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Morningstar | AT&T Reported Mixed 2Q Results with Wireless Improving, but Dragged Down by DirecTV

AT&T reported mixed second-quarter results with improving wireless results, but continued entertainment struggles. For now, we are maintaining our $40 per share fair value estimate and narrow moat rating. While the stock is trading below our fair value estimate, with all the moving parts from the recent acquisition of WarnerMedia, we would prefer a larger margin of safety before adding to a position. Reported revenue fell 2% year over year, but this was primarily due to a $900 million revenue reduction from choosing to net its universal service fees. Adjusted for this and other accounting changes the firm’s revenue increased slightly. Our 8.1% full-year revenue growth projection is not comparable as it is based on six months of WarnerMedia revenue, while the quarter only included 16 days of its revenue.

Like Verizon, AT&T reported improved wireless results and free cash flow generation. The firm added 46,000 postpaid wireless phone customers and 356,000 prepaid phone subscribers. While we’re happy to see these gains, the postpaid is far less than T-Mobile U.S. has been generating. Plus, AT&T’s prepaid customers generate significantly lower average revenue per user. Our biggest concern is the entertainment division. Its total subscriber base has held steady at a bit over 25 million, but it has been losing higher spending linear and satellite subscribers and gaining customers to its OTT service DirecTV Now that generate much lower revenue. This led to a revenue decline of 6.4% adjusted for accounting changes. We’ve never been fond of the DirecTV acquisition and this quarter doesn’t change our thinking.

The firm’s adjusted EBITDA margin excluding the reporting changes was 32%. While this is in line with our full-year projection of 31.8% it is down from 33.8% in the year-ago period during the historically strongest quarter of the year. This doesn’t provide much of a cushion for the fourth quarter that is historically much lower due to end of year promotions.

On the call, management discussed its strategy with WarnerMedia and opportunities to bundle video content with its wireless service and increase advertising revenue. One concern is whether HBO can continue to charge the premium rates it historically has when so much quality content is being produced by other OTT providers, such as Netflix and Amazon that are spending significantly more on productions? AT&T countered that scale in customers is more important than scale in content and that it has strong scale in customers due to owning CNN and other properties. We are still debating this issue ourselves, but generally think content scale is important.

We were pleased to see AT&T’s free cash flow increase 37% thanks to tax reform and stable capital expenditures. While the firm’s net debt of $177 billion initially looks very large, management emphasized that with its higher EBITDA from the WarnerMedia acquisition it is only about 2.9 times this year’s EBITDA and its objective is to reduce that to 2.5 times by the end of 2019.