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Morningstar | AT&T’s Entertainment Margins Jump in 1Q; Shares Remain Undervalued

We view AT&T’s start to 2019 somewhat more optimistically than the market seems to. While the wireless business and WarnerMedia performed about as we’d expected, the entertainment segment put up surprisingly strong margins. On a consolidated basis, cash flow was solid and the firm made nice progress in its effort to repay debt. Our view of AT&T is unchanged, and we don’t expect to materially alter our $37 fair value estimate. With the market’s negative reaction to earnings, we continue to view AT&T shares as undervalued.

AT&T reported a loss of 544,000 “premium” television customers (its combined satellite and U-verse subscribers) during the first quarter, a figure that appears to have benefited from 117,000 customers not disconnected as a result of a policy change. In any case, customer losses were, by far, the worst on record. The firm’s online television offering, DirecTV Now, also lost customers for the second consecutive quarter (83,000). On the flip side, AT&T easily bested our expectations for revenue per customer. While we remain bearish on the long-term potential of the television business, AT&T’s performance in the quarter far surpassed our expectations, as total television revenue declined only 2% year over year (we expected a 6% decline in 2019).

Total entertainment segment revenue declined 0.9%, the best result in more than a year. With relative revenue stability and continued cost cutting, AT&T also exceeded its promise to stabilize segment margins in 2019. We suspect that a sharp decline in satellite television customer installations, which entail significant upfront expense, played a significant role in cost cutting. If so, we appreciate the decision to absorb customer losses rather than chase uneconomical growth. Still, we expect changing customer habits and preferences will cause a persistent loss of television customers and declining profitability per customer, pressuring entertainment margins over the next several years.

In the wireless business, AT&T added 80,000 net postpaid phone customers, its fourth consecutive quarter of growth. As with Verizon, AT&T’s results indicate that the wireless market was a bit more competitive than a year ago, with customer churn ticking higher. AT&T seems to have reacted somewhat more aggressively than Verizon, though, with AT&T posting a 20% year-over-year increase in gross postpaid phone additions against ARPU that was flat sequentially. This situation is the opposite of that of the fourth quarter, where Verizon was more aggressive. Until the fate of Sprint and T-Mobile is settled, through their proposed merger or another strategic reshuffling, we don’t expect the competitive environment to change, with Verizon and AT&T periodically becoming more aggressive to maintain the size of their customer bases. Despite AT&T’s relative aggression during the quarter, the firm still increased wireless service revenue 2.9%, while record-low customer phone upgrades helped lift the EBITDA margin slightly versus a year ago.

WarnerMedia had a relatively quiet quarter, with revenue up 3.3% year over year. The Turner segment posted a 5.9% decline in advertising revenue, primarily related to the shift of Final Four college basketball games to CBS this year. HBO again posted a drop in subscription revenue (6.6%) because of its dispute with Dish Network.

On a consolidated basis, AT&T generated $5.1 billion of free cash flow during the quarter, including the repayment of $800 million of vendor financing that is considered a financing activity. Excess cash flow was used to reduce leverage, with net debt declining $2.3 billion to $169 billion during the quarter. Since the end of the second quarter of 2018, when the Time Warner deal closed, net debt has declined $7.7 billion, taking leverage down to about 2.8 times adjusted EBITDA from 2.9 times. With the sales of AT&T’s Hulu stake and real estate in New York bringing in nearly $4 billion in proceeds, management remains confident that net debt will decline to about $150 billion by the end of 2019.