Description

Management is essentially liquidating the company—now is the time. At $21 per share, AT&T is cheap, possesses identifiable catalysts to drive stock price appreciation and has limited downside risk at current prices. The risk/reward is now finally in our favor. Specifically, we now have a better understanding of the debt allocation, post break-up. In summary, there are two value creation phases to this story—the restructuring value phase adds $10 per share and the operational improvement value phase adds another $5 to $7 per share. Management can achieve the two simultaneously, but I doubt it. So I focus on these two separately. Our downside risk is a potential decrease of $4 of value per share on a temporary basis as I expect index funds to sell shares of AT&T due to the expected change in the company’s index weighting. (There seems to be no other clear, fundamental reasons that are on the horizon that is not priced in the stock).

On May 11, AT&T filed its proxy regarding the restructuring plan to break the company up into 4 pieces. Without boring you with the details, I’ll get to the point: Business & Consumer Services are bad businesses but generates lots of cash. I really don’t care what they are worth, as long as they can take on some of the parent’s debt (about half). AT&T Wireless (AWE) is not a “cash flow-type” company—so I can’t get to its fair, intrinsic value. I’ll take a risk and use AWE’s market value as a measure of the company’s current worth. (You can email me later about these decisions.) At the end of the day you are buying a cable business. Here is what is important: Broadband is a good business in an industry that is becoming more and more favorable. The broadband segment is essentially the business combinations of Media One and TCI. Top line growth will come from price increases from digital cable not unit growth. That’s ok. As in the past, AT&T can raise prices given the nature of the business. Top line growth will come from added services as customers shift to digital cable. Cost cutting in this business is critical. The economics of the business signifies that the company has significant opportunities to improve profitability. (Having lower margins than other industry participants in a commodity-like business, while having no “real” competition in your local markets is an opportunity). AT&T Broadband has real and sustainable competitive advantages as well. The company’s competitive advantage is based on technological and scale economies. The company’s level of scale will allow the company to defend its market from over-builders (like RCN). Technologically, the company has an advantage over substitute products (such as Direct-TV) because these products have limited technology. For example, two-way communication is not possible with the Direct-TV model and direct marketing (i.e., home, neighborhood-specific marketing) will be very difficult to implement. Therefore, competition from satellite providers is not a strong threat. As a result, the company will gain market share from competitors such as Direct-TV because their current advantage over cable is not sustainable over time. A few years ago, customers flocked to satellite providers. As a result, new entrants as a group saw their customer list grow to 15 million in the past six years. Why were customers excited? The value-added proposition was clear: more channels for the same price. For example, while Direct-TV customers pay relatively similar rates as do cable customers, they have access to 400 to 500 channels vs. the 60 to 80 channels that analog cable customers receive. With digital cable, customers will have a similar number of channels and thereby eliminating Direct-TV’s advantage. The only (perceived or real) advantage industry participants such as Direct-TV and Echostar might have over cable is better content, but that’s debatable. All told, AT&T Broadband is a good business in a favorable industry because a) the assets are hard to replicate creating high barriers to entry; b) digital cable (growing at double-digit rate, with better margins) offers a higher average revenue per user due to increased channel capacity; and c) although CapX may remain high—despite what some on wall street think—it should not be enough to destroy more than $1 to $2 of value per share, by my calculations. As for what I believe to be a potential upside, (some may think this is a negative) the company has not performed very well operationally (for example, AT&T’s margins should be much higher given the company’s scale) and also the company’s migration to digital service is slower than its peers and what management expected. I believe these negatives stem from legacy issues from the old TCI operations. That’s ok for now, since we are in the “restructuring value” phase and that the company would have to shutdown operations to loose significant market share.


As for valuation, in aggregate, AT&T is currently trading at less than 6.5 x EV/EBITDA. If you back out three of the business segments to isolate broadband, you are paying about 7x for that business, post restructuring on low EBITDA due to poor operations. How good can operations get? I don’t know. But if you assume broadband can get to about 85% of comparable margins, you will own broadband at 6x EV/EBITDA. The private equity firms that I contacted indicated that less that 7x is a good price to pay for cable operations—buy at 7x and exit at 12 to 14x. The current valuation of 6x does not including the premium one would pay for the AT&T market strength, brand and reach. On a comparable analysis basis, cable companies are trading at 16x to18x EV/EBITDA. In the final analysis, broadband, wireless and business/consumer services are worth about $30 (based on EV/EBITDA: broadband—15x on ~$2.5bn; wireless @ $19 per share; business services—5x on ~$9bn; consumer services—2x on ~$5bn). Including margin improvements in broadband, the valuation yields to a $37 stock price. As for my downside protection, at $17 per share, both consumer and business services would be free.

In conclusion, your upside is +76% while and your downside is 19% in 18 months.

Catalyst

1) Aggressive deleveraging: AT&T’s debt reduction is on schedule. To mention a few, they sold cable systems to Mediacom for $2.2bn (pretax) in cash; sold Japan Telecom stake for ~ $1.4bn in cash proceeds—after-tax proceed are expected to be in the neighborhood of $1bn which will be share evenly between AT&T and AWE; sold a few cable systems to Charter Communications for $1.8bn; recently requested that the entire stake of approximately 25.55% in Time Warner Entertainment be designated for registration with the SEC; the company is also evaluating on its options in regards to its 49 million shares of Cablevision Systems. On April 5, 2001, AT&T requested that Cablevision register 30 million shares of this stock with the SEC; AT&T plans to complete an equity carve-out of AT&T Broadband in the fall. Et cetera…

2) The completion of the breaking up.

3) Operational improvements: A focus on the operations of the company is the most potent catalyst to drive AT&T’s share price appreciation. I believe if current management is unable to get the operations up to par, new managers will be installed—the current management is already on a short leash.

4) Lower interest rates: Historically, cable companies tended to perform well when the Fed lowers interest rates. In fact, if you go back 12 years from 1988 to the 2000 and graph cable companies in relation to the move in interest rates, the relationship is quite encouraging.