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AT&T (NYSE:T) has had a strong year despite growing macroeconomic uncertainties hanging over its operating backdrop. The consistent fundamental outperformance demonstrated over the past year continues to underscore AT&T’s ability to deliver on improving its wireless business after offloading the last of its media assets in April 2022.
The company finished the year with 656,000 postpaid phone net adds and 280,000 net fiber adds in the fourth quarter, on par with its impressive results demonstrated through the first nine months of 2022, and outperforming consensus expectations for 644,800 postpaid phone net adds. The results were also in line with those of rival T-Mobile (TMUS), underscoring substantial market share gains. Despite a slight revenue miss, the company still expanded its top-line in the fourth quarter by 0.7% y/y to $31.3 billion, likely impacted by “aggressive promotions during the holiday season” to capitalize on upgrade opportunities. But the slight earnings beat (non-GAAP EPS $0.61 vs. consensus estimate of $0.57) continues to corroborate management’s prudent management of promotional offers without compromising on profitability.
Looking ahead, similar headwinds experienced in 2022 are expected to persist through AT&T’s 2023 operating backdrop – or even worse as macro conditions continue to deteriorate into a likely recession before the end of the year. But management’s consistent prudence in handling of promotions within the competitive industry, while also balancing plan price increases to offset cost pressures without compromising on market share gains, continue to bolster investor confidence in the stock’s longer-term outlook.
The upcoming wind-down of massive 5G spend incurred in previous years, and the growing volume of subscriber net adds in recent quarters after AT&T introduced its higher-priced premium unlimited plans are also expected to contribute positively to free cash flow expansion (2023 guidance $16 billion, up from $14.1 billion in 2022), which will be much needed to support AT&T’s ongoing deleveraging goals. The continued build-out of its fiber-to-the-home (“FTTH”) business is also delivering consistent favourable progress, assuaging investors’ angst of any material near-term weakness ahead of the looming economic downturn by addressing consumers’ growing connectivity needs that may prove to be relatively recession-resistant (previously discussed here).
Despite lingering macroeconomic uncertainties that have left no corner untouched, we believe AT&T is onboarding an era of transition from the previous spending cycle to a longer-term returns-generating phase over coming years. This is expected to support continued expansion of AT&T’s cost-returns spread- which remains a key focus area that is currently preferred by market participants over “growth at all costs” – and support the free cash flows that underpin both its valuation prospects, as well as the dividend yield (annualized expectation: 5.8% T; 3.9% NYSE:T.PA; 5.7% NYSE:T.PC) that the stock’s income-focused investors favour.
Exposure To Potentially Worsening Near-Term Macro Challenges
While recent consumer and producer price data shows the generation-high inflationary pressures experienced through 2022 may be on the way to a structural cooldown, the Fed’s relentless stance on continued rate hikes is dialing up market angst that the “economy may be moving closer to recession”. And the latest data reports on consumer trends are further corroborating a rapidly deteriorating macroeconomic backdrop.
As we have discussed in a previous coverage, depressed consumer sentiment observed earlier last year has quickly shifted to the materialization of real consumer weakness, as discretionary spending slows while American household savings onboard a decline with a rising debt load met with surging borrowing costs. The average savings rate in American households is now approaching a record low at the low 2% range, while “credit card balances increased by the most in three months” by $28 billion in December from the previous month, versus economists’ consensus estimate of $25 billion. Accumulated revolving credit outstanding – a gauge that includes credit card debt – has also climbed $17 billion between November and December to $1.2 trillion, a steep run-up that has now exceeded pre-pandemic levels.
Worsening consumer weakness is further corroborated by soft December-quarter retail sales, despite the holiday shopping season. Retail sales fell 1.1% in December from the prior month, accelerating from the 1% m/m decline observed in November as demand for goods continued to fade. Merchants have had to turn to significant discounts averaging in the 30% to 40% range during the most recent holiday season to offload inventory, given increasing price sensitivity among consumers. Related spending data also shows that consumers had “increased their credit spending by nearly 11% from the previous year over the peak holiday shopping days between December 19 and December 26”, underscoring the pinch of persistent inflation and surging borrowing costs on Americans, and inadvertently, the broader economy.
While management has previously said lengthening payment cycles observed earlier in 2022 have shown signs of improvement, the combination of declining household savings and an increasing debt burden based on recent data points to a continuation of exposure to higher-than-usual churn and payment collection risks through 2023.
And on the consumer side of our business, we’re seeing an increase in bad debt to slightly higher than pre-pandemic levels as well as extended cash collection cycles. However, it’s important to note that historical patterns in previous economic cycles suggest customers have managed their accounts similar to what we’re experiencing today.
Source: AT&T 2Q22 Earnings Call Transcript
This is – we saw 1.5 days extension of collection cycles. That has not gotten — that has not gotten worse at all. It’s remained the same. So really, there’s nothing different from what I had characterized in our Q2 earnings forecast — Q2 earnings conference call.
Source: AT&T, Citi’s 2023 Communications, Media & Entertainment Conference Transcript
But so far, given AT&T’s robust fundamental performance through 2022, it appears that the company’s investments into next-generation connectivity infrastructure such as 5G and FTTH, paired with stabilization of its “promotional position in the market” has allowed it to capitalize on secular growth momentum supported by connectivity and digitization trends. Specifically, Despite the GAAP-based operating loss of $23.1 billion (or $3.20 per share) due to a $25 billion one-time non-recurring impairment charge pertaining to “rising interest rates and asset impairments”, AT&T’s adjusted EPS beat in the fourth quarter without the need to “back off” on seasonal promotional activity (e.g. Black Friday sales) over the same period continues to corroborate management’s prudence in ensuring disciplined growth within the increasingly competitive wireless industry. This is consistent with management’s notion that connectivity is becoming a mission critical service, differentiating the impending economic downturn with relatively more resilience from previous experiences as quoted above. While increasing uncertainty in IT budgets could potentially weigh on near-term digitization spending, spending on critical connectivity services, in which AT&T remains a key beneficiary of, will continue to underscore its relative resilience under the current macro climate that has left essentially no industry unscathed.
In fact, we feel even better about the resiliency of our services, given the elevated importance of connectivity in everyone’s lives. We view this cycle no differently and still expect customers will pay their bills, albeit a little less timely.
Kicking Off A Positive Inflection
Looking ahead, AT&T’s solid wrap-up of 2022 supports a strong kick-off to its post-media and easing spending cycle era. On one hand, AT&T continues to improve its average revenue per user (“ARPU”) buoyed by robust postpaid phone net adds in recent quarters after the rollout of higher priced unlimited premium plans, as well as an increasing mix of higher-margin fiber subscriptions. Specifically, ARPU specific to postpaid phone was at $55.43 in the fourth quarter, up 2.5% y/y thanks to “pricing actions, higher international roaming and a mix shift to higher-priced unlimited plans”. The results also demonstrate that the price increases to legacy postpaid phone plans implemented in mid-2022 continues to leave a favourable impact on the company’s top-line with anticipated churn still within expected levels. Taken together, AT&T kicks off the new year with a positive accretive impact on the revenue front when it comes to expanding the company’s profit margins.
Meanwhile, on the other hand, hefty 5G investments incurred in past years are also coming to an end, adding to the benefit of a lapping cost advantage through the current year without the substantial “3G network shutdown costs” previously incurred. Paired with continued expansion of its fiber coverage under a shared cost structure through the newly announced joint venture with BlackRock, AT&T is also well-positioned for sustained longer-term margin expansion by taming the spending front.
Robust Consumer Wireless Market Share Gains
The continuation of six-digit postpaid phone net adds, despite slight sequential deceleration in the second half of 2022, remains an impressive feat for AT&T considering the tough consumer environment, blighted by tightening financial conditions. AT&T’s net gain of 656,000 (-7% q/q) postpaid phone customers (total wireless subscribers totalling 217.4 million at 2022 year-end, including “4.4 million FirstNet connections”) outpaced consensus estimates of 644,800 (-9% q/q), underscoring robust share gains in a saturated market in which it currently dominates alongside two rivals, T-Mobile and Verizon (VZ). Churn has also remained at levels consistent with historical trends with even slight improvement – postpaid churn improved from 1.02% in 4Q21 to 1.01% in 4Q22, while postpaid phone churn improved from 0.85% in 4Q21 to 0.84% in 4Q22. For comparison, Verizon added 217,000 postpaid phone subscribers in the fourth quarter, while T-Mobile added 927,000. As discussed in a recent coverage, while Verizon had managed to put a stop to net postpaid phone subscription losses in the second half of 2022, propelling gradual acceleration through the fourth quarter, it is evidently losing its grip on the industry crown with rapidly declining market share and slight increases in churn rates, while rivals like AT&T benefit from resilient demand thanks to 5G coverage expansion and a variety of attractive plans that fit consumers’ evolving preferences without compromising on its own fundamental targets. AT&T’s 5G mid-band network now provides coverage for “150 million people, more than two times higher than original end-of year target” which was previously set at 70 million.
And on the fiber front, the net addition of 280,000 subscriptions in the fourth quarter also puts it on par with market expectations, underscoring the benefits of continued expansion of coverage across the U.S. to address growing consumer connectivity needs. The company’s fiber network now reaches more than 10 million business customer locations alone, putting it on track towards the 30+ million fiber locations it plans to reach by mid-decade. Consistent progress on the fiber front is expected to further bolster the higher-margin business buoyed by a higher average revenue per user (“ARPU”), and will be critical to cushioning the impact of secular moderation in demand for AT&T’s legacy business wireline services.
Again, fiber is performing really well. and the mix shift that we’re seeing to fiber comes with higher profit margins, higher ARPU. So that’s also expected — Consumer Wireline is expected to grow next year… I know you’ve observed that there’s still room for our margin expansion in the Consumer Wireline business and that we should be looking at that relative to others in the industry… And I think that’s an accurate observation over time as we continue to scale the business, that we’ll continue to improve profitability in it.
Source: AT&T, Citi’s 2023 Communications, Media & Entertainment Conference Transcript
The company’s recent announcement of a planned “Gigapower” joint venture with BlackRock, which aims to add an incremental “1.5 million customer locations initially” on top of AT&T’s current target for 30+ million locations by mid-decade, will also further its competitive advantage in securing fiber market share. The joint venture, currently pending regulatory approval, will help AT&T expand coverage beyond its “traditional 21-state local phone territory”, without the need to carry the full burden of related investments, which will be positive to its free cash flow margins. While the joint venture’s results will not be consolidated into AT&T’s financial statements, and instead flow through the telco’s PnL as share of income from an equity-accounted investment, the expanded coverage would benefit the company’s longer-term fiber aspirations by expanding its reach, and inadvertently, market share – both in terms of net subscribers and real earnings – nonetheless.
Moderating Spending Cycle
As management had briefly noted in the previous earnings call and in their most recent update, AT&T is preparing a shift from the heavy spending cycle in past years, as “investments begin to peak and begin to dissipate over time”. Specifically, the aggressive 5G arms race between the big three telcos in recent years are likely nearing an end, as many pivot towards monetization on the years-long investments. AT&T has well exceeded its previously planned pace of expanding 5G coverage, ending the previous year with more than double the 70 million PoPs (“points of presence”) it had initially targeted at 150 million PoPs. This effectively puts AT&T “well ahead” of its target to reach 200 million PoPs by the end of the current year, which further corroborates that the company is reaching “peak investment cycles” as C-band deployment moderates.
Meanwhile, as discussed in the earlier section, AT&T’s growing focus on fiber expansion is also coming at a lower cost than expected thanks to partnerships forged with infrastructure partners. Specifically, the company’s latest joint venture with BlackRock will help it expand beyond its traditional 21-state coverage. The new locations will likely be in areas where AT&T would become the first provider of FTTH. And partnering with infrastructure partners on related investments will remain critical for AT&T’s fiber aspirations, given hefty wiring costs – especially in rural areas that the company is now trying to reach:
Fiber connections are among the most desired because they offer high capacity and blazing speeds at 1 gigabit per second and faster, but the wiring is expensive. To serve a city or suburb, a branch of fiber has to run off a primary trunk, either on poles or in trenches, to a network hub. That middle mile usually costs about $1,000 per home. Connecting a home from that hub is usually an additional $1,000. For rural fiber expansion, the costs get a lot higher…”The spending formula is challenging,” says Roger Entner of Recon Analytics Inc. “Whatever it costs you to get the first 80% of the fiber coverage will cost you that much again to get to 95% and all of that again to get to 99%.”
Source: Bloomberg News
AT&T’s latest joint venture with BlackRock also complements well with its fiber expansion efforts to rural areas beyond its “traditional territory”, which is already well underway, starting with bringing “reliable, high-speed broadband to the Mesa, Arizona area” this year. The company has also recently expanded plans with the Kansas Office of Broadband Development to provide fiber access to “more than [10,000] additional customer locations in Sedgwick County”, which marks a $2.2 million opportunity that is expected to come online by the end of 2024, with contract finalization currently pending state approval. Taken together, the efforts will put AT&T more evidently on the map for $100 billion in federal incentives aimed at supporting fiber build-out across the U.S. to enable “100% coverage by 2030”.
The Bottom Line
As a result of the shift from 5G deployment to monetization, as well as access to external capital via partnerships and favourable federal policy support to fund its longer-term fiber aspirations, AT&T’s capex spend is expected to moderate from elevated levels of as high as $19.6 billion (or $24.3 billion in capital investment, inclusive of vendor financing) in the previous year, and consistent levels in the current year despite projected free cash flows of $16+ billion (+14% y/y), closer towards $20 billion over time. Paired with improving profit margins in consumer wireless / fiber as deployment continues to scale, AT&T remains well rooted in a sustained longer-term trajectory of free cash flow expansion, which will be critical to its ongoing deleveraging efforts, as well as supporting dividends that its income-focused investor base demands.
Specifically, the stock still boasts an impressive dividend yield of just under 6% after a recent rally. And the pay-out remains well supported by the underlying business’ robust fundamental outlook, which is conservatively and reasonably reflective of near-term macroeconomic and industry-specific challenges (e.g. payment collection risks / extended collection cycles, price competition, etc.) in our opinion. Now trading at about 8x estimated earnings, which is “well below historical levels“, AT&T remains a favourable longer-term investment.
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