Description

Note: I had written this prior to 4Q earnings today, which were more of the same and so it doesn't change the overall thesis.  I tried to update as much of the numbers as I could, but with the 10Q not out, I decided to keep some numbers as 3Q19 and I'll post an update after the 10Q is out as many off-balance sheet items aren't updated in their Investor Brief.  Apologies for the confusion, but I wanted to get this up.

AT&T stock had a phenomenal 2019, up 48% including dividends and the best annual return since 2006, the year before current CEO Randall Stephenson took over.  

The shares performed well in 2019 due to the Company executing on its deleveraging story by reversing EBITDA declines in its Entertainment segment and via asset sales.  It’s also been helped by 10 year treasury yields declining from 2.68% to 1.92% during the year. Also, in September Elliott announced an activist campaign that called for a halt in destructive M&A and increased operational focus that would lead to increasing margins and a $60 stock price by 2021.  This pressure led to management providing 2020 and 3-year guidance with their 3Q19 earnings which called for EPS to grow to $4.50-4.80 from $3.57 in 2019.

We disagree with the bull case and believe it’s a good time to be short AT&T because: 1) after years of relatively benign wireless competition, we are entering what we believe is a prolonged phase of price and investment competition fueled by cable entry, 5G rollout, and the outcome of S/TMUS, all of which will impact [40%] of revenues; 2) pressures in the video business, as 2019 was the worst year of cord-cutting on record and AT&T experienced the vast share of the sub losses; 3) guidance provided by management seems extremely aggressive in light of industry conditions; 4) proposed vague cost cutting initiatives seem ill-timed as competitors ramp up investments; 5) management has utilized accounting levers to boost their definition of free cash flow and lower reported leverage (to reach compensation objectives).

Elliott’s Bullishness

Let’s address Elliott’s letter to the Company.  First, it was hard to tell if the shareholder letter was advocating a long or a short.  They cite a string of mismanagement by the current CEO over the years -- over $200b of poor M&A (biggest being DirecTV and Time Warner), poor operational execution leading to declining wireless share, and leadership turnover -- resulting in severe stock underperformance.  While Elliott argues for the opportunity at hand, they also recognize that each segment of the conglomerate faces an uphill battle:

“For its managers, each of the business units is extremely complex in and of itself, competing against large and well-funded competitors in rapidly changing landscapes, some in areas where AT&T has neither history nor expertise.” 

Yet, they paint an optimistic picture when describing each segment. 

Wireless: AT&T is best positioned to be the market leader in 5G due to FirstNet, strong spectrum holdings, a virtualized network, and product offerings.  The 5G shift will provide an opportunity for AT&T to displace Verizon as the market leader.

Entertainment: Stability is increasing as lower value subs churn.  

Wireline: Wireline revenue losses are slowing as Managed Services grows, offsetting legacy Voice and Data services.  

WarnerMedia: WarnerMedia is a premier media franchise that has the assets to compete and win against the likes of DIS and NFLX.

With their positive view, Elliott paints a plan to get the stock to $60.

Our Variant View

We believe the rosy picture Elliott paints ignores current industry dynamics and many key risks that will prevent AT&T from hitting their projected financial goals.  Each segment is facing significant headwinds that we address below:

Wireless: Should the market be right and Sprint/T-Mobile merger be blocked, a wounded and desperate Sprint will need to resort to heavy discounting again to add subscribers in a bid to grow revenues.  T-Mobile will continue its disruptive ways, especially if Sprint sells some 2.5ghz spectrum to them to raise capital to pay down debt and invest in its network. If the deal goes through, DISH will have the lowest cost MVNO in the market and will be able to offer very cheap service almost immediately.  And the wireless carriers are just getting started with their offering. When the 5G iPhone launches later in 2020, it should be the most competitive wireless market in years. Already this year, TMUS commented on 1/8/20: “the hallmark of this quarter was a more competitive environment with more switching going on.”  

Entertainment Group: The stability AT&T promised came as revenue declined less and EBITDA actually improved in 2019.  But the reasons for this stability are also why revenue and EBITDA must decline again in 2020. Video connections will end 2019 down 15% from 2018 as cord cutting accelerated through the year at DirecTV.  The lack of subscriber acquisition costs actually perversely helped EBITDA and margins, but the lower subscriber base will impact all of 2020. With broadband users flat, that won’t be enough to offset the video declines.  

Business Wireline: Long term, this business is subject to price deflation as software defined networking and the move to third-party data centers allows enterprises to take advantage of connectivity to multiple carriers to find lower pricing.  Growing Managed Services just replaces higher margin business with lower margin business.

WarnerMedia: WarnerMedia is the segment facing the most disruption.  Between 1) over-the-top (OTT) providers like Sling, YouTube TV, and even AT&T’s own DTV Now disrupting the cable bundle and giving consumers more choice impacting subscriber and viewership numbers at Turner, and 2) Disney+, Apple TV+, and Peacock launching into the streaming space ahead of HBO Max and at much lower price points, the next few years for WarnerMedia look extremely volatile.

Is Guidance Achievable?

In November, AT&T announced 2020 and 3 year targets that were very close to what Elliott had laid out.  Given AT&T’s goals are less optimistic, we’ll focus on whether they are achievable.  

1. Revenue growth every year with 1-2% 3-year CAGR (2019: $181.2b)

1. 39% of revenues comes from Wireless, which will grow 0.3% in 2019 after 0.4% in 2018.

1. After a few years of benign competition, we believe that has changed beginning in 4Q19, which was confirmed by TMUS.

1. Besides a new iPhone in the quarter, which prompted discounting, cable companies are becoming more promotional with their wireless offerings.

2. The market is pricing in that the S/TMUS deal will be blocked, but even if it isn’t, competition will ramp up:

1. Standalone S would need to restart promotions that they have been dialing back, in order to add subscribers

2. If the merger is passed, DISH would be enabled with an extremely low-cost MVNO that would allow them to price even lower than the cable companies.

3. We have wireless revenue up 1.4% for 2020, but only because equipment revenue will increase 7.4% due to a likely 5G iPhone launch.  Service revenue will be flat given the increasing competition.  

2. 25% of revenues is Entertainment Group - residential Video (70%) and Broadband (20%) - which declined 2.9% in 2019 after declining 7.1% in 2018.

1. The decline in Premium Video subscribers through 2019 puts Video in a precarious situation starting 2020 where ARPU gains will not be able to offset the subscriber declines.  Consequently, we think group revenue will decelerate by 7%.

2. Growth in Broadband via ARPU increases will be offset by declining Voice.

3. 14% of revenues comes from Business Wireline

1. After declining 8.4% in 2018, the rate of decline improved to -1.7% in 2019 as Managed Services grows to offset declines in SMB and enterprise revenue due to the share loss to cable.

2. Revenue will decelerate again to -3.3%, as trends continue and the Company laps a one-time $125mm IP licensing deal in 2Q19.

4. 19% of revenues is WarnerMedia: ~40% Turner, 20% HBO, and 40% Warner Bros

1. Turner suffers from the cord cutting pressures that also impact the Entertainment Group.

2. HBO should grow healthily with the launch in May of HBO Max, though the HBO Max investments in 2020 and 2021 will impact margins.

3. Warner Bros has a decent slate and should see some growth.

4. Overall, we see 6% growth for WarnerMedia.

5. We see total company revenue growth of -0.3%, with no major reason to inflect upwards in 2021 and beyond.

2. EBITDA margin stability in 2020, followed by 200bps expansion

1. EBITDA margin will be 33% in 2019, flat with 2018 when it received a large 606 boost.  

2. When asked about the planned 200bps improvement, CFO John Stephens cited i) improvement in Mobility, ii) improvement in Mexico, iii) WarnerMedia cost synergies, and iv) additional cost cuts from restructuring czar Bill Morrow’s effort.

3. However, each segment is facing margin pressure that we believe will offset the improvements Stephens is looking for:

1. Mobility

1. With increased churn due to competition, a higher mix of equipment revenue, and credit for cost cuts that the CFO has announced, we see Mobility EBITDA margins down from 42.9% to 42.0% as service margins remain flat but the increased mix of low margin equipment offsets the margin impact of cost cuts.

2. Entertainment Group

1. AT&T promised “stability” in its Entertainment Group for 2019.  After seeing revenues and EBITDA drop 7.1% and 9.6%, respectively, in 2018, they will be -3.2% and +1.5%, respectively, for 2019.

2. However, revenue growth is getting worse through the year, mainly because of increasing subscriber loss. 

3. As a result, we think revenue and EBITDA declines will reaccelerate in 2020, down 6.3% and [4.2]%, respectively.  [The reason we forecast margin compression is that 2019 saw expansion due to less subscriber acquisition costs, which we see as having less of an impact in 2020.]

3. Business Wireline

1. Managed Services is a low-margin business and will need to grow a lot more to replace the near 100% incremental margin dollars that are bleeding off.  As a result, we see margins down []bps.

4. WarnerMedia

1. $2b of HBO Max spend will hit in 2020, which on $33.8b of revenue is almost 600bps of margin headwind.

2. Somewhat offsetting this are run rate synergies of $2.5b by 2021.

3. Despite 6% revenue growth, margins will decline to 26% from 29% because of the HBO Max spend.

4. The combined result is actually a 70bps decline in EBITDA margin from 33.1% to 32.4%.

1. Total EBITDA actually falls 2% from $59.3b to $58.4b due to margin contraction.

3. Free cash flow - stable in the $28b range in 2020

1. The problem for AT&T with guiding to flat FCF growth has nothing to do with whether EBITDA will grow or not in 2020, it’s that the $28b they will generate in 2019 includes $5.1b of manufactured cash flow.

1. Starting in March 2019, AT&T began factoring WarnerMedia receivables.  As of 9/30/19, $3.5b had been factored, which results in AT&T’s cash flow from operations increasing, flowing into its definition of free cash flow.

2. AT&T has ramped up its use of vendor financing.  LTM 3Q19 vendor financing payments of $2.1b are excluded from cash flow from operations as well, up from $560mm in 2018.

2. Thus, the true 2019 run-rate FCF is much closer to $23b than $28b. 

1. The dividend payout ratio is closer to 65% at this rate.

3. While we don’t rule out AT&T’s ability to manufacture more cash flow to meet their $28b target, these don’t appear to be moves a healthy company would choose to make.

4. Thus, we question the ability to reach a dividend payout ratio of <50% by 2022 on true FCF.

4. Leverage of 2.00-2.25x by 2022

1. The immediate goal was to get leverage down to 2.50x by the end of 2019.  Why? Because per the proxy, 20% of short term incentives were based on that 2.50x level.

1. At the end of 3Q19, AT&T reported a leverage ratio of 2.66x.  

2. To meet their goal, AT&T’s finance department put in some overtime in 4Q:

1. Oct: sale leaseback of domestic tower assets to Pepper tree for $680mm

2. 12/11: Raised $3b incremental preferred interest in tower assets

3. 12/12: Issued $1.2b 5% perpetual preferred shares

4. 12/23: Privately placed $1.95b 4.75% preferred equity interest to pull forward proceeds from Puerto Rico sale into 4Q19

1. Announced in Oct and expected to take 6-9mo to close, that would mean the Company is paying ~$46mm of preferred interest… so that management can meet their compensation hurdles?

3. AT&T announced plans to return $75b to shareholders from 2020-2022 on 10/28/19.  On 1/8/20, the CFO said it retired 140mm shares so far, including 80mm share in 2020, implying 60mm shares were purchased in 4Q19.  

1. The average share price from 10/29/19-12/31/19 was $38.51.  From 1/2/20-1/7/20, it was $39.06, and including a premium for the accelerated share repurchase they could’ve easily paid $40/share.  My guess is they got the balance sheet to a level where the management met its compensation hurdles, and then waited until the first week of January to buy more shares.

2. Given AT&T’s definition of leverage excludes various off balance sheet financings, they could quite easily miss EBITDA goals and still hit their defined leverage targets.

1. Moody’s recently commented on 12/19/19 that “there is also a material difference between management’s calculation of leverage and ours, and it has been widening.”

What is AT&T Worth?

The big question is what is this conglomerate worth?  Elliott put out a $60 price target: 12x FY22 EPS of $4.60 with a couple dividends added on.  At their target price, it would value AT&T at 7.5x their FY22 EBITDA. It would also imply a ~8% FCF yield ($31b guided by AT&T on $368b market cap).  Those multiples don’t seem aggressive at first glance.  

Yet, the main problem with using a basic EPS multiple to value AT&T is it ignores the balance sheet, the largest balance sheet in the world.  Using an EV/EBITDA approach seems more reasonable, and Elliott’s FY22 net debt of $130b (after $26b of paydown) implies $156b of current net debt, close enough to AT&T’s 3Q19 net debt of $159b on its balance sheet.  However, that ignores many off-balance sheet liabilities (including the receivables factoring and preferred equity mentioned previously) that need to be considered: i) $6.9b of equipment installment receivables; ii) $3.5b of WarnerMedia receivables; iii) $3.8b of underfunded pension and $15.1b of underfunded OPEB; iv) $8.8b of wireless preferred equity that was contributed to its pension in 2013; v) $1.5b of tower preferred (as of 3Q19); and vi) $1.9b of other supplier financing.  That would add $41.5b of additional liabilities, which would shave ~$6 off the price target. 

Given our variant view on revenue and EBITDA growth (or lack thereof) and the numerous headwinds each segment faces, we would argue that a 6.0x multiple of EBITDA is more appropriate.  That would imply $26.39/share, and when you add two years worth of dividends you get $30.55, or roughly 18% downside.

As a sanity check, on $22b of run-rate cash flow, that would equate to a 12% levered FCF yield.  It also implies an 8% dividend yield. Based on how the competitive dynamics are evolving and the true leverage, we feel that is fair.

Catalyst

Key Catalysts

• Accelerated wireless competition increases post-paid churn
• 5G is seen as just a marketing ploy and ARPUs don't increase to compensate for investment
• Accelerated cord-cutting impacts Entertainment Group
• Credit markets focus on off-balance sheet liabilities
• Increase in 10-year yield

Key Risks

• Wireless competition subsides
• 5G monetization is immediate
• DTV sold to DISH for high multiple
• HBO Max as successful as DIS+/NFLX
• Negative real rates in US like in parts of Europe