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Morningstar | AT&T Seeks to Reassure Markets With Analyst Day; Shares Modestly Undervalued

AT&T's analyst event, which we attended Nov. 29, was designed to deliver two main points, in our view: reducing leverage over the next two years is the company's top priority, and the much-maligned consumer segment will achieve EBITDA stability in 2019. We view both messages as part of the effort to calm the growing negative market sentiment concerning AT&T's ability to fund the dividend and invest in the business, including potential spectrum purchases, while repaying debt fast enough to bring down leverage. Although we suspect AT&T will meet its 2019 leverage target given the extreme management focus on this effort, we remain negative on the prospects for the consumer segment. We believe this business is heavily exposed to the shifting trends in the television business, which are creating growth headwinds that make the focus on continued debt reduction necessary. We believe AT&T’s current limited financial flexibility reflects management’s poor capital-allocation decisions in recent years. We are maintaining our narrow moat rating and $37 fair value estimate, leaving the shares about 15% undervalued.

AT&T expects to generate $26 billion of free cash flow in 2019 with about $12 billion left over after funding the dividend, expectations we think it will meet. In addition, management expects to generate $6 billion-$8 billion in proceeds from the sale of nonstrategic assets, sale-leaseback transactions, and working capital initiatives. In total, AT&T expects net debt will decline to around $155 billion at the end of 2019 from $175 billion currently, taking net leverage to 2.5 times EBITDA. CEO Randall Stephenson stressed that the 2.5 times target is not negotiable, that the company will hit the target even if it decides to acquire additional spectrum during 2019, and that reaching the target early is his preference.

Additionally, when asked if the firm would put off hitting the debt target to instead take advantage of the current stock price to buy back shares, Stephenson ruled out that possibility. We view this decision as a key opportunity cost of the Time Warner deal, as AT&T’s shares trade at a significant discount to our fair value estimate and buying back shares would ease the dividend burden. At this point, however, we believe management feels it must demonstrate a commitment to reducing leverage to put balance sheet concerns to rest as quickly as possible, ensuring favorable long-term access to the debt markets. Maturities over the next couple of years should be manageable without issuing additional debt. Still, we think investors should be comfortable with the potential, in the longer term, for some form of a dividend cut in an adverse scenario.

In the entertainment business, management expects that the price increases taken earlier this year on DirecTV Now, customer roll-off from two-year promotional pricing for traditional DirecTV service, continued Internet access growth, and cost-cutting will fully offset the loss of television and phone customers, enabling the segment to produce stable EBITDA in 2019. Management also expects total television customers will remain at about 25 million during the year, which we think is a stretch. We believe the traditional television bundle will face constant pricing pressure as new entrants, like YouTube TV, price the service aggressively as these entrants look to build broader service and hardware ecosystems. If AT&T doesn’t respond to this aggression, we believe it will lose customers at an accelerating rate. In any event, we believe the traditional television business, which probably contributes more than half of the segment’s $10 billion in annual EBITDA, will see a steady erosion in profitability over the next several years.

Regarding the wireless business, AT&T believes that its investment to deploy additional spectrum, including the FirstNet build, will produce a step-change improvement in network performance over the next several months. The firm plans to "get loud" in touting the strength of its network, pushing back against the claims of its rivals. We are pleased to see management taking this step, as a company with AT&T’s scale and resources should be at the forefront of network quality year in and year out. We believe the firm has an opportunity to regain footing in the traditional postpaid market as the transition to 5G technology takes place. The work that AT&T has undertaken to put more spectrum to use has also prepared the network for 5G, which management claims will require only a software upgrade to deploy.

Details concerning new initiatives at WarnerMedia were limited. John Stankey, who heads the business, provide a sketch of the planned direct-to-consumer video offering slated to launch in late 2019, including a movie-focused entry-level tier that wasn’t clearly part of the original announcement. Stankey also reiterated that the firm hopes to build a platform that attracts other content owners looking for a home for both subscription- and ad-supported fare. It seems as if this DTC offering, coupled with the firm’s investments in ad technology, is intended to provide the ability to recreate content bundles that could eventually replace the traditional television model, at least for scripted programming. Until we have more details, however, we won’t know exactly how AT&T hopes to position this offering relative to the other services it provides and to its many competitors in the space.