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Morningstar | We Expect Only Modest Synergies Between AT&T and WarnerMedia; Lowering FVE to $37

After taking a fresh look at AT&T following the Time Warner acquisition, we’re lowering our fair value estimate to $37 per share from $40. Our AT&T moat rating remains at narrow, but we’ve upgraded our trend rating to stable from negative. We believe AT&T’s shares are modestly undervalued, but not to a degree that we believe makes them attractive for new investment.

We’re doubtful AT&T’s transformation into a diversified media and telecom company will deliver significant strategic benefits, as we don’t believe these industries complement each other well despite their close association. Rather, we prefer to evaluate each of the firm’s businesses in isolation. With this in mind, we expect the same trends that have hit AT&T’s businesses recently will remain in place, yielding modest wireless revenue growth, continued declines in the consumer fixed-line business, and steady performance in the media segment.

We believe AT&T still deserves a narrow moat based primarily on cost advantages within the wireless business and intangible assets acquired with Time Warner. These advantages should enable the firm to maintain relationships with customers and increase free cash flow. However, recent capital allocation decisions have sharply lowered returns on invested capital. The acquisition of DirecTV in 2015, in particular, has left AT&T with a competitively disadvantaged consumer business that earns poor returns. In aggregate, AT&T is a collection of businesses that should produce double-digit ROICs, but high acquisition prices will likely leave ROICs roughly in line with the firm’s cost of capital, as we calculate it, over the longer term despite significant competitive advantages.

In the wireless business, AT&T’s scale continues to give it a strong competitive position versus smaller rivals Sprint and T-Mobile. Providing solid nationwide coverage requires heavy fixed investments in wireless spectrum and network infrastructure. While a larger customer base does require incremental investment in network capacity, a significant portion of costs are either fixed or more efficiently absorbed as network utilization reaches optimal levels in more locations. We believe the benefits of fixed-cost leverage and the difficulty of providing a differentiated wireless offering create an efficient scale advantage in the wireless industry, which could become even more apparent if T-Mobile and Sprint compete their merger.

While video distribution continues to evolve, WarnerMedia holds a strong competitive position, in our view. The firm owns a deep television and film content library, with a plethora of well-known characters and franchises. With wide distribution globally, this library creates a virtuous cycle: Video platforms like traditional cable companies, online distributors, and theater chains have an incentive to work with WarnerMedia, which attracts strong content creators seeking as large an audience as possible.

On the other hand, we are far less fond of the consumer and entertainment segment, which includes DirecTV. An increasing number of consumers are choosing Internet-based alternatives to traditional television services. In the nearly three years since the deal closed, AT&T has lost about 9% of its traditional television customer base, with customer losses accelerating recently. Nearly 80% of AT&T’s television customers receive service via satellite, a base particularly susceptible to on-line competition in our view. AT&T’s online (over-the-top) television offerings, DirecTV Now and Watch TV, are growing nicely, but we expect limited profitability with this model, as competition with new entrants like YouTube and Hulu remains fierce. The legacy consumer fixed-line business is also competitively disadvantaged, in our view, thanks to inferior networks relative to cable competitors.