Image Source: AT&T Inc – Second Quarter of 2021 IR Earnings Presentation
By Callum Turcan
The communications and media giant AT&T Inc (T) is pivoting back to its roots, a strategy that we think will pay off handsomely in the long run, though there have been plenty of rough bumps along the way. Management has finally found a strategy that AT&T can stick with. We include AT&T as an idea in the High Yield Dividend Newsletter portfolio and shares of T yield ~7.7% as of this writing (note that the company will rightsize its dividend in the coming quarters, resulting in a yield adjustment lower).
Warner Bros. Discovery
AT&T’s WarnerMedia segment is joining forces with Discovery Inc (DISCA) that will see shareholders of AT&T own 71% of the new company’s equity once the deal closes. This move was announced in May 2021 and is still expected to be completed in the middle of next year. AT&T’s HBO Max video streaming service will be a core part of that new entity’s operations (along with its traditional HBO offering provided as an add-on through pay-TV services) as will Discovery’s new video streaming service, Discovery+ (which launched in January 2021).
The new company will be known as Warner Bros. Discovery and will have significant scale in the media, entertainment, and video streaming services industries. Additionally, AT&T expects Warner Bros. Discovery will be able to generate at least $3.0 billion in annualized cost synergies by 2023, which in turn will be utilized to support massive investments in original content geared towards its direct-to-consumer (‘DTC’) operations.
Even after taking into account expected volatility in subscriber figures due to HBO leaving Amazon Inc’s (AMZN) channels service in September 2021, AT&T forecasts that HBO/HBO Max will exit 2021 with 70-73 million paid subscribers worldwide (excluding free trial figures). Launching HBO Max into new markets represents a core way AT&T expects to grow the video streaming service’s paid subscriber base.
During the recent Communacopia Conference hosted by Goldman Sachs Group Inc (GS), AT&T’s CEO John Stankey had some interesting commentary regarding past mistakes involving the rollout of HBO Max, which launched back in May 2020, and how the firm can correct those mistakes before the planned separation. In summary, AT&T initially thought of HBO Max as a complementary service to its domestic wireless packages that could help AT&T reduce customer churn and boost the total revenue potential of each customer. However, as time progressed and AT&T’s strategic vision changed, it became clear that a lot of the growth opportunities sitting in front of HBO Max were overseas.
AT&T’s CEO noted that part of the reasoning behind the pending WarnerMedia-Discovery merger was to ensure that nothing was getting in the way of HBO Max’s global growth story. Put another way, it seemed Mr. Stankey was implying that as a part of a communications giant, HBO Max was not able to live up to its full potential. This does represent a complete 180-degree pivot from AT&T’s previous strategy, and please note that this comes on the heels of AT&T recently completing the partial divestment of its DIRECTV and other US pay-TV operations by spinning off that entity (though it retains a 70% equity stake in the venture). AT&T previously spent lavishly acquiring DIRECTV in 2015 and Time Warner in 2018 (which owned WarnerMedia at the time).
Within a recent press release, AT&T noted that HBO Max would expand into six additional European countries in October 2021 after getting launched in 39 Latin American territories in June 2021. Furthermore, the goal is to launch the video streaming service in at least 14 additional European territories in 2022 to keep the momentum going on this front. As it concerns HBO Max’s near-term growth trajectory, management expects “subscriber growth in the second half of 2021 to primarily come from outside the United States” due in part to HBO Max leaving Amazon’s channels service and in part due to the service aggressively expanding its reach overseas.
During the recent IR conference, AT&T’s CEO noted that the goal was to boost the subscriber base of HBO Max as a standalone service to 120-150 million by 2025. For reference, HBO/HBO Max had 67.5 million paid subscribers at the end of the second quarter of 2021 (including 47 million paid domestic subscribers). Stankey recently noted that the rollout of the HBO Max service in Latin American had gone quite well so far.
AT&T intends to use the merger of its WarnerMedia unit with Discovery to trim its total debt load, aided by its recent divestment activities (I, II), something that we already covered in detail through our July 2021 article High-Yielding AT&T Remains Free Cash Flow Cow (link here). The communications giant had $179.8 billion in total debt (inclusive of short-term debt) on the books at the end of June 2021, modestly offset by $11.9 billion in cash and cash equivalents on hand. Its stellar free cash flow generating abilities and ample liquidity levels combined with its pending spinoff and divestment activities should enable AT&T to stay on top of that burden going forward.
5G Wireless, Fiber, and Dividend Considerations
Another key part of AT&T’s reasoning behind separating its media operations from its communication operations is so the company can focus more on building out its 5G wireless infrastructure and fiber optic internet service provider (‘ISP’) business, both of which are relatively capital-intensive operations. In order to grow the appeal and ultimately the paid subscriber base of its video streaming services, AT&T is investing heavily in original content for HBO Max and likewise, Discovery is investing heavily in original content for Discovery+, something that will likely continue once the merger closes. However, managing the investment needs of both sides of its business was a difficult task for AT&T when also taking its large dividend obligations into account.
Once the merger of WarnerMedia and Discovery has been completed, AT&T has communicated to investors that its payout would be rightsized. Management noted back in May 2021 that AT&T would pay out around $8.0-$9.0 billion in annual dividends post-merger, compared to $15.0 billion in 2020. That is partly due to the loss of cash flows relating to WarnerMedia, and partly due to the need to free up cash flow to invest in its core communication businesses which have been growing at a brisk pace of late. In 2023, AT&T aims to generate $20.0 billion or more in free cash flow post-merger (keeping its various divestments of late in mind as well).
During the first and second quarters of 2021 combined, AT&T’s ‘Mobility’ business added 2.0 million net postpaid customers including 1.4 million net postpaid phone customers. Its prepaid phone business added 0.4 million net customers during this period. Pivoting to AT&T’s ‘Consumer Wireline’ business, this segment added 0.5 million net fiber internet customers during the first and second quarters of 2021.
As it concerns AT&T’s wireless business, utilizing aggressive handset promotions has been key, including promotions involving the new iPhone 13 from Apple Inc (AAPL). The entire wireless industry in the US has been leaning heavily on handset promotion of late, and AT&T has been no exception. During AT&T’s latest IR presentation, Stankey noted that in the past, the company had been less aggressively using handset promotions to win over wireless customers so the firm’s pivot towards more generous promotions represents AT&T converging towards industry norms (in the view of AT&T).
Stankey also noted that AT&T was utilizing some of its recent cost savings to cover the cost of these promotions while maintaining the firm’s margins. For reference, AT&T is targeting $6.0 billion in annualized cost savings by 2023 (a plan announced back in 2020 that involves meaningful headcount reductions), roughly $2.0 billion of which has been realized so far, and Stankey reiterated this guidance during the firm’s recent IR presentation.
To maintain the customer growth trajectory of its Mobility business going forward, management aims to continue offering generous handset promotions in the medium-term while also considering how to optimize AT&T’s advertising and brand building efforts. In particularly, AT&T’s CEO wants to position the brand to be more appealing to younger demographics.
Stankey stressed that having the best service is one key way to differentiate the company’s 5G wireless offerings from the rest of the industry, though that is easier said than done given the immense amount of capital companies like Verizon Communications Inc (VZ) and T-Mobile US Inc (TMUS) are also pouring into the space. However, AT&T’s CEO did note that the recent strategic agreement with DISH Network Corp (DISH) that will enable DISH to utilize AT&T’s domestic wireless infrastructure as it seeks to build up its own 5G wireless network in the US speaks favorably towards AT&T’s efforts on this front (while also creating a new source of revenue for the firm).
AT&T has been bulking up its C-band spectrum portfolio and by the end of 2023, the firm aims to cover 200 million people in the US with its 5G C-band network. For reference, C-band spectrum and the related 5G wireless infrastructure is what would ultimately enable such services to offer significant performance improvements over 4G wireless services. To do so, AT&T intends to spend $22.0-$24.0 billion on capital expenditures per year in 2022-2024, compared to the $20.4 billion it spent on average per year in 2018-2019 before the coronavirus (‘COVID-19’) pandemic hit.
Pivoting to AT&T’s fiber business, the company’s goal is to expand its footprint to cover 30 million customer locations by the end of 2025, up from roughly ~15 million as of the middle of 2021. Combined with a rising penetration rate (greater number of households in its coverage region utilizing its fiber internet services), that should result in powerful growth in its customer base on this front in the coming years. For reference, AT&T’s fiber internet business had a penetration rate of 31% and 4.3 million customers in the second quarter of 2020. By the second quarter of 2021, its penetration rate had risen to 36% while its customer base had grown to 5.4 million, with ample room for upside (the firm’s coverage area also grew during this period).
Looking ahead, the goal is to drive the penetration rate of AT&T’s fiber internet service up to around 40% and over the long haul, management aims for AT&T’s fiber internet business to have penetration levels near 50% in regions where AT&T Fiber (the brand name of its fiber optic ISP business) is well-established. As AT&T builds up its scale in this space, the cost of adding a new customer to its operations should shift meaningfully lower, aided by the increased effectiveness of its promotion and advertisement programs and existing infrastructure in the ground.
Supply Chain and Labor Hurdles
However, supply chain and labor hurdles have modestly slowed down its growth efforts on this front. During AT&T’s recent IR presentation, a Goldman Sachs analyst noted that AT&T had recently communicated to investors the firm would expand the reach of its fiber footprint to moderately less households than previously expected this year (~2.5 million versus ~3 million previously). AT&T’s CEO responded by noting that the firm was facing headwinds securing fiber optic cable from its manufacturing partners as its partners had to deal with labor hurdles resulting from COVID-19 and the related quarantine measures. Please note that AT&T’s management team noted that these headwinds largely represented a 90-day delay to its growth ambitions on this front, and that over the past month, deliveries have tracked with its expectations.
Looking ahead, AT&T plans to aggressively speed up the annual growth rate of the number of households capable of utilizing its AT&T Fiber services. Specifically, AT&T’s CEO noted that “we have cast this in a way where getting this kind of an engine ramped up to go from building 3 million to 4 million to 5 million homes passed” during the recent IR presentation. AT&T’s CEO also commented that “my goal is I feel very comfortable, we have places we can go to build 30 million homes right now on an owned and operated basis. They have very attractive returns in the mid- to upper teens” as it concerns the firm’s AT&T Fiber business. Furthermore, if the bipartisan infrastructure bill currently waiting for approval in the US House of Representatives gets signed into law, Stankey noted that AT&T would be able to embark on a more aggressive service network expansion program.
Another supply chain headwind AT&T has faced from the COVID-19 pandemic concerns the generators that act as a backup power source for its cell sites. While Stankey noted that each generator costs around $15,000, the shortage of resins and the related parts (in particular, a part worth about $0.25 in this instance) were delaying efforts to rollout those generators. In our view, AT&T will be able to adeptly navigate these headwinds going forward while maintaining its growth trajectory.
Concluding Thoughts
Keeping in mind that AT&T intends to rightsize its dividend, we continue to view its income generation potential quite favorably. The company’s stock price has faced significant headwinds over the past couple of years due to AT&T’s strategic pivots, though it now appears the company has found a lane it can stick in. Getting back to its roots as a communications powerhouse is the right call, in our view, and we continue to like shares of T as an idea in the High Yield Dividend Newsletter portfolio (more on that publication here).
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