by David Dixon and Mike He, FBR & Co. (edited by Alan J Weissberger)
Summary and Recommendation:
AT&T reported largely mixed 4Q16 results, with both top-line and adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) misses driven by fewer upgrades and continued legacy service weakness. Lower depreciation expenses helped lift adjusted EPS to $0.66. Strong international and entertainment revenues were key to offsetting ongoing weakness in consumer mobility and an anemic business solutions segment, which continues to be handicapped by weak legacy service demand. Promotional pricing of DIRECTV NOW (Internet TV package), with zero-rating , saw strong initial adoption, helping to offset churn from the 2G network shutdown.
With Ajit Pai recently named as chairman of the FCC, net neutrality is likely to be overturned; and zero-rating will likely be endorsed, paving the way for AT&T’s bundling strategy. Potential tax and regulatory reform should help the telcos attack cable’s historic advantage through a fiber-lead investment uptick amid consolidation. So, while tax reform is accretive to cash flow, we believe much of this benefit will be absorbed from a higher capex trajectory.
Note 1. Zero-rating (also called toll-free data or sponsored data) is the practice of mobile network operators (MNO), mobile virtual network operators (MVNO), and Internet service providers (ISP) not to charge end customers for data used by specific applications or internet services through their network, in limited or metered mobile data plans.
■ 4Q16 results recap. Consolidated revenues declined 0.7% YOY, to $41.8B, in line with our estimate but below consensus’ estimate of $42.0B. By segment: Business solutions delivered revenues of $18.0B, entertainment and Internet services had revenues of $13.2B, consumer mobility had revenues of $8.4B, and international had revenues of $1.9B. Adjusted EBITDA was $12.2B, versus consensus’ estimate of $12.8B and our estimate of $13.1B. EBITDA margins expanded by a modest 6 bps YOY, to 29.1%. Consumer mobility postpaid net adds were 270,000, prepaid net adds were 406,000, and postpaid churn was 1.25%.
■ In-line FY17 guidance. Management provided FY17 revenue guidance of low single-digit growth, in line with consensus’ estimate of +1.6% YOY, with adjusted EPS growth in the mid-single-digit range, adjusted operating margin expansion, capex of $22B, and free cash flow of $18B.
■ Stay tuned for a fiber-induced investment uptick. Management would not take the bait on plans to extend fiber investment, but we think this is inevitable. Beyond the in-region Boston fiber deployment, our checks indicate that Verizon has issued fiber construction RFPs for the two-year buildout of an additional 20 to 30 cities. Not only would this likely invoke a competitive response from cable companies, it may also drive an acceleration and expansion in T’s fiber plans to deploy to 12.5 million homes (aside from any tax reform and the extension of bonus depreciation, which could both accelerate deployment).
Can AT&T drive earnings growth?
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 US becomes spectrum challenged, which we think is still one year away and a function of T-Mobile’s commitment to continue network investment.
How will AT&T fare in the changing wireless landscape in 2017 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 WiFi 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 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 the wireless segment to continue to be challenged by T-Mobile US and a resurgent Sprint. 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.
“2016 was a transformational year for AT&T, one in which we made tremendous progress toward our goal of becoming the global leader in telecom, media and technology,” said Randall Stephenson, AT&T Chairman and CEO. “We launched DIRECTV NOW, our innovative over-the-top streaming service. Our 5G evolution plans and improved spectrum position are paving the way for the next-generation of super-fast mobile and fixed networks. And we shook-up the industry with our landscape-changing deal to acquire Time Warner, the logical next step in our strategy to bring together world-class content with best-in-class distribution which will drive innovation and more choice for consumers.”
“At the same time, we performed at a high level in 2016 with growing revenues, expanding adjusted consolidated operating margins and solid adjusted earnings growth, and we hit our $1.5 billion DIRECTV cost-synergy target. We also delivered record cash from operations, which allowed us to return substantial value to investors and invest more in the U.S. economy.”