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Morningstar | AT&T Continued to Cut Debt in 2Q; Shares Remain Attractive Despite Sprint/T-Mobile Uncertainty

We continue to believe AT&T is moving in the right direction. The firm delivered solid wireless results during the second quarter, while Game of Thrones provided a lift at WarnerMedia’s HBO unit, which has struggled to grow amid a carriage dispute with Dish Network. The troubled entertainment segment again outperformed our expectations, balancing pricing and expenses better than we thought possible, contributing to profit growth. Consolidated cash flow was also again strong, enabling another quarter of significant debt reduction. Management increased its 2019 free cash flow projection to $28 billion from $26 billion. This increase was based primarily on the sale of WarnerMedia receivables, rather than any major change in the business, which appears to reflect management’s desire to begin repurchasing shares as soon as possible. We agree that repurchases would add value for shareholders given the current stock price.

Our view of AT&T's competitive position is unchanged, and we don’t expect to materially alter our $37 fair value estimate. While Sprint and T-Mobile’s negotiations with regulators concerning their merger could cause some turbulence in the near term, we believe AT&T has the scale and network resources needed to maintain a strong position in the wireless industry. At current prices, the shares remain one of our favorites among U.S. telecom stocks.

AT&T added 72,000 net postpaid phone customers, its fifth consecutive quarter of growth, while revenue per customer continues to edge modestly higher (up 2.2% year over year). Total wireless service revenue increased 2.4%, in line with the pace seen in recent quarters. The pace of phone upgrades remained low, which has contributed to steadily improving wireless margins in recent quarters. We also believe competition in the wireless industry has been reasonable, contributing to relatively stable pricing.

AT&T has invested a tremendous amount of capital in its wireless business over the past several years, buying spectrum and aggressively upgrading its network. As a result of this investment and minimal revenue growth amid stiff industry competition, AT&T’s returns on capital in the business, by our calculation, have declined sharply but remain modestly above its cost of capital. If Sprint and T-Mobile merge, we don’t expect the combined firm will have enough scale or resources to match AT&T’s cost structure, limiting that firm's ability to reignite price competition in the market without risking the long-term health of its business.

If the firms, as rumored, agree to sell assets to Dish Network to win approval for their merger, we expect they will be smart enough to include provisions that limit Dish’s ability to compete aggressively on price. Dish will have minimal scale initially, leaving it heavily reliant on the terms of a wholesale network agreement with the new T-Mobile. At this point, we suspect T-Mobile and its controlling shareholder, Deutsche Telekom, would rather walk away from Sprint than agree to reset the industry structure in a manner that leaves it (and by extension AT&T) worse off in the long run. Further, even if T-Mobile can pull together a deal that preserves the long-term health of the business and appeases the Justice Department, it then faces uncertainty surrounding states' attorneys general that are poised to challenge any agreement.

Turning to AT&T’s entertainment segment, the firm reported a loss of 778,000 satellite and U-verse television subscribers during the quarter, a horrifically large number. However, the firm also delivered a 5% increase in revenue per customer, the best rate in about three years. This performance lends credence to the view that a core base of high-value television subscribers remains, masked by customers attracted by heavy discounts in recent years. Total segment revenue declined 1%, but lower costs pushed EBITDA 1% higher. We suspect the segment has benefited as customer acquisition costs decline (due to fewer gross customer additions), but better unit economics in the television business, thanks to higher pricing and constrained programming costs, have also likely helped.

AT&T continues to talk up the potential of its planned thin-client television box, which it believes will cut customer acquisition costs in half relative to the traditional satellite business. We still disagree with this position, as we believe new online television services like YouTube TV have already made significant progress in obviating the need for a box of any kind while ratcheting up the level of competition in the industry.

WarnerMedia posted 6% revenue growth, a sharp acceleration versus the prior quarter. Revenue at HBO increased for the first time since the Dish dispute began, with subscriptions sales down only 1%. Management indicated that online subscription (HBO Now) growth has more than offset lost Dish customers over the past year. The firm was reluctant to provide HBO Now customer numbers given the cancellations likely to follow the conclusion of Game of Thrones, but it also mentioned that new seasons of popular shows like Big Little Lies seem to have limited churn thus far. AT&T plans to hold an investor event in October to provide additional details around the business and the upcoming HBO Max launch.

On a consolidated basis, AT&T generated $8.8 billion of free cash flow during the quarter, though this figure included the benefit of a $2.6 billion receivables sale at WarnerMedia. The firm also raised $3.6 billion in proceeds from asset sales. As expected, cash flow was used to reduce leverage, with net debt declining $6.8 billion to $162 billion during the quarter. Net leverage ended the quarter at about 2.7 times adjusted EBITDA from 2.9 times at the time of the Warner acquisition. Management remains confident that net debt will drop to $150 billion by the end of 2019. Further, the firm expects to pursue share repurchases to the extent it exceeds that target.