AT&T reported largely mixed 4Q results that included one full quarter of Direct TV results. While subscriber metrics were generally in line to modestly better, financial metrics missed the mark.

Given intensifying competition, we think the company has shifted focus on improving profitability over subscriber growth. We believe AT&T has been relegated   to this path given T-Mobile”s continuing net add momentum. Furthermore,   with iPhone 6S supporting Band 12, T-Mobile should see improved coverage using its 700 MHz A Block spectrum.

We also expect AT&T to be affected by the eSIM in the iPhone 7, which will increase churn risk for the wireless carrier  industry. Recent increases to monthly data allowance and free music streaming at T Mobile suggests the company may not be as capacity  constrained as the Street believes; however, our re-seller checks are highlighting significant network coverage-based challenges within the T-Mobile subscriber base.

While T-Mobile is still a net spectrum acquirer, we believe leveraging WiFi-first calling may have been more successful   than the company had expected, resulting in more generous data allowances.

On the wireline front, competition from Google Fiber and cable companies high speed internet services have forced AT&T to continue to build out GigaPower, a negative NPV, but strategically important, asset.

 Key Points:

    * 4Q15 results recap: Including the full month of DTV results (the Direct TV acquisition closed on 7/24/15), consolidated revenues increase 22.3% YOY to $42.1B, below consensus of $42.7B.  

Business Solutions revenue of $18.2B, Entertainment and Internet Services revenue of $13.0B, Consumer Mobility revenue of $8.7B, and International revenue of $1.8B. Adjusted EBITDA of $12.2B were also short of Street expectations of $12.9B. EBITDA margins improved by 160 bps YOY to 29.1%, driven by increased cost efficiencies in Business Solutions and contributions from Direct TV within the Entertainment group. Mobility postpaid net adds of       526,000 and prepaid net adds of 469,000, compared to consensus of 485,000 and 354,000, respectively. Postpaid churn was 1.18%.

    * Potential for spectrum acquisitions and asset sales. While AT&T has not committed an exact amount for the 600 MHz incentive auction, management has been clear that it would like to acquire two 10 MHz blocks.

We believe there is growing urgency to shed less profitable businesses, such as consumer wireline, to fund spectrum       purchases.

    * FY16 guidance maintained. Management maintained prior issued guidance of double-digit consolidated revenue growth, adjusted EPS growth of mid single digits, or better, stable consolidated margins, and $22B in capex.

FBR Comments:

Declining iPhone churn confirmed that the loss of exclusivity and resurgence of T-Mobile were manageable.

Extended upgrade eligibility, upgrade fees, and accelerated upgrade opportunities through AT&T Next have material margin implications, and we expect continued discipline on upgrade eligibility, even in the event of flow share to Verizon and T-Mobile.

With the LTE network buildout complete and AT&T diversifying into Mexico to alleviate churn pressures, further changes to upgrade eligibility are likely. 6 to 12 Months Can AT&T drive earnings growth? Smartphone activations remain significant.

Strategic initiatives with Samsung and Google, coupled with support of the Windows Phone ecosystem by MSFT, NOK, and other OEMs, are key to lower wireless subsidy pressure, but it is early days.

We think AT&T will continue to consider pricing action to augment growth once the LTE network build is complete, but competitive intensity is likely to increase in FY16, so this will prove difficult absent consolidation or until T-Mobile becomes spectrum challenged, which we think is still one year away and a function of T-Mobile commitment to continue network investment. Timeframe: 6 to 18 Months

How will AT&T fare in the changing wireless landscape in 2016 and beyond?

Our strategic concerns for AT&T include:

1) the Apple eSIM impact, should Apple be successful in striking wholesale agreements;

(2) the Google MVNO impact, which could strip the company of the last bastion of connectivity revenue; and

(3) a Wi-Fi first network from Comcast, coupled with a wholesale agreement with a carrier, which would enable a competitor and increase pricing pressure. Timeframe: 6 to 18 Months

Does AT&T have a sustainable spectrum advantage compared with other carriers?

AT&T is behind Verizon in spectrum and out of spectrum in numerous major markets, according to our vendor checks. However, with additional density investment, it is reasonably well positioned to benefit from the combination of coverage layer (700 MHz and 850 MHz) and capacity layer (1,700 MHz and 1,900 MHz and soon-to-be-confirmed 2,300 MHz) spectrum and will focus on LTE and LTE Advanced, as well as refarming 850 MHz/1,900 MHz spectrum for additional coverage and capacity.

Yet this non-standard LTE band will cost more capex and take longer to implement. In the short run, aggressive cell splitting is expected, and metro Wi-Fi and small-cell solutions with economic backhaul solutions are becoming available, allowing for greater surgical reuse of existing spectrum. Sprint differentiation through Clearwire spectrum in FY16 is only likely to modestly affect AT&T relative to Verizon. Furthermore, with 70% 80% of wireless data traffic on Wi-Fi and only 20% of capacity utilized, this suggests a focus in this area to manage data usage growth.

We expect AT&Ts wireless segment to continue to be challenged by a resurgent T-Mobile US. We are less bullish on near-term improvements in capex intensity, due to cultural challenges associated with the much-needed migration to software-centric networks, coupled with the need to upgrade its fiber plant aggressively to improve its competitive positioning and lay the foundation for efficiency improvement.

Risks:

Outperformance at AT&T, Inc. depends on a sustainable economic recovery. Revenue pressures could accelerate in the event of a further economic slowdown, and cost cutting could be inhibited by increased competitive intensity.

Incremental capital spending remains high within the telecommunications segment, driven by technological and competitive challenges. As a result, the inability to control costs effectively could result in downward pressure on free cash flow and affect the sustainability of the company’s current dividend policy.

Overall industry risks continue to center on pricing pressure, particularly in the business segment and accelerated wireless substitution in the consumer segment. Economic recovery factors continue to play key roles in a sector where growth in wireless subscribers, growth in revenue from existing subscribers, and enhanced wireline services are large determinants of growth.

Regulatory uncertainty also continues to play a significant role in the valuation outlook for both the wireline and wireless sectors; therefore, the regulatory landscape must be watched carefully.