AT&T (NYSE: T) is a telecommunication company that offers wireless and wired communication services to the general public. The company also helps businesses by offering them a reliable and secure communication network for their organization. AT&T operates through two primary segments: wireless and wireline. Its wireless solutions include data roaming services including high speed 3G and 4G internet, and local and long distance voice services for consumer, small businesses and government. The segment also offers wireless equipment and accessories such wireless handsets, battery chargers, etc. The wireline segment offers wired solutions such as U-verse TV and Internet access, VOIP services, secure network management to businesses, data and voice communication services. Since its inception, the company has been investing in many other companies. Its recent acquisitions include Spectrum (SPPI, Financial), Leap (LEAP, Financial), GSF Telecom, NII Holdings Inc. (NIHD, Financial) and DIRECTV (DTV, Financial) etc. The company faces stiff competition from its peers. In wireless market, it faces competition from Verizon (VZ, Financial), Sprint (S, Financial) and T-Mobile (TMUS, Financial).
In 2014, net sales of the company totaled $132 billion, an increase of 3% on a year-over-year basis. Majority of the company’s revenue was generated by its wireless operations which amounted to nearly $74 billion that is 55% of the total operating revenue, while the wireline segment brought in the remaining 45%. Geographically, AT&T’s main source of revenue is North America while revenue share from Mexico and Latin America is nominal. AT&T Inc. was founded in 1983 and is based in Dallas, Texas.
The bull case
Demand for telecommunication will be driven by the market for cellular products including smartphones and tablets. IDC predicts that the market for U.S. smartphones will grow in the future but at a slower rate. The firm predicts a CAGR of 5.3% between 2013-2018. Reuters predicts a rising trend for U.S. mobile data traffic by 2018 as more people shifts from laptops and PCs to smartphones and tablets.
AT&T is a market leader along with Verizon in the wireless communications market. Currently, the company has captured 31.2% while Verizon controls 33.7% of the total wireless subscribers base. A combined market share of nearly 65% leaves the two company in a duopoly position which enable them to control prices and margins. Due to AT&T’s significant position in the market, we believe the company is in a great strategic position to turn future opportunities, from growth in smart-phone shipments and mobile data traffic, into profits.
AT&T recently completed its acquisition of DIRECTV, a multinational pay TV provider. Through this combination, the company intends to capture the video entertainment market by providing efficient video delivery platform to millions of additional households through its mobile and high speed internet service. Management expects cost synergies will exceed $1.6 billion by the end of the third year of closing the deal. The acquisition also allows the company to penetrate into Latin America since DIRECTV has a leading presence there. The acquisition of Nextel Mexico and GSF Telecom further allows AT&T to extend its subscriber base, regionally, by capturing more Latin America consumers and businesses. AT&T’s recent acquisitive strategy focuses on spreading its coverage to more than 400 million consumers and business in Mexico and the United States.
AT&T has posted EPS surprises in the last three quarters. The latest surprise was of 9.5% during the second quarter of 2015. This indicates that analysts' estimates may trend higher for the upcoming quarters. The company has experienced 23 upward EPS revisions in the last 30 days for the fiscal year end 2015, which is a bullish indicator.
The bear case
The demand in the wire-line telecommunication sector is dropping, especially on the consumer side, due to the shift of consumers to wireless communication. A report by Ibisworld states that, with increasing numbers of households using wireless phones, revenue from fixed local and long distance services is expected to decline over the next five years. IDC believes VoIP and broadband services will stay in demand, but these gains will not be enough to overcome revenue losses from fixed voice services. Considering wireline products and services form 45% of the company’s revenue, falling trends in the wireline products, especially from fixed voice services, will have a negative effect on AT&T’s future earnings. The popularity of 3G and 4G can cannibalize the company's wire-line internet business.
AT&T faces stiff competition from its counterparts Verizon and T-Mobile. T-Mobile's un-carrier strategy is leading to prices wars which will put pressure on industry profits. The recent launch of T-Mobile’s simple choice plan with mobiles without border will provide more cost efficiency for consumers compared to options from AT&T, Sprint and Verzion. Furthermore, T-Mobile’s Jump on demand phone leasing plan for Apple users bodes ill for competition as T-Mobile tends to attract maximum users for the next iteration of the iPhone. Further, AT&T is trading at a premium to its larger counterpart, Verizon.
Accounting for value
Prudena's models indicate that AT&T is appropriately valued. There is no reason to expect above-market price appreciation, though a healthy dividend yield will attract investors seeking stability and income.
Assuming 8% required rate of return, the current market price of $34.58 implies 1.14% long term residual earnings growth. This is a reasonable level, given AT&T's growth history and ROE. Prudena's residual earnings model estimates value per share of $35.19. This model assumes EPS in line with analyst estimates over the next two years, 3.5% EPS CAGR over the next five years, and low single digit growth in the long term. A Monte Carlo simulation, which builds input uncertainty into the residual earnings model returns a value distribution ranging from $30.94 to $39.67 and a most likely value of $34.55. Both models agree very closely with current share prices.
Bottom line
Due to the increase in demand for smart phones and tablets, the wireless communication industry is expected to grow. This growth will spur many opportunities for wireless communication players especially through data consumption. AT&T has positioned itself well amid DirecTV acquisition. The acquisition will bring-in tremendous benefits in terms of lower costs and increased market share. The main challenge for the company will be the falling demand for its wired communication services. AT&T needs to divert its resources from the legacy voice services to other profitable segments in order to keep its competitive position intact. Overall, strong financial position and a dominating share in the U.S. wireless communication market along with the recent acquisition makes AT&T attractive for income investors. Nonetheless, value investors might not get capital appreciation from the stock.
A different version of this article with a valuation focus appeared on Prudena.
