Summary & Overview:

AT&T delivered in-line 1Q16 financial results, but domestic subscriber metrics were disappointing. While total wireless net adds of 2.3 million were impressive, most of this was driven by growth in Mexico, which has a much lower wireless penetration and profitability than the U.S. market. Excluding Mexican postpaid net adds of 529,000, this implied U.S. domestic postpaid sub growth of 129,000—business segment of 133,000 + consumer mobility of (4,000)—a YOY decline of 70.8%.

We believe this corroborates with T-Mobile’s very strong 1.75 porting ratio against AT&T during the quarter, the highest among T-Mobile’s competitors. With the DIRECTV acquisition now closed, AT&T is shifting towards bundling of two-year contracts (wireless, video, broadband), which has not yet resonated with consumers, in our view. Pressure from T-Mobile should continue: Its rollout of extended LTE on 700 MHz A Block spectrum (covering 194 million PoPs) is running ahead of schedule, with plans to acquire additional A Block spectrum that will cover 48 million PoPs. We expect AT&T to continue its ramped-up fiber network investment strategy (despite our view that this generates negative NPV), due to increased market share erosion risk from cable, which enjoys a lower incremental cost curve.

Meanwhile, T-Mobile USA reported (April 26) materially better 1Q16 financial and  operating results, versus consensus and our estimates. It is likely that T-Mobile captured the bulk of the industry’s net subscriber adds this quarter, in our view. It is seeing increased success in capturing better quality market share at the expense of Sprint and AT&T, due to a similar network and device portfolio and customers balking at AT&T’s (pricier) bundles. The porting ratio was the highest (with AT&T as noted above), at 1.75 this quarter, followed by Sprint at 1.35 and Verizon at 1.34.  T-Mobile is riding high on momentum, yet our vendor checks suggest it has about two years of network capacity left, which bodes well for another kick at the M&A can in 2017, in our view.

Key Points:

■ 1Q16 results recap. Consolidated revenues increased 3.8% YOY to $40.5B, in line with consensus’ estimate but modestly below our estimate of $40.8B. By segment: Business solutions delivered revenues of $17.6B, entertainment and Internet services had revenues of $12.7B, consumer mobility had revenues of $8.3B, and International had revenues of $1.9B. Adjusted EBITDA of $13.3B were in line with Street expectations and a hair below our estimate of $13.4B. EBITDA margins improved by 16 bps YOY, to 32.7%, driven by increased cost reductions. Mobility postpaid net adds were 28,294, and prepaid net adds were 12,171. Postpaid churn was 1.24%.

■ Worsening wireline business deterioration. Legacy voice and data service revenues continue to worsen as customers switch to wireless or VoIP. We believe there is a greater management urgency to shed the consumer wireline business to help fund low-band spectrum purchases. We think management is exploring additional consumer access line sales, given the looming wireless access substitution risk, higher costs, and a negative NPV profile to upgrade copper plant to fiber, in our view.

■ While we believe AT&T will continue to reap the benefits of an under-penetrated Mexican market and cost synergies and cross-selling opportunities with DTV, competition from T-Mobile USA will likely continue to weigh on wireless subscriber acquisitions in the medium term.

Outlook for discounted handset eligibility:

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

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 US becomes spectrum challenged, which we think is still one year away and a function of T-Mobile US s commitment to continue network investment.

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.

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 nonstandard 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 s 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.

Conclusions:

We expect the wireless segment to continue to be challenged by a resurgent T-Mobile USA. 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.