AT&T Weathers IPhone Hit

 AT&T (T) weathered the impact of  Apple's (AAPL) iPhone 5 launch reasonably well during the fourth quarter, though the device continues to have an outsize impact on the firm. The fixed-line business turned in fairly solid results, while strong consolidated cash flow enabled aggressive share repurchases without adding significantly to leverage. We don't expect to change our fair value estimate materially in light of the quarter. 

Cash flow was the biggest bright spot at AT&T during 2012, in our view. The firm generated $4.3 billion of free cash flow during the fourth quarter, bringing the total for the year to $19.5 billion. After funding $10.2 billion in dividend payments and spending $12.8 billion to repurchase shares, AT&T's net debt load increased about $3.4 billion during 2012 to $65 billion. With modest growth in revenue and stable margins, net leverage increased only slightly to 1.58 times operating income, excluding depreciation and amortization, from 1.54 times at the end of 2011. AT&T repurchased 371 million shares (6% of the total outstanding) during 2012 and expects to complete its 600 million-share authorization by the middle of 2013. The buyback completed in 2012 will cut about $670 million off AT&T's dividend payout in 2013. Considering that the firm can currently borrow money for 10 years at less than 3%, we believe the modest increase in leverage is an attractive trade for stronger dividend coverage as capital spending ramps up over the next couple of years.

AT&T produced stable margins during the fourth quarter and 2012 despite a significant jump in iPhone sales. The firm activated 8.6 million iPhones during the quarter, or 84% of total smartphones sold. Both figures were record highs as nearly 1 in 5 AT&T smartphone customers activated the device during the quarter. The cost of subsidizing iPhones pushed wireless operating income, excluding depreciation and amortization, down to 29% of wireless service revenue from 43% through the first three quarters of the year. The margin in the fourth quarter was down only slightly versus a year ago. Still, we had expected margin improvement, with the revenue benefit of smartphone customers added over the past year more than offsetting the cost of subsidizing phones. In addition, smartphone net customer additions dropped about 25% in 2012 versus 2011, so AT&T won't get as much revenue benefit heading into 2013 for the margin hit taken during the quarter as it did the year before. Management expects to improve wireless profitability in 2013 as it seeks efficiencies and benefits from more restrictive phone upgrade policies.

While smartphone customer growth has slowed considerably, AT&T continues to do a solid job of holding on to the customers it already has. Postpaid customer churn (the pace of defections) dropped versus a year ago, adding evidence that AT&T doesn't face a mass exodus of iPhone customers at some point in the future. The firm also found success in promoting tablet sales, adding 400,000 tablets with postpaid data plans during the quarter. In total, AT&T added 780,000 postpaid customers during the fourth quarter, its best performance in two years. Average revenue per customer increased about 2% year over year, as smartphone benefits and increased data plan pricing outweighed dilution from data-only devices and the impact of the introduction of shared data plans. Wireless service revenue increased 4.2% during the quarter, a bit stronger than we had expected.

On the fixed-line side, consumer revenue growth accelerated to 3.0%, the strongest in several years. AT&T continues to expand its television customer base at a steady pace, adding 192,000 customers during the quarter to bring the total to 4.5 million. The biggest driver of consumer growth, though, has been increased revenue per Internet access customer (up more than 10% year over year) as the firm has moved customers to faster speed tiers. The plan to push U-verse to more customers should further aid in moving customers up the speed curve and drive additional revenue benefit. Business services remain a weak spot, with quarterly sales down 2.1% versus a year ago. Sales to larger business customers have shown stability, but smaller businesses remain more reluctant to increase spending. Fixed-line margins remain fairly stable. 

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