T/AT&T: Not Looking So Good, But Valuation Is Attractive

Summary

• AT&T’s shares have underperformed over a long period of time.
• Lost share in wireless mobility over the last 2 years—subscribers and revenues falling faster than Verizon, while T-Mobile has been gaining share.  Warner Media subscribers, revenue, and margins also declining.
• Valuation attractive, but will become less so if revenues and earnings continue descent.
• Activist investor Elliott Management engaged with the company but has slashed its ~$1 billion position by 80%.
• Growth from 5G will likely take a while to materialize.

AT&T’s shares have underperformed all relevant benchmarks over the last 10 years

Since 2010, AT&T shares have appreciated a whopping $1.50 or 10.3% (chart 1). Even though the shares paid a dividend of 4-6% over that period, AT&T shares have vastly underperformed the S&P500, which was up 234% (chart 2).

Chart 1: AT&T shares were up 10.3% since October 2010

Chart 2: The S&P 500 has appreciated by 234% over the last 10 years

According to activist fund Elliott Management Corporation (“Elliott”), AT&T has underperformed across all relevant benchmarks and timeframes for more than 10 years (chart 3). The stock edged up in 2019 but has since given back the gains.

Chart 3: AT&T’s performance has underperformed its peer group, Verizon, the S&P500 and DJIA

AT&T’s financial metrics have underperformed both its competitors

AT&T’s per-share revenue is barely above its 2010 levels and is below 2015 levels (chart 4). Furthermore, its 2020 margins are back to 2010 levels (chart 5), which is both surprising and disappointing, as its acquisition of the higher-margin Time Warner content businesses should have contributed to higher margins

Chart 4: AT&T’s per-share revenues since 2010

Chart 5: AT&T’s operating margins are back at 2010 levels

On September 9, 2019, Elliott wrote an open letter to AT&T’s board of directors.  In the letter, Elliott detailed the company's strategic setbacks, which include the botched acquisition of T-Mobile (AT&T’s very large breakup fee gave T-Mobile the resources and spectrum to turn itself into a formidable competitor), the overpriced purchase of DirecTV (rumors are that AT&T is seeking buyers due to the subpar performance), and the poor bet on Time Warner (which has steadily lost revenues).  Elliott also had pointed words for the damage that resulted from AT&T’s poor leadership, poor wireless execution, and product issues.

On April 24, 2020, AT&T announced the retirement of CEO Randall Stephenson (he receives an astonishingly rich $64M retirement plan), even as the performance metrics continue to weaken and the stock continues to drop.

Wireless mobility, AT&T's largest segment, subscriber count and revenues have declined steadily over the last 4 years

1. Over the last 2 years, AT&T’s subscriber count in this segment, excluding connected devices, has fallen slowly but steadily at an annualized rate of 0.8%, and average revenue per user (ARPU) has been flat (chart 6). Even though AT&T has added subscribers in its Prepaid and Connected Devices segments, both are less lucrative and sticky than the Postpaid segment. I note that the decline is nothing new—it began more than 4 years ago in 2016 (chart 7).

Chart 6: Decline in postpaid and reseller subs (2018-2020)

Chart 7: Decline in postpaid and reseller subs (2016-2018)

2. Even though ARPU for the video communications and broadband connections segments have increased with the rollout of IP-Fiber, it has not been sufficient to offset the decline in subscribers, revenues or EBITDA or EBITDA margins (chart 8)

Chart 8: Video and broadband connection revenues, EBITDA and margins have been declining

3. AT&T's Business Wireline Revenues have been similarly disappointing. The segment’s revenues have declined by 2.7% p.a. since September 2018 (chart 9):

Chart 9: Business wireline revenues have declined over the last 2 years

T-Mobile and Verizon, AT&T's two main competitors, have fared better:

T-Mobile has been gaining subscribers over the last 1.5 years, thanks to the large breakup fee and spectrum AT&T was contractually obligated to pay T-Mobile when the proposed combination was rejected by the government on antitrust grounds (chart 10—note that the jump in 2Q202 was due to the merger with Sprint). Verizon’s subscriber count has held relatively steady (Chart 11), as has its average revenue per account.

Chart 10: T-Mobile’s subscriber count has grown steadily

Chart 11: Verizon’s subscriber count has held steady

AT&T’s media revenue falling even faster

When Elliott wrote the open letter to AT&T’s board almost a year ago, Elliott stated that “it is too soon to tell whether AT&T can create value with Time Warner”. Unfortunately, the answer appears to be “no"—over the last 7 quarters, Turner, HBO, and Warner Brothers’ annualized revenue growth rates have been flat, -0.7% and -7.3% respectively. As a result, AT&T’s Warner Media segment revenues and operating income declined at annualized rates of 12.7% and 21.2% respectively, while its operating income margin contracted by 550bps, from 33.5% to 28.1% (chart 12)

Chart 12: Warner Media segment revenues and EBITDA falling even faster

Valuation is attractive but will become less so if revenues and earnings continue to decline

Valuations attractive at a free cash flow yield of over 12% (chart 13), but its per-share revenues have been declining since it peaked in 2016, and is now below 2014 levels (chart 14).

Chart 13: AT&T’s valuation (based on trailing 12-month free cash flow and net income)

Chart 14: Quarterly per-share revenue for 1Q2020 is below 2014 levels

Activist investor Elliott Management engaged with the company last fall, but has since slashed its position by 80%

Elliott Management, the activist hedge fund mentioned above, took up ~$1 billion position in AT&T in the 4th quarter of 2020 as it engaged with AT&T management. However, it has cut back its position by 80% as the price of the stock decline, suggesting that it did not see appreciation potential that meet its return requirements (chart 15). It would not surprise me if Elliott completely exited its position by the next SEC filing cutoff date.

Chart 15: Elliott Management’s position in AT&T (source: SEC 13F-HR filings)

Bottom line: stability due to the tripoly structure of the wireless carrier industry, but growth from 5G will likely take a while to materialize

As one of the 3 players in the essential wireless carrier triopoly, I believe AT&T’s market and customer base is quite stable. However, as Elliott pointed out, AT&T has underperformed due to poor wireless execution and self-inflicted wounds from a flawed M&A strategy.

Furthermore, the 4G LTE space is already quite well penetrated, and it is perhaps unsurprising how little pricing power AT&T has (as measured by ARPU), even as the COVID-19 pandemic accelerated the move towards digital online media consumption.

It is an appealing hypothesis that the upcoming rollout of 5G will cause a near-term spike in AT&T and other wireless carriers’ growth. However, I am skeptical that existing wireless subscribers will pay substantially more for their 5G subscription, as they did not pay more for their upgrade from 2G to 3G, or from 3G to 4G LTE. As such, I believe that growth will most likely come from AT&T offering a reasonably priced data service to new subscribers with new apps and internet of things (IOT) devices that would otherwise be unfeasible to run without the speed, low latency of 5G.

In any event, I think it will take time until the rest of the data infrastructure, customers’ devices, and applications catch up to the higher 5G speeds. As such, I do not see a reason to rush in on the thesis that 5G will supercharge wireless carrier returns.