Will AT&T Be Back On Growth Path Despite Saturation In 2018?

It is turning out to be disappointing 2017 for AT&T Inc. (NYSE:T) . The U.S. telecom behemoth continues to struggle in the competitive and almost-saturated wireless market. Adoption of several unlimited data plans resulted in a reduction of wireless service revenues and average revenue per user (ARPU). Year to date, AT&T’s investors’ have lost 15% against 16.9% growth for the benchmark S&P 500 index.

We believe that the company is currently facing several headwinds. Here, we will discuss those briefly.

Question Mark on Time Warner Deal

On Nov 20, 2017, the U.S. Department of Justice (DOJ) filed a lawsuit against AT&T for its proposed $85.4 billion takeover of media giant Time Warner Inc. (NYSE:TWX) . AT&T has challenged the DOJ verdict in court. However, a court ruling is unlikely to come before May 2018. Notably, both the companies have resettled the closing date for the deal at Apr 20, 2018.

If the court ruling goes against AT&T, three options available -- either scrap the deal, or divest its DIRECTV division or acquire Time Warner without the Turner Broadcasting assets including CNN.

We believe that disinvestment of DIRECTV is out of question as the company is gradually promoting its satellite-based DIRECTV brand over its fiber-based U-Verse as its new pay-TV offerings. Moreover, DIRECTV NOW online streaming service is quickly gaining market traction, which recently surpassed 1 million subscribers.

On the other hand, disinvestment of Turner Broadcasting assets including CNN will prevent AT&T to derive maximum synergies. Management expects the deal to be accretive to both adjusted earnings and free cash flow, in the first year post its closure. The company is likely to achieve cost synergies of $1 billion per annum within the first three years of the merger. The company expects the deal to help in diversifying its revenue mix, lower capital expenditure and reduce regulatory restrictions.

Finally, if AT&T abandons the Time Warner deal, it will be the company’s second big ticket merger which will fail after the FCC discarded its $39 billion merger proposal with T-Mobile US. AT&T’s growth in 2018 will largely depend on the court ruling on the Time Warner merger deal.

Intensely Competitive U.S. Wireless Market

The U.S. wireless industry is likely to get competitive in 2018 with the entry of cable MSOs (multi-service operators). Comcast (NASDAQ:CMCSA) has already entered this space with its Xfinity Mobile offering. Charter Communications (NASDAQ:CHTR) has reiterated its plans of launching wireless service in the first half of next year.

Technological upgrades and breakthroughs have resulted in cutthroat price competition. Although AT&T added domestic postpaid wireless customers in the third quarter of 2017, a closer look gives us a more interesting picture. Net addition of 117,000 postaid connections actually dropped a substantial 44.8% year over year. Notably, postpaid customers are those who are billed monthly and considered more profitable to telecom operators.

Moreover, AT&T’s wireline division is struggling with persistent losses in access lines as a result of competitive pressure from voice-over-Internet protocol (VoIP) service providers and aggressive triple-play (voice, data, video) offerings by cable companies. These are weighing on the company’s revenues and margins.

Cord-Cutting a Major Concern

In the third quarter of 2017, AT&T lost 251,000 satellite TV customers and 134,000 U-verse TV customers. Of late, the legacy pay-TV industry has been facing stiff competition from online video streaming service providers. The low-cost over-the-top video streaming service has resulted in massive cord cutting that is currently threatening the pay-TV business model.

A major cause for concern for pay-TV operators, who recently entered into Internet TV streaming, is that the latter has actually cannibalized the legacy pay-TV service. Most of these companies are offering both legacy pay-TV services as well as Internet TV streaming service, with selected TV channels at lower costs.

The operators are yet to find out an appropriate trade-off between these two types of services. Making attractive online ventures are drawing subscribers to the new service at the cost of traditional pay-TV business model. Ultimately, the Internet TV service is yet to stop cord-cutting, the biggest threat for pay-TV operators.

Other Headwinds

At the end of the third quarter of 2017, AT&T had approximately $163.3 billion of total debt outstanding with a debt-to-capitalization ratio of 0.55. AT&T’s debt has skyrocketed after its decision to acquire media mogul, Time Warner Inc.

In June 2017, AT&T was selected by First Responder Network Authority (FirstNet) to build and manage the first nationwide broadband network dedicated to America's police, firefighters and emergency medical services. This move was considered a necessary boost to the company’s profile. However, the company is yet to receive favourable response from states and government bodies for network deployment.

In November 2017, Mexico’s telecommunications regulator stated that America Movil could start charging local rivals for mobile calls to its network for the first time since a 2014 sector reform. This has come as a bane for companies like AT&T which are desperately trying to strengthen foothold in Mexico but still depend on America Movil’s network due to its sheer size across the nation.

Rays of Hope Still Persists

Despite the above-mentioned concerns, there’s also a silver lining.

First, there is little doubt that if the new FCC scraps Net Neutrality laws, the ISP (Internet Service Provider) industry will be the major beneficiary. AT&T is a major ISP. Net Neutrality, which disallowed discriminatory pricing policy, has significantly reduced revenues and margins of ISPs.

Second, the U.S. telecom industry is going to be a major beneficiary of the proposed tax-reform bill of President Trump. The proposal to reduce corporate taxes from the current 35% to 20% is likely to bring corporate tax rate at its historic low in 78 years. Large telecom operators book much of their revenues in the homeland. Therefore, a significant reduction in corporate tax rate faced by telecom carriers would be immediately accretive to cash flow.

Third, if the court ruling on the Time Warner deal goes in AT&T’s favor, the merged entity will enjoy control over both high-quality content and distribution medium. This may enable AT&T to raise prices without investing much in innovative products. The proposed merger with Time Warner will provide AT&T a portfolio of lucrative contents. Time Warner's media empire includes HBO and Turner Broadcasting, which has the rights to sports telecasts in addition to Warner Brothers movie studio.

Fourth, in 2018, AT&T is likely to deploy 60 MHz of fallow spectrum and 600 MHz low-band spectrum coupled with its ongoing network-densification project. Therefore, the immediate expensing of investment in all tangible, intangible and real property (other than land) would significantly benefit AT&T.

Our View and Zacks Rank

So far we discussed major concerns and some revival options for AT&T. In a nutshell, we can conclude that the U.S. telecom market continues to witness intense pricing competition as success depends largely on technical superiority, quality of services and scalability.

Challenges in the form of competitive product introduction and cut-throat pricing pressure will persist in the telecom sector. AT&T is aggressively offering bundled services. However, it needs to set the stage right, as so far, its bundled customer addition has failed to match the outflow of users from its legacy services.

We do not find any near-term catalyst for the stock in the ongoing holiday season. AT&T carries a Zacks Rank #4 (Sell). However, other major national carriers, namely Verizon Communications Inc. (NYSE:VZ) , T-Mobile US Inc. (NYSE:T) and Sprint Corp. (NYSE:S) carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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