T's wireless division remains strong with most recent quarterly results showing a continuation of the record low churn rates and a strong postpaid net additions.
My Takeaway
AT&T's share price has been rightfully so punished by the market for its poor capital allocation decisions made over the recent years. Destroying shareholder value does come at a cost and therefore low multiples are by no means a sign of the company being undervalued.
However, the narrative seems to be increasingly influenced by the recency bias. In other words, AT&T's poor decisions made during the tenure of the previous CEO are used as a basis to judge the most recent developments in the company. In my view, AT&T is now making the right steps towards turning the business around and although the transition will not be painless it certainly gives a glimpse of hope.
All that does not make AT&T a compelling investment opportunity in my view either as certain competitors in the wireless sector seem to be better positioned at this point, while at the same time WarnerMedia deal will also take time to complete. The recent moves by the management, however, put AT&T and its media spin-off on my watch list.
This article was written by
Vladimir Dimitrov is a former strategy consultant with a professional focus on business and intangible assets valuation. His professional background lies in solving complex business problems through the lens of overall business strategy and various valuation and financial modelling techniques.
Vladimir has also been exploring the concept of value investing and in particular finding companies with sustainable competitive advantages that also trade below their intrinsic value. He supplements his bottom-up approach with a more holistic view of the markets through factor investing techniques.
Vladimir made his first investment in farmland right out of high school in 2007 and consequently started investing through mutual funds at the bottom of the market in 2009. In the years that followed he has been focused on developing his own investment philosophy and has been managing a concentrated equity portfolio since 2016. Vladimir is LSE Alumni and a CFA charterholder .
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