AT&T's Moving in the Right Direction

We’ve long disliked AT&T’s T capital-allocation decisions, including the acquisitions of DirecTV and Time Warner. With considerable skepticism around the company’s telecom and media integration strategy and fears concerning its debt load, investors have punished the shares. However, given the size of the moves AT&T has made recently and the company’s emphasis on reducing leverage, we don’t expect another costly strategic shift anytime soon. As a result, we believe the shares are now attractive for investment.

We doubt that AT&T’s transformation into a diversified media and telecom company will deliver significant strategic benefits, as we don’t believe these industries complement each other well, despite their close association. The Time Warner acquisition was the latest in a string of ill-advised capital-allocation decisions for AT&T, in our view. However, we believe AT&T’s most important segments (wireless and media) are still solid businesses on their own, and we suspect the company has now largely placed its bets, as efforts to reduce leverage are likely to preclude additional major strategic moves.

Our view of the Time Warner deal is based on our belief that media companies need to reach as wide an audience as possible to maintain relationships with content creators and fend off rivals. In AT&T’s case, we expect this need will limit opportunities to create unique experiences for its telecom customers. In addition, other wireless carriers have already responded to AT&T’s strategy, partnering with Netflix, Hulu, and others to bundle content with telecom services. Finally, while we agree that AT&T can improve the advertising business, using data to better target consumers, we believe the changing nature of television viewing limits the size of this opportunity. We don’t see major strategic benefits in linking content with telecom services.

AT&T’s scale in wireless is still an advantage over smaller rivals Sprint S and T-Mobile TMUS, enabling the company to generate far stronger profitability while charging similar prices. (Verizon VZ and AT&T dominate the U.S. wireless market, claiming roughly 40% and 30%, respectively, of the postpaid phone market between them.) While the proposed merger of the two smaller carriers would narrow this scale advantage, it would also greatly improve the industry’s structure, leaving three players with little incentive to price irrationally in search of short-term market share gains.

WarnerMedia remains a media powerhouse with a deep content library and the ability to reach audiences across a wide variety of platforms. While we have some concerns about the company’s direct-to-consumer plans, this position should enable its studios and networks to remain a destination of choice for the best content creators well into the future.

Still Deserves Narrow Moat Rating Following the Time Warner acquisition, AT&T is truly a behemoth, with roughly $480 billion of invested capital employed in the business, or about $335 billion excluding goodwill. Its operations are now diversified across several distinct but interrelated businesses. AT&T's grand strategy is to meld its consumer-facing telecom and media businesses into cohesive service offerings that attract and retain customers. We doubt that this plan will yield significant benefits. The telecom and media businesses are simultaneously mature and rapidly changing. We believe most consumers are generally aware of the wireless carriers' strengths and weaknesses, choosing providers primarily based on service quality and price rather than add-ons or bundle options. We also expect the best content creators, including writers and actors, will migrate toward media companies that deliver the best mix of audience size and monetization potential over time. This dynamic should limit AT&T's ability to overly restrict access to or discount the content it produces. Finally, AT&T's scope should enable it to improve advertising yields, but we also expect changing consumer demands will force an offsetting reduction in ad loads across the traditional television market.

Looking at AT&T’s businesses individually, we believe the company still deserves a narrow economic moat rating based primarily on cost advantages in the wireless business and intangible assets acquired with Time Warner. These advantages should enable the company to maintain relationships with customers and increase free cash flow. However, recent capital-allocation decisions have sharply lowered returns on invested capital. In aggregate, AT&T is a collection of businesses that should produce double-digit ROICs, but high acquisition prices will probably leave ROICs roughly in line with the company’s cost of capital, as we calculate it, despite significant competitive advantages.

Primary Risks Are Technological and Regulatory Wireless standards continue to evolve, putting more spectrum to use more efficiently. The cost to deploy wireless networks could come down to the point where numerous new companies are able to enter the market. The cable companies are already making serious attempts to leverage their existing networks to provide limited wireless coverage using Wi-Fi. Technology could quickly enhance these efforts.

Also, regulators control the flow of wireless spectrum into the industry, which has created scarcity in the past, pushing carriers to pay high prices for licenses. The Federal Communications Commission seems intent on making more spectrum available for both licensed and unlicensed use. A flood of new spectrum available could drive down prices, further easing entry into the wireless business. Alternatively, incumbents could be compelled to bid up prices to protect the market, as we suspect AT&T did in 2015 during the costly AWS-3 auction.

AT&T is still responsible for providing fixed-line phone service to millions of homes across the United States, including many in small towns and rural areas. Wireless technology may enable the company to serve small-market customers more efficiently, but it would also open the doors to greater competition. More pressing, regulators may not allow AT&T to decommission old copper-based networks quickly enough to avoid burdensome maintenance costs.

Technology has also dramatically altered the media and television industry. Faster Internet connections and more capable devices have made online television a more compelling alternative to traditional cable and satellite. As one of the largest traditional television providers and a large content producer, AT&T has a lot at stake as new consumer habits take hold.

Focus on Debt Paydown AT&T currently carries net debt of $169 billion, down from $177 billion after the Time Warner acquisition closed, equal to about 2.8 times pro forma EBITDA. This figure is far higher than the company has operated under in the past: Immediately before the current capital-deployment binge began in 2012 (with a round of heavy share repurchases), the company carried leverage of around 1.5 times EBITDA. The current leverage figure isn't alarmingly high, especially considering the capital efficiency of WarnerMedia. Several telecom carriers and cable companies operate with significantly more burdensome debt loads.

However, AT&T’s commitment to a growing dividend constrains the amount of leverage it can comfortably carry. At the current level, dividends will require payments of $15 billion annually, equal to about 25% of EBITDA. Cash interest and taxes will probably consume around 20% of EBITDA annually, leaving about 55% for capital spending, pension and other retirement benefit contributions, and debt reduction. In total, we expect AT&T will have $12 billion-$15 billion available annually over the next few years to repay debt.

AT&T aims to bring leverage down to 2.5 times EBITDA by the end of 2019 and to historical norms, around 1.8 times, by the end of 2022. We believe the company can hit these targets through a combination of modest growth, asset sales, and debt reduction. The company has announced sales of its stake in Hulu and real estate in New York, raising nearly $4 billion and putting it on track to hit its 2019 target. We still see downside risk in hitting the 2022 target, though. In our bear scenario, EBITDA declines modestly and cash flow available for debt reduction declines, causing leverage to fall only slightly. In this scenario, we expect AT&T would need to strongly consider cutting its dividend, at least temporarily. Additionally, tight credit market conditions could cause the company to cut the dividend to boost creditor confidence.