Sold AT&T Due to Fear of Wireless Price War

All Northlake positions in AT&T have been sold in the last couple of trading days. The stock has been a disappointment. It did not participate in the big market rally in 2009, providing only a minimal return through its dividend yield. Among the many issues that have been troubling the stock are (1) weak enterprise spending on telecommunications, (2) bad press on the quality of the company’s wireless network, (3) fear of the loss of iPhone exclusivity, and (3) price competition on low end phone plans.

I have felt these issues were fully discounted in the stock. It was last week’s news that Verizon, followed immediately by AT&T, was cutting prices on unlimited voice minute plans that triggered the decision to sell. I actually do not think that financial impact of the price cuts will be negative on either company. However, 2009 witnessed a downward price spiral on low end, prepaid voice plans. These plans gained market share and restricted subscriber growth for more traditional postpaid plans. I fear that Verizon’s price cut may be just the first in a similar downward spiral for voice pricing on postpaid plans. Prepaid stocks collapsed in 2009, some falling 70% or more.

I do not expect the same for AT&T or Verizon in 2010 even if a price war breaks out due to both companies strong finances and high and stable dividends. But the upside from earnings growth is not enough to compensate for the risk of a price war. Thus, the upside in AT&T shares no longer seems sufficient to account for growing downside risks.

Clean Beat for AT&T -- Shares Headed Higher

AT&T reported better than expected 1Q09 results. The upside was driven by margins in both the wireline and wireless business segments. Cost control and better than forecast benefits from the iPhone were the drivers as revenues fell a bit shy of estimates. Overall, EPS of 53 cents beat the 48 estimate handily. It was a clean beat with no unusual one-time benefits. Morgan Stanley even noted that the tax rate was the highest since 1Q07.

Guidance was maintained but clearly looks conservative. Most of the conference call Q&A centered on margins. Analysts clearly were trying to determine why margins won't exceed current guidance and estimates. Management's only real pushback was the uncertain revenue environment but even here I though it was interesting that management now seems to fully understand the magnitude and sources of the revenue pressure. The street will probably play it safe and maintain estimates while noting they have upside. I fully expect the 2009 EPS number to eventually go higher.

At the subscriber level, wireless net additions were better than expected as were U-Verse TV and broadband subs. Wireless voice ARPU was a bit light but data ARPU continued to grow strongly, up almost 40%. Data now represents 27% of total wireless ARPU. Churn was low. The iPhone is going gangbusters with quicker and larger financial benefits materializing. This is a substantial source of EPS upside for 2009 as the original guidance was for heavy dilution form handset subsidies.

The only significant shortfall was in enterprise revenues which fell 4%. This was at the high end of expectations.

With 2009 EPS going higher and growth initiatives in wireless, U-Verse, and business data in place, I think T shares can increasingly look ahead to a resumption of growth in 2010. EPS could rise toward to $2.40-$2.50, good enough to push the stock into the $30s without stretching the P-E multiple. The stock gets further support from the very secure 6% plus dividend yield. The dividend is almost certain to go up again next year.

T shares continue to offer one of the best offense/defense combinations. Offense comes from growth business in wireless, business data, and U-Verse. Defense comes form the dividend, a strong balance sheet, and high free cash flow. New this quarter to the both sides of the ball is superior cost controls.

There is still the possibility of a strike on the wireline side and the company faces $10 billion in debt refinancing. The strike is a risk only if is prolonged and nasty enough to generate front page headlines. The refinancing should not be a problem given the company's free cash flow and the significant recent narrowing of spreads on the outstanding debt.

Disclosure: AT&T is widely held in Northlake client accounts including Steve Birenberg's personal accounts.

Negative Reaction to Verizon 4Q Raises Stakes for AT&T

AT&T is projected to report EPS of 65 cents on revenues of $31.35 billion. A negative reaction to Verizon's report and some negatives that cropped up took T shares down hard ahead of the report. This may take out risk as the bar is lowered but it also raises the stakes for the "resilience" theme as if T has a slight miss and negative stock price action, investors may decide to that telecom is no longer the place to hide.

Even before VZ reported, investors were going to be focused on slowing wireless growth and negative revenue in Enterprise. VZ's subscriber growth miss and higher churn and larger than expected decline in Enterprise revenue raise the stakes. VZ also announce higher pension expense despite using smoothing while T will does not smooth and may take a larger than expected hit.

On the positive side, VZ had good wireless data growth, solid overall wireless ARPU, and better than expected growth in its advanced broadband and TV services. T should benefit from all these factors especially with iPhone adding millions of subs over the past two quarters. One interesting thing to watch will be whether VZ's sub shortfall will be repeated or T did better in market share than expected.

Other key measures to watch are access lines (down sharply but possibly not getting worse), total broadband adds (213,000 estimated), U-Verse TV subs adds (250,000 estimated), and U-Verse Internet sub adds (225,000 estimated). Wireless churn is supposed to be flat at 1.6% with ARPU trending slightly lower near $50.24.

Wireline revenue and EBITDA is projected at $31.4 billion and $10.5 billion. The Wireline segment should be around $17.6 billion in revenues and $5.85 billion in EBITDA. Wireless consensus calls for $13 billion in revenue and 3.9 billion in EBITDA.

Overall, VZ's report has increased worries that wireless growth will slow more than expected in 2009. T will either confirm that as fact or not. The question is whether the bloom is off for the major telcos. VZ suggests investors are saying yes even if results are decent. T will need to do better to reverse the wavering sentiment.

New FCC Chairman Presents Risk

In big news for media and telecom, major media outlets are reporting that President-elect Obama will nominate Julius Genachowski to head the Federal Communications Commission (FCC). Genachowski was technology adviser to Obama during the campaign. According to the Wall Street Journal, he put together detailed plans for Obama "that expressed support for open Internet or "net neutrality" protections; media-ownership rules that encourage more diversity; and expansion of affordable broadband access across the country."

Business interests may be concerned if early reaction from political and creative communities are an indication. Free Press, a media reform group, likes the appointment. So does The American Association of Independent Music, a group representing the interests of indie musicians.

Net neutrality is the big issue. Major networks owners including cable and telcos would are quietly against net neutrality because they want to price access to their networks based on usage. Google and other major online companies are leaders in the fight for net neutrality.

Media consolidation is another big issue. Media companies would prefer an FCC that is willing to allow consolidation. An Obama FCC is not going to go that route but Genachowski may be viewed as worse than average on this issue. Then again, credit markets remain closed and media companies have been penalized for acquisitions even when they were fundable.

Although, I am about as far politically as possible from Karl Rove, one quote of his I always liked was "elections have consequences." A changing of the guard at the FCC leading to policies that are considered more consumer friendly is just one of the consequences that many business interests may not like.

New Purchase: Why You Should Own AT&T

On Friday, December 5th, I purchased AT&T for Northlake clients and in my personal accounts. The following commentary appeared on RealMoney.com on December 3rd when AT&T was about $2 higher than the purchase price. When the shares pulled back after the the company announced job cuts, a buying opportunity was created. I slightly prefer AT&T to Verizon because it has a lower P-E ratio, more cost cutting opportunities and does need to finance a major pending acquisition.

AT&T (T) and Verizon (VZ) , the leading telecommunications companies in the U.S., both look attractive to own for the short and long term.

AT&T has a market cap of $164 billion with projected 2008 revenue of $124 billion. Verizon has a market cap of $91 billion with projected 2008 revenue of $97 billion. AT&T should end this year with about $64 billion in net debt. Verizon has about $43 billion in debt but needs to finance its $27 billion purchase of Alltel.

Both stocks have reasonably low valuations and good dividend yields, which provide downside protection. And both companies have recession-resistant business models due to the utility-like nature of most of their revenue streams. While competition is tough in all the businesses that both companies compete in, the only area that is clearly in secular decline is consumer wireline, where access lines are falling due to wireless substitution and inroads by cable companies.

Enterprise services to corporations represent about 25% of revenue for each company and currently face cyclical pressures. Wireless is the primary growth business, at about 40% of revenue, and advanced consumer services such as TV and high-speed Internet are also growth businesses, even though they account for only 5% of revenue.

Why You Should Own AT&T Now

These revenue mixes should enable both AT&T and Verizon to at least maintain flat revenue and earnings growth in 2009 and probably eke out small gains. Estimates call for low-to-mid single-digit gains on both metrics. Investors will seek out the defensive nature of AT&T and Verizon while also understanding that the long-term growth story is improving as the business mix continues to shift toward the growth businesses.

Long-Term Drivers

Recently, Jim Cramer succinctly nailed the long-term attraction of AT&T and Verizon. He noted that both companies' competitive positions are improving rapidly as they come to dominate the business-facing telecom industry and develop an oligopoly with the cable companies when facing consumers. Further, Jim notes that the trend toward wireless and digital communication benefits the telcos.

The shift to wireless and digital communication is evident in the revenue mixes and gives AT&T and Verizon a chance to grow in 2009 despite the massive economic headwinds. Both companies also have the opportunity to use their relatively strong stock prices and still-open access to credit markets to further enhance their digital positioning via acquisition. For example, Alltel is a win for Verizon, and AT&T has quietly scooped up a few small wireless players to enhance its geographic footprint.

What Could Go Wrong

The biggest risk facing AT&T and Verizon is that the wireless business could slow down more than expected. Trends in voice are already under pressure, with average revenue per user falling and new subscriber growth slowing. The shift to smartphones hurts margins in the near term as phone subsidies soar. This is a worthwhile investment if data growth continues. If wireless data growth, which has been near 50%, slows more sharply than expected, the defensive nature of AT&T and Verizon will be seriously undermined. Keep an eye on smartphone sales for any sign of slowing.

A second fear is that enterprise spending proves more cyclical or has a deeper cyclical downturn than expected. A key driver of enterprise is employment at larger corporations, so unemployment rising to the worst predictions of 10% would likely lead to estimate cuts that take away the defensive veneer of AT&T and Verizon.

The Bottom LIne

AT&T and Verizon provide near-term defensive characteristics with improving long-term growth profiles as communication continues its relentless shift toward wireless and digital applications. High current yields and above-average financial strength provide assurance for nervous investors.

AT&T: Steady As She Goes

AT&T reported very solid 1Q08 results. Almost every key metric matched analyst estimates with the exception of wireline line loss which continues to accelerate. Guidance was restated and the numbers suggest that the company will have little trouble meeting 2008 estimates for EPS, revenue, free cash flow, and subscriber growth. Most importantly, there was no indication that the economy is taking an accelerating toll on T's business. Challenges on that front remain and competition across all business lines is intense but the shares remain attractive as a defensive investment with offensive characteristics. I think in a decent market the shares can trade back in the $40s over the next couple of months.

The highlight of the quarter was wireless. Service revenues grew 17% and margins expanded a better than expected 280 basis points. Gross and net adds met expectations and data revenues continued to ramp, up 57%. Churn remained stable with slight improvement in prepaid. On the call, management noted that consumers with integrated devices (smart phones) had ARPU's more than twice the corporate average. ARPU continued to grow in 1Q, up 5%, to over $50. Wireless represented 40% of total revenue so the impact of double digit growth is increasingly important and helpful for T to drive mid-single digit or better total corporate revenue growth.

The other highlight was Enterprise which returned to positive revenue growth driven by data applications. Management said it had seen little impact from the economy so far and did not take the bait in questioning to discuss trends in financial services.

The consumer business continues to be pressured by falling access lines (count me for eliminating two in 1Q)....

....Access line loss accelerated to 7.7%, worse than analyst estimates. U-Verse continues to ramp with more subscribers added this quarter on a sequential basis. Management indicated they were having some success selling wireless/TV bundles. Margin expansion thanks to merger synergies continues to provide growth for this business on the operating income line. The company announced another round of job cuts last week which should extend the margin story into 2009.

Overall, I have nothing to complain about this quarter. The great fears that surrounded T earlier this year when management noted the economy was clipping wireline growth have receded. The shares reflect that risk even after the recent run up so I think T remains a good place to invest. You'll get downside protection but also can participate in upside given the growth businesses that reside within T. T shares are another investment that are high on my wish list for Northlake client accounts.

Verizon OK But Growth Slowing Slightly

Verizon (VZ) reported a pretty solid quarter and made constructive -- if not detailed -- comments about 2008. The market is focusing on some slight misses in key metrics, but I think that has more to do with the suddenly negative sentiment toward the telcos than with the quarter.

EPS, adjusted for one-time items, of 62 cents exactly matched estimates. Revenue of $23.8 billion were just short of estimates. Wireless results were good, with something for bulls and bears. Revenue growth of 13.6% was a little shy of estimates, but net adds, churn and data revenue look good. The small revenue shortfall appears to emanate from lower-than-expected average revenue per unit, with the best explanation being a competitive environment in the important holiday season.

The conference call had several questions about the sustainability of wireless growth, especially if the economy weakens. Verizon appears to be gaining share at the expense of Sprint Nextel (S) . AT&T (T) can make the same claim. Management said that the company is monitoring the economy and its impact on all of Verizon's businesses very closely, and so far, there is nothing evident that would make it change its sales expectations for any business, including wireless.

On the wireline side, revenue was as expected, with slightly better margins. Looking out several years, management said that margins in wireline can move meaningfully higher. Access line losses were 8.1%, a bad number, but not an acceleration from last quarter.

FiOS numbers look pretty solid, with TV adds of 225,000 very close to estimates and broadband adds of 246,000 at the low end of estimates. I think some of the weakness in the shares this morning is due to a few estimates that had broadband adds closer to 300,000.

For 2008, management said it expected a "solid year," with EPS growth and rising margins. The company also stated that it has contingency plans to cut expenses quickly should the economy begin to negatively impact revenue. Capital spending is projected to be lower than 2007.

Overall, I think investors are finally realizing that the fears about competition and economic weakness that have surrounded cable shares are also relevant for telco shares, including wireless. The 80%-plus penetration in wireless in the U.S. is definitely a concern given economic fears.

Will wireless growth slow? Will new subscribers be lower quality?

Less optimism about wireless and slightly more cautious estimates of FiOS broadband adds will probably linger, but I think the sharp pullback in Verizon shares (and AT&T) is incorporating a scenario that is worse than what currently exists. Thus, barring a sudden slowdown in operating metrics, the shares should stabilize relative to the market. And relative to the market, I think they represent decent value, although not as good value as AT&T.

Verizon 1Q07 Earnings Offer Upside

Verizon 1Q07 earnings were right on target with EPS of 54 cents and revenues of $22.6 billion right in line with the consensus estimates. Key subscriber metrics also closely matched analyst estimates. With the numbers all very close to expectations, I don’t expect a big reaction in the shares. Additionally, analyst estimates for the balance of 2007 should be quite stable.

As always with VZ, it is a story of wireless vs. wireline. Wireless grew very strongly with service revenues up 18% as the company added 1.7 million new subscribers. Industry leading churn was even lower than expected at 1.08%. The mix of new subscribers was virtually all postpaid which is usually greeted favorably by investors. If there was one surprise in VZ's results it was better than expected wireless ARPU of $50.73. I think most analysts were looking to slightly less than $50. Growing data revenues appear to be the source of the upside with data ARPU at almost $9 per month, up sharply vs. a year ago....

On the wireline side, revenues fell slightly as growth areas like DSL and business data could not overcome FiOS dilution, significant residential line loss, and roll off of the former MCI's mass market consumer revenue. Investors will be happy that FiOS dilution of 11 cents matched estimates. Further, management noted that the dilution would fall in the second quarter and would still be at previous guidance of mid-30 cents. FiOS does seem to be gaining traction as VZ added 141,000 TV customers in the quarter and penetration of high speed was 16% of homes passed. Access line losses continue to be much higher than AT&T (T). 1Q07 access line loss was 7.9% with residential lines declining by over 10%.

I remain favorably disposed toward VZ because I believe the company is making the right choice to build out a fiber optic network. VZ will be able to offer the best quad play product across the bulk of its network by mid-2008 leaving it in a strong competitive position. A premium product will also probably keep ARPU at healthy levels which will ultimately ease investor worries about the clash with cable – the fact that cable has been able to sustain high speed data ARPU by offering premium speeds could be a sign of the future at VZ. FiOS also will provide VZ with substantial cost savings in terms of maintaining its network and servicing customers. Assuming that wireless growth is sustained, as FiOS dilution winds down in 2H07 and 2008, I think the shares can work higher.