AT&T (T) 18Q1 Results

AT&T reported diluted EPS of $0.56 per share, down from $0.75 a year ago.  Non-GAAP adjusted EPS of $0.86 per share was up slightly from $0.85 last year and in line with consensus estimates.   The difference between GAAP and non-GAAP EPS reflects amortization and integration costs associated with the Time Warner and other mergers and non-cash actuarial gains and losses on benefit plans.

Revenues increased 17.8% to $44.8 million but are not directly comparable because of the Time Warner acquisition.  The addition of Time Warner more than offset declines in legacy wireline service (business and consumer), Vrio (AT&T’s Latin American satellite video service), wireless equipment and domestic video.  In addition, the company reported growth in its domestic wireless services and Xandr, its internet advertising business. Despite the overall increase in revenues, investors were concerned about the revenue declines across most of AT&T’s businesses.

Operating income improved to $7.2 billion from $6.2 billion, mostly as a result of the TimeWarner merger.  As with revenues, the profit gain from TimeWarner more than offset modest declines across most of AT&T’s other businesses and increases in corporate, acquisition-related and other significant expenses.

Selected Segment highlights:

Communications.  Segment operating contribution increased slightly from $8.03 to $8.05 billion, with gains in Mobility and the Entertainment Group mostly offset by a decline in Business Wireline.  Wireless added 2.7 million subscribers domestically, but more than all of the gains came from connected devices which generate lower monthly revenues.  Postpaid, prepaid and reseller wireless subscribers declined by a net 359,000 in the quarter.  Domestic video subscribers declined by a net 627,000, but broadband had 45,000 net additions (as increases in IP Broadband were offset partially by declines in DSL).  Voice connections also continued to decline.  Management said that it is making progress in raising net average monthly revenue per user in its DIRECTV NOW product, as it transitions early buyers to undiscounted monthly rates.

Latin America.  AT&T’s Latin American segment, which includes its satellite video service and Mexican wireless service saw its modest operating loss widen in the quarter from $111 million to $173 million.  Revenues in both businesses also declined.  Vrio, the satellite offering, suffered a small net decrease in subscribers, but its revenues declined 21.2% and operating income declined 78.4%.  Mexico added 93,000 net subscribers, but its operating revenues slipped 3% even as its operating loss narrowed from 259,000 to 205,000.

XANDR.  This business uses advanced analytics to generate highly targeted advertising.  AT&T believes that XANDR has the ability to grow rapidly as it scales up and applies its services to Time Warner’s content business.  Although highly profitable, it is still ramping up its business, growing expenses faster than revenues.  In the quarter, XANDR’s revenues increased 26.4% to $426 million, but its operating income declined 11.5% to $253 million. For now, the growth in costs is outpacing the growth in revenues, as AT&T seeks to scale the business.

Despite the challenges across many of AT&T’s businesses, the company touts its strong cash flow generation, which will allow it to reduce a significant portion of the $42 billion in debt that it took on to purchase Time Warner.  In 2019, AT&T expects to reduce its net debt-to-EBITDA ratio from 3.0 times to below 2.5 times, all the while continuing to pay an annual dividend of $2.04 which equates to a 6.6% yield at the current quote.

AT&T’s ability to reduce debt was set by the structure of its offer for Time Warner, which included $42.1 billion of cash (financed almost entirely with debt) and $36.6 billion in AT&T stock.  The $42 billion of cash requires annual interest cost of roughly $2 billion, but Time Warner generated roughly $4.4 billion of free cash flow (CFOA minus capital expenditures, according to AT&T’s definition) in 2017 (its last full year as a public company).  Thus, it should generate at least $2.4 billion of free cash flow after interest costs, which will be used to reduce debt.

In addition, AT&T continues to look for ways to raise cash by selling non-core assets.  For example, in recent weeks, AT&T announced that it was selling its 9.5% stake in Hulu (formerly owned by Time Warner) back to Hulu for $1.43 billion and also WarnerMedia’s office space in Hudson Yards (New York City) for $2.2 billion.

Although the TimeWarner acquisition made both strategic sense (as a defensive move) and financial sense, a major concern going forward is whether AT&T management can sustain and grow WarnerMedia’s revenues and profits.  TimeWarner had a creative culture that produced a steady stream of successful movies and television series over the years.  While AT&T management rightly sees the potential to add value to the business by applying advanced analytics to target advertising and inform the content creation process, it remains to be seen whether WarnerMedia will continue to produce the same level of popular content over time.

In the near-term, AT&T is benefiting from a content pipeline that was built prior to the merger.  (it touted, for example, the hit movie Aquaman, which is approaching $1 billion in box office receipts.)  This should help the company achieve its 2019 guidance of $26 billion in free cash flow, net debt-to-adjusted EBITDA of 2.5 times by year end, and adjusted EPS growth in the low single-digits.

Besides the ongoing integration of WarnerMedia, investors remain concerned about the increasing pressure to lower rates, as evidenced by saturation of the wireless business and the challenges posed by cord cutters (including the impact of the growth in over-the-top streaming services on its core video business).

The stock gapped down at the open April 24 after the earnings announcement and closed at $30.79, down 4.1% on the day.  At the current valuation, T trades at less than nine times anticipated 2019 earnings per share and, as noted, has a dividend yield of 6.6%.  Investors are therefore skeptical about whether AT&T can sustain its earnings and dividend going forward.

From a technical perspective, AT&T’s stock has been in an uptrend since bottoming out at an intra-day low of $25.95 in December. After the recent price drop, the stock has been trying to hold above its 50-day and 200-day moving averages. A move above $32.91 – its Oct. 2018 high – would confirm the uptrend, but a failure to break above this level within the next several weeks could signal a more significant retest of the December low.

As with most of the stocks that have gapped up or down so far this earnings season, I expect that AT&T’s stock will eventually regain what it lost, effectively retracing or closing this gap. In the short run, while business momentum seems to point to continued pressure, I think that the company can show progress against its key initiatives. Meanwhile, investors get a 6.6% dividend yield while monitoring the company’s progress and waiting for the results.

April 29, 2019

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 975-0250

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