One of Verizon Communications' (VZ) latest commercials shows the view of an engineer climbing an icy cell tower in rural Alaska. It’s a heroic take on networks and their keepers.
Then there’s AT&T's (T) marketing campaign. In the wake of its $106 billion purchase of Time Warner, the company has turned its stores into a paean to Game of Thrones, with dragons plastered on walls above smartphone displays. In some outlets, there’s an Iron Throne replica for customers to rest on while they shop.
After years spent running their businesses in virtual lockstep, America’s largest phone companies are furiously heading in opposite directions.
Verizon Communications is doubling down on its network, while AT&T is rapidly diversifying beyond the phone business. The Time Warner acquisition came just three years after a $66 billion deal for satellite-TV provider DirecTV.
Both companies are reacting to the same external forces. Nine out of 10 Americans now have wireless phone service, and they are increasingly paying up for unlimited data plans. In that respect, the wireless market has never been better—but it may also be as good as it gets.
“The industry right now is as healthy as it has been since 2012,” says J.P. Morgan analyst Philip Cusick, noting that years of bruising price wars have finally come to an end.
One wrinkle: The once dependable cash-rich landline and cable-TV businesses are still dealing with an industrywide exodus of subscribers. The search for growth has forced the nation’s wireless companies to step outside of their once monopoly-protected comfort zones.
AT&T and Verizon need a new act, and are responding in different ways, as their recent marketing attests.
This year, Verizon is expected to generate 71% of sales from wireless services. Wireless-related business will probably be about 40% of AT&T’s revenue.
Verizon management says that the rollout of fifth-generation, or 5G, technology and related services will be more than enough to increase earnings in coming years. Executives made almost 150 references to their company’s network at a recent investor day. It’s a straightforward strategy that doesn’t take the company far from its decades-old mission: connecting Americans to one another.
AT&T, meanwhile, believes that owning content gives it a distinctive tool for keeping customers in the fold. HBO has been used by cable-TV providers for years as a sweetener or bonus for customers signing up for new contracts.
The CEO of AT&T, Randall Stephenson, tells Barron’s, “We believe we are standing up a very unique situation that not only creates a unique experience for customers, but also creates a company with a very unique financial profile.”
For now, investors have been quite clear on their preference for Verizon’s strategy. Its stock, at a recent $59, has returned 29% over the past year, including dividends, versus 9% for the S&P 500 index. AT&T’s stock, meanwhile, has slid 12%, to $31, though the negative return is softened by AT&T’s generous dividend.
The stocks have historically paid a similar yield, with Verizon averaging 4.5% over the past half-decade, and AT&T averaging 5.4%. Today, they have diverged. Verizon’s dividend yield is 4.1%, while AT&T’s yield, boosted by its falling stock, is 6.6%.
AT&T’s generosity shouldn’t be overlooked. It’s the fifth-highest yield in the S&P 500. And while some skeptics are probably worried about the long-term safety of the payout, the company tells Barron’s that the dividend is “extremely safe.”
With Treasury yields falling and the Federal Reserve committed to holding interest rates in check, AT&T’s yield could be investors’ best bet for nearly guaranteed income. Its stock, which fetched 14 times year-ahead earnings estimates in 2013, now trades at less than nine times estimates. Verizon stock, meanwhile, looks fairly valued at 13 times year-ahead estimates.
An uncertain economy makes the telecom business a popular haven for investors. The business typically holds up even in recessionary times, thanks to a wide moat and hefty free cash flows. This time, investors are faced with a choice.
AT&T’s diversification is now forcing longtime telecom investors to grapple with a new business model, a different risk profile, and a huge debt load.
“For a stock that has historically been a very low-risk investment, it is now a much riskier proposition,” says veteran telecom analyst Craig Moffett of MoffettNathanson, who rates AT&T Neutral with a $30 price target. He rates Verizon Neutral with a $58 price target.
But as it pays down its debt, AT&T’s risk profile will return to normal. “When they took the leverage up over three times, they shut out a lot of investors, and I think they’re going to come back as they see that leverage come down,” says Frank Louthan, an analyst with Raymond James.
AT&T is in a transition, to say the least. The company paid a combined $172 billion, including debt, for DirecTV and Time Warner. The cost goes beyond the monetary outlay. It fought a rare court battle with the U.S. Department of Justice, which spent almost two years arguing that AT&T was making an anticompetitive play. Since the deal closed last year, AT&T has taken an active role in the division, which it renamed WarnerMedia. Multiple executives have left in recent months, leading to questions about whether Hollywood talent wants to work for a phone company.
AT&T has tried to push through the distractions. The company has begun calling itself a “diversified, global leader in telecommunications, media and entertainment, and technology.”
The diversification strategy could prove prescient, especially as wireless phones reach a saturation point. Yet, AT&T has also put itself in a line of fire that includes Netflix (NFLX), Apple (AAPL), and Walt Disney (DIS), among others. Verizon, Sprint (S), and T-Mobile US (TMUS) won’t be yielding any ground, either, when it comes to the much-hyped opportunity in 5G.
AT&T has work to do, but the stock is now pricing in a low chance of success. And investors get paid handsomely while management executes on its grand vision.
Today’s AT&T and Verizon trace their roots to the 1980s breakup and subsequent reunion of the former Baby Bells. Once-familiar names like Cingular Wireless, Bell Atlantic, Nynex, and SBC Communications were rolled up into the dominant forces at the top of telecom ecosystem. AT&T and Verizon account for a combined 65% of the U.S. wireless market, 47% of landlines, and 32% of home internet. They have a combined $760 billion in enterprise value.
Also-rans T-Mobile and Sprint, by contrast, are worth about $144 billion combined. After a long dalliance, the companies are seeking regulatory approval for their merger. They say the deal would give them the scale to compete with AT&T and Verizon. While a merger would create a more powerful rival, it could also relieve some of the pricing pressure that T-Mobile brought to the industry.
Verizon’s wireless division made up about 70%—or $91.7 billion—of its revenue and all of its operating income in 2018. The bulk of the remainder of Verizon’s revenue came from its Wireline segment, where sales fell 3% last year, to $29.8 billion. Verizon Media, the former AOL and Yahoo! properties that Verizon acquired in 2015 and 2017, respectively, represented $7.7 billion in sales last year. (Starting next quarter, Verizon will report its segments by target market.)
Wall Street expects Verizon’s adjusted net income to be down slightly in 2019, to $19.2 billion, or $4.66 a share, versus $19.5 billion, or $4.71 a share, last year. The adjustments strip out acquisition-related expenses and other one-time costs.
AT&T’s wireless phone business is likewise the most significant part of its portfolio. The company’s Mobility division was responsible for about 40% of revenue last year, and nearly 60% of operating income. Mobility sales were flat at $71.3 billion. From there, things get more complicated.
The company’s Entertainment Group includes 2015 acquisition of DirecTV, along with its existing cable- and fiber-TV, internet, and home-phone service. That group’s sales fell 7.1% in 2018 to $46.5 billion, 27% of AT&T’s total revenue, while operating income dropped 14%, to $4.7 billion. WarnerMedia, which includes HBO, the Turner family of networks, and the Warner Bros. Hollywood studio, would have brought in $18.9 billion last year, or roughly 11% of AT&T’s revenue. Add in a shrinking Business Wireline unit ($26.8 billion in sales last year), AT&T’s Latin America segment, and the company’s new advertising business, and you have the new AT&T, with $171 billion in revenue last year.
Analysts estimate that AT&T’s adjusted net income will climb 9%, to $26.2 billion, this year, or $3.58 a share, from $24 billion, or $3.52 a share, in 2018.
Some of those same Wall Street analysts were scratching their heads in 2014, when AT&T announced its intention to buy DirecTV. AT&T again seemed to go against the tide with its decision to acquire Time Warner, just as consumers were showing less loyalty to cable channels (like its TNT) and traditional movie studios (like Warner Bros.).
But AT&T executives are feeling giddy these days about the opportunities ahead. The company offered its entire leadership to Barron’s to talk through the company’s strategy. Verizon declined to make its executives available.
The takeaway from our interviews? AT&T believes that combining distribution, content, and some advertising can restore the luster to all three businesses. It’s planning a new, direct-to-consumer streaming service for later this year that combines original and licensed content, plus live and on-demand tiers. Consumers will still pay up for unique content, as Netflix has proved. And AT&T plans to combine insights from customer viewing habits with its trove of subscriber data to serve customers with targeted advertising. That business, called Xandr, had $1.7 billion in revenue last year at a 77% operating profit margin.
“Traditionally, we were in the part of the value chain that was largely distribution-oriented, either through infrastructure or through bundling content and distributing over it. Now we’re looking at a similar model where we have the ability to manufacture content,” says John Stankey, previously AT&T’s chief strategy officer and now the CEO of WarnerMedia.
DirecTV’s subscriber base shrunk over 6% in the fourth quarter from a year ago. While those losses won’t ever return, AT&T’s legacy businesses are still profitable in their decline, funding the development of AT&T’s new initiatives.
“All these businesses over the next couple of years are going to be very profitable, generating a lot of cash flow and allowing us to reinvest in a virtuous cycle to keep developing these capabilities,” CEO Stephenson says. “So I just think it’s an exciting 18 to 24 months as we assemble all of it.”
Wall Street is coming around to the plan. Two weeks ago, Louthan of Raymond James raised his rating on AT&T shares to Outperform with a $34 price target, 9% above current levels. Much of Louthan’s argument revolves around AT&T’s plan to pay down its substantial debt, but the analyst is also modeling in the economic benefits of combining a wireless network, a TV distribution business, and an iconic content brand like HBO.
“The name of the game here is to use content and be able to lower churn across the 130 million or so customers that they have,” Louthan says.
Last year, AT&T’s churn, or customer defections, added up to 1.6% of its subscriber base. Louthan calculates that every 0.1 percentage point drop in churn would add 1.5 percentage points to earnings growth. That’s a substantial bump for a company that has been increasing earnings at a 2.8% annualized rate over the past 10 years.
“Lowering churn across your broadband and your wireless customers is really where we think the better long-term profitability is,” Louthan says.
With its large dividend, investors need a good reason not to buy AT&T these days. The best argument is that its enormous debt load will imperil its dividend payment, particularly if customers continue to cut the cord on their satellite-TV subscriptions.
To fund its Time Warner deal, AT&T took on $40 billion in new debt in addition to almost $21 billion of Time Warner’s existing debt, raising its postmerger debt load to nearly $180 billion. Wall Street tends to measure debt against earnings before interest, taxes, depreciation, and amortization, or Ebitda. After the merger closed, AT&T’s net debt jumped to almost four times Ebitda. Verizon, meanwhile, has been shrinking its debt load. The company’s net-debt-to-Ebitda ratio stands at a three-year low of 2.3 times.
AT&T is now the most indebted company in the world. But AT&T’s earnings just about top the global list, as well. In the U.S., only Apple generated more last year. (Apple’s adjusted Ebitda was $79.3 billion, versus $56.6 billion for AT&T.) Telecom companies have always been comfortable carrying eye-popping debt: the second-most indebted company in the U.S. is Verizon, with $110 billion in net debt, followed by Comcast (CMCSA), with $108 billion.
AT&T has paid down $9 billion of its obligations since the Time Warner deal closed last June. The company says it plans to pay off another $18 billion to $20 billion this year, and it’s targeting a debt-to-Ebitda ratio of 2.5 times by year end. That would put AT&T’s relative debt load back near its five-year average heading into the merger.
And here’s the key line for income investors: AT&T says its dividend payout ratio (the portion of net income distributed as dividends) will be in the high 50% range in 2019. That’s generally in line with the S&P 500’s most consistent dividend payers, the so-called Dividend Aristocrats. The group’s payout comes to an average of 49%.
“The dividend is extremely safe,” AT&T CFO John Stephens tells Barron’s. “We’ve raised it for 35 years.” AT&T’s board last raised the dividend in December, just months after it closed the Time Warner deal. Stephens is confident in AT&T’s ability to continue on that trajectory, citing a forecast of $26 billion in free cash flow after capital expenditures in 2019 and a dividend payment in the $14 billion range. “The math is easy to do…and it still leaves a dramatic amount of free cash flow left to pay down debt,” he says.
AT&T is funding most of the debt pay-down from operations, but the company also plans to sell $6 billion to $8 billion in noncore assets, including real estate and its minority stake in Hulu.
AT&T’s transformation is up against the other major story line in telecom: 5G.
These wireless networks promise as much as 20 times faster data speeds than current 4G LTE networks, with lower latency and better performance in high-density areas. Proponents foresee 5G networks enabling faster mobile access to data-intensive forms of entertainment like mobile gaming, 4K video streaming, and virtual reality; self-driving vehicles and remote medical procedures; and millions of Internet of Things devices.
Sure enough, both AT&T and Verizon are racing to win the shift to 5G networks, and once again, their approaches are meaningfully different. AT&T Communications CEO John Donovan called the fight for 5G leadership “nothing short of a religious war.”
The question that investors want answered for both companies is how the shift to 5G results in higher earnings.
Verizon CEO Hans Vestberg, who was elevated from chief technology officer in August, identified several opportunities at an investor day in February.
First is through winning business from cable companies by replacing wired home broadband internet connections with a hotspot-like device in your home that picks up a 5G signal and broadcasts a Wi-Fi network for local users. Unlike mobile 5G, the antenna-receiver connection is fixed and requires relatively clear lines of sight. Verizon’s first service started in October in parts of four U.S. cities, including Houston and Los Angeles, and promised data speeds of around 300 megabytes per second. Pricing was initially $50 a month for customer with a Verizon Wireless phone plan or $70 a month for those without. A 300 Mbps Verizon Fios internet plan currently costs $60 a month, plus taxes and fees.
AT&T has been focused on mobile 5G from the start. It had an initial launch in parts of a dozen U.S. cities last year, including Atlanta and Houston. Without any 5G-enabled phones available, however, AT&T’s first device was a 5G mobile hot spot that Stephenson calls a “puck.” Customers could get average speeds of 200 to 300 Mbps and 15 gigabytes of data for $70 a month. Verizon plans to introduce mobile 5G in over 30 markets by the end of 2019. Its first two cities, Chicago and Minneapolis, will get 5G service in some areas on April 11. In its initial launch, the service comes with an additional fee of $10 a month per line over Verizon customers’ existing unlimited plans. 5G-enabled smartphones from handset makers like Motorola and Samsung have begun to come to market.
Despite the marketing hype, both AT&T and Verizon will slowly and steadily deploy 5G networks without meaningful increases in their already sizable capital-expenditure budgets. They cite service cost savings from more-efficient 5G networks, but because customer adoption will be slow, investors shouldn’t expect 5G to be a financial game-changer for some time. Verizon doesn’t expect its 5G offerings to meaningfully contribute to revenue growth until 2021.
Ultimately, AT&T is making a bet that it needs to differentiate itself from other carriers on more than just its wireless service and its pricing. That’s where its new diversity comes in. AT&T hopes that premium offerings like HBO—Game of Thrones is about to start its last season—will ultimately be key to drawing customers to its telecom services and keeping them there.
The company is taking an expensive gamble, but there’s one thing to be certain about: AT&T isn’t resting on its laurels. Investors have the chance to collect a handsome dividend while they wait for the strategy to play out.
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