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AT&T (T)

AT&T and Time Warner got the green light to merge on June 12, 2018. Read about the implications of the merger on AT&T's dividend and the ensuing drama when the Department of Justice appealed the ruling.

Founded in 1983 as SBC Communications (the company bought AT&T in 2005 and adopted the more famous moniker), AT&T is a telecom and media conglomerate that operates four business segments:

Business Solutions (43% of 2016 sales): offers wireless, fixed strategic, legacy voice and data, wireless equipment, and other services to over 3 million business, governmental, and wholesale customers, as well as individual subscribers.

Entertainment (31% of sales): provides video entertainment and audio programming channels to approximately 25.3 million subscribers; broadband and Internet services to 12.9 million residential subscribers in over 240 markets; local and long-distance voice services to residential customers, as well as DSL Internet access services. This division has connections to over 60 million locations nationwide.

Consumer Mobility (20% of sales): offers wireless services to over 136 million U.S. customers and wireless wholesale and resale subscribers, such as long-distance and roaming services, on a post and pre-paid basis.

This segment also sells a variety of handsets, wirelessly enabled computers, and personal computer wireless data cards through company-owned stores, agents, or third-party retail stores, as well as accessories, such as carrying cases, hands-free devices, and other items.

International (4% of sales): offers digital television services, including local and international digital-quality video entertainment and audio programming under the DIRECTV and SKY brands throughout Latin America. This segment also provides postpaid and prepaid wireless services to approximately 13.1 million subscribers under the AT&T and Unefon brands; and sells a range of handsets.

Business Analysis

The key to AT&T’s ability to generate such high and growing dividends for more than 30 consecutive years is the wide moat created by the extremely capital intensive nature of the industries in which it operates.

For example, AT&T spent more than $140 billion between 2012 and 2016 on maintaining, upgrading, and expanding its networks, including over $22 billion in 2016 (13.4% of revenue).

Few other companies can afford to compete with AT&T on a national scale. Only Verizon (VZ), T-Mobile, and to a lesser extent Sprint (S) have the resources to operate networks that offer similar levels of connectivity.

To make matters even more challenging for new competitors, most of AT&T’s markets are very mature. The number of total subscribers is simply not growing much.

In other words, it would be almost impossible for new entrants to accumulate the critical mass of subscribers needed to cover the huge cost of building out a cable, wireless, or satellite network.

In addition to covering network costs, AT&T’s scale allows it to invest heavily in marketing and maintain strong purchasing power for equipment and TV content. Smaller players and new entrants are once again at a disadvantage.

Barring a major change in technology, it seems very difficult to uproot AT&T. It’s much easier to maintain a large subscriber base in a mature market than it is to build a new base from scratch.

While AT&T’s wireless division is its most consumer-facing business, the company’s strong presence in hundreds of broadband internet markets, as well as its expansion into pay-TV, via the $67 billion acquisition of DirectTV in 2015, have helped it continue growing despite a highly saturated U.S. market in both wireless and internet service.
Source: AT&T Earnings Presentation
In addition, DirectTV has allowed AT&T to bundle many of its offerings to customers, helping it fend off the worst of the cord-cutting trend that has plagued so many of its rivals.

In fact, AT&T showed continue improvement in phone churn and has seen satellite churn drop by 50% when bundled with wireless. More of its pay-TV customer base is also using the company’s wireless plans compared to two years ago.
Source: AT&T Earnings Presentation

With plans to acquire Time Warner, the media content juggernaut, in an $109 billion mega-acquisition (including debt), AT&T hopes to better leverage its various platform offerings to remain competitive in the cutthroat wireless industry.

For example, thanks to T-Mobile reviving the popularity of unlimited data plans, once price insensitive rivals such as Verizon have been forced to reduce their wireless plan prices to $80 per month for unlimited data (first line).

In contrast, AT&T offers a $90 unlimited plan that continues to gain subscribers thanks to the company bundling a $25 pay-TV discount, as well as offering free HBO (a Time Warner company).

In fact, thanks to the popularity of these bundled unlimited data plans, AT&T’s postpaid churn rate (what percentage of subscribers leave each month) hit a record low for the third quarter of 0.84%, and the wireless segment’s EBITDA margins have risen to a record high of 42%.

In other words, AT&T’s track record of expanding into media and related industries appears to be bearing some fruit, including hitting its synergistic cost saving targets and leveraging its new platforms and properties to strengthen its existing core offerings.

That in turn has allowed it to achieve higher-than-average profitability in a massively capital intensive industry not known for its impressive margins or returns on shareholder capital.

AT&T could also be poised to see very strong growth in free cash flow (what funds and grows the dividend) due to ongoing vertical integration efforts and the economies of scale that go with it.
If the contested Time Warner acquisition goes through, AT&T would enjoy a higher-margin business (Time Warner’s operations are relatively much less capital intensive) that is also growing faster, helping fuel a continued rise in AT&T’s free cash flow.

That in turn could accelerate AT&T’s long-term dividend growth and total return potential, once AT&T uses the additional free cash flow to pay down the debt it’s taking on to fund the deal.

Meanwhile, while still not itself a needle-moving business segment, AT&T’s international divisions are continuing to grow nicely thanks to AT&T successfully gaining new customers in Mexico.

That’s a market it entered in 2014 with its $4.4 billion purchases of lusacell and Nextel Mexico to gain access to a fast-growing region; one in which the population is expected to grow 32% between 2010 and 2050 to reach 156 million people.

Management has previously stated that they believe AT&T’s Mexican operations could eventually grow to be at least 25% of the size of its U.S. wireless business over the long-term, and subscribers grew 29% year-over-year last quarter.
Source: AT&T Earnings Presentation
In other words, while international may still be a small fraction of sales, AT&T’s strong presence in Latin America means that it also offers long-term double-digit organic growth potential.

At the end of the day, AT&T seems to enjoy a strong economic moat due to its ability to provide customers with their video, data, and communication needs anytime, anywhere, and on any device. Few companies have the financial firepower and brand strength to effectively compete.

However, the telecom industry and consumer preferences are constantly evolving, making incremental earnings growth more challenging for the large incumbents.

Key Risks

While AT&T has historically been a relatively low risk stock, there are nonetheless several major risks to be aware of.

Domestically, AT&T’s organic growth has basically stalled because of the saturated nature of the markets it operates in.

On the wireless side, smartphone saturation and the rise of T-Mobile (TMUS) have intensified competition for existing subscribers. The major players have been forced to offer unlimited data plans to maintain their subscriber bases, losing out on lucrative data overage fees.

While there was hope of industry pricing becoming more rational with T-Mobile and Sprint (S) appearing likely to merge, the odds of a deal happening now appear to be low.

There’s also hope that the “internet of things” could bring new wireless data growth opportunities in areas such as smart cars and automated homes, but these categories are much smaller than the total revenue generated from smartphones today.

If growth in the wireless market remains weak and there is no further consolidation, the battle for existing subscribers could intensify between carriers, pressuring the industry’s strong margins.

Perhaps more concerning, AT&T’s big bet on DirecTV has shown some cracks in recent quarters. You can see that DirecTV satellite subscribers declined during the second quarter and saw an even larger drop during the third quarter.
Source: AT&T Earnings Release, Simply Safe Dividends
Craig Moffett, an industry analyst for Moffett Nathanson LLC, said in a Bloomberg Radio interview that DirecTV is now probably only worth about half what AT&T paid for it ($67 billion)!

The rise of over-the-top streaming services could be winning over traditional pay-TV subscribers at an increasing pace. AT&T launched its own streaming service, DirecTV NOW, and has seen it grow to more than 800,000 subscribers in less than a year (compared to company-wide TV subscribers of about 25 million).

However, DirecTV NOW is at a much lower price point than satellite TV and is far less profitable. It also risks cannibalizing AT&T’s higher-margin, traditional pay-TV subscribers.

Given some of these pressures, the company’s domestic sales, earnings, and free cash flow are almost entirely dependent on continued large-scale acquisitions.

For example, while AT&T reported strong double-digit growth in 2015 and 2016, that was entirely due to the DirecTV acquisition. Once those favorable comparison quarters passed, the company's sales growth rate basically returned to zero.
While the Time Warner deal has the potential to once again boost growth, investors need to realize two important risks about that transaction.

First, a successful integration of Time Warner is far from assured. After all, due to overpaying and failed synergistic cost savings, the majority of large acquisitions fail to generate shareholder value. These are two companies with very different cultures and lines of business.

In addition, AT&T is currently locked in a lawsuit with the U.S. Justice Department over the merger. Regulators are worried AT&T will abuse its control over content distribution once it has its own significant media assets, potentially reducing choice for American households and causing costs to rise.

Should the Department of Justice block the acquisition (or require serious divestitures), then not only would AT&T lose an opportunity to boost its overall profitability and growth prospects, but it would also incur a $1.73 billion breakup fee and face greater strategic uncertainty with plans for its existing businesses.

If the merger does gain final approval, AT&T will be saddled with even more debt.
Source: The Dallas Morning News, Moody’s
AT&T management has stated they expect to repay debt with free cash flow and return the company’s leverage to historical levels within four years of the Time Warner deal closing, according to The Dallas Morning News.

Adding more debt raises AT&T’s annual interest expense, could result in a credit rating downgrade (raising its cost of capital), increases refinancing risk, and leaves less margin for error if industry conditions change faster than expected.

Here’s what Moody’s noted:

“The deal’s financing costs will consume the majority of acquired free cash flow due to an incremental $2.3 billion in annual dividends and $1.3 billion in additional after-tax annual interest expense.

Moody’s believes that given AT&T’s limited excess cash after dividends and modest EBITDA growth potential, that organic leverage reduction is limited to around 0.1x to 0.2x annually…

AT&T’s funded debt balance could exceed $170 billion following the transaction close and average annual maturities will be greater than $9 billion starting in 2018…This may cause AT&T’s cost of debt to rise, especially in times of market stress. Rising benchmark rates, combined with wider credit spreads would put pressure on AT&T’s free cash flow.”

While this much higher debt load seems likely to remain manageable, courtesy of the combined company’s substantial free cash flow stream, investors need to realize that paying down debt is going to be the primary use of Time Warner’s additional earnings.

As a result, the Time Warner acquisition isn’t likely to boost dividend growth anytime soon. Investors worrying about the deal compromising AT&T’s ability to pay dividends may find some comfort in management’s recent commentary.

“We continue to have strong cash flows, and we view that very positively, particularly as we have great coverage on our dividend. And as we go to that time of year, we want to make sure that we continue and we will be able to continue to provide our board the opportunity to continue raising our dividend if they so choose...”

Furthermore, AT&T’s free cash flow generation remains robust. The company’s free cash flow grew by more than 13% year-over-year to reach $5.9 billion in the third quarter of 2017, which compares to approximately $3 billion of dividends paid during that period.

On a year-to-date basis, AT&T has generated $12.8 billion of free cash flow compared to $9 billion of dividends paid (i.e. 70% free cash flow payout ratio).

Time Warner has generated $3.6 billion of free cash flow year-to-date, up 8%. If we annualize and combine each company’s free cash flow amounts and account for higher interest expenses from the merger, we get a ballpark figure free cash flow figure of around $18 billion to $20 billion (before any merger integration costs).

With AT&T’s annual dividend commitment expected to rise to $14.5 billion following a successful merger with Time Warner, the combined company’s free cash flow payout ratio would likely sit around 70% to 80%.

That would leave only around $5 billion of excess free cash flow (after paying dividends) each year that can be used to gradually reduce AT&T’s estimated total debt burden of approximately $190 billion.

Management has also stated they plan to divest some assets over the next two years to raise cash that can be used to further assist with debt reduction.

The stakes are clearly high, and it’s not out of the question that AT&T’s dividend could become at risk within several years if some markets shift faster-than-expected in unfavorable directions (e.g. wireless commoditization, pay-TV declines accelerate), although that outcome seems unlikely.

The company also becomes more dependent on favorable credit market conditions and potentially has less wiggle room to invest as heavily in future initiatives (e.g. 5G infrastructure, spectrum) or acquisitions.

AT&T not only needs to deliver on its expected cost synergies, but it needs to hope that its big bets on bundling, pay-TV, and content are the right ones to keep it relevant in a fast-changing technology world.

As Bloomberg noted, there are no other companies offering TV distribution, mobile distribution plus content. This is a bold strategy that could differentiate the firm for the better, or it could ultimately have costly consequences.

A final risk to consider when it comes to AT&T’s growth potential is its international segment, whose success is similarly uncertain.

That’s because while AT&T’s Mexico wireless business is growing strongly, the company is by far the smallest fish in the Mexican wireless sea, facing off against far larger and very well-capitalized rivals such as Telefonica and America Movil.
Even if AT&T does manage to gain market share in Mexico, keep in mind that it’s far from certain that it will be able to do so while generating the same kinds of impressive 40+% EBITDA margins as its U.S. wireless business does.

After all, Mexico is still a developing economy where per capita wealth is far lower than in the U.S., meaning more price-sensitive consumers.

Closing Thoughts on AT&T

AT&T has taken a number of bold steps in recent years to proactively take on changing industry conditions across wireless, video, and media markets.

It will probably take at least several years to determine just how savvy these massive capital allocation bets actually are. For now, AT&T remains a mature cash cow that is a reliable source of income over at least the short to medium term.

However, any dividend investor considering AT&T must understand and accept the risks that come with the company’s ballooning debt load and evolving business strategy, assuming the Time Warner deal ultimately gains regulatory approval.

Between AT&T’s sluggish growth in wireless postpaid subscribers and recent DirecTV satellite subscriber losses, there are certainly a few signs that the company’s bundling strategy and large-scale expansion into pay-TV may not be living up to expectations.

Investors must not forget that AT&T’s acquisitions of DirecTV and (likely) Time Warner give it meaningful exposure to two companies that are facing their own unique sets of disruptive challenges. These are far from sure bets.

If industry conditions take an unexpected turn for the worse or management becomes distracted (very different cultures and businesses would be combining), the company’s debt burden, refinancing risk, and elevated payout ratio could become a big deal within the next five years.

This certainly isn’t the predictable AT&T of old, but as part of a well-diversified income portfolio, the company’s generous dividend yield looks interesting for investors who are comfortable with the risks.

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