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AT&T Shows Signs of Stability as Business Evolution Continues

AT&T shares rallied 5% in early trading today following the company's third-quarter earnings results.

The media and telecom giant's revenue declined 5%, better than analysts expected and an improvement compared to the second quarter's 9% slump.

AT&T's wireless business (around 40% of sales) recorded its highest level of postpaid phone net adds and lowest churn rate in years, helping its sales edge higher despite lower roaming revenue due to the pandemic.

High-speed internet (5% of sales) and business network services (9%) also grew slightly as these divisions remained insulated from the downturn.

This continued stability, coupled with improving cash collection rates and working capital management, led AT&T to increase its 2020 free cash flow guidance from around $24 billion previously to $26 billion or higher.

This will result in a full-year dividend payout ratio in the high 50s% and over $10 billion of retained cash flow after paying AT&T's $15 billion dividend.

Less than $8 billion of debt matures each year through 2025, so AT&T can continue chipping away at its $149 billion net debt load with minimal refinancing risk. (The company reduced its net debt by $2.9 billion last quarter.)

Standard & Poor's, Moody's, and Fitch each have a stable outlook on the firm's investment-grade credit rating as well. While AT&T's pace of deleveraging has slowed due to the pandemic, we do not believe this threatens the dividend.

That said, AT&T's high yield reflects several challenges facing the business.

Short-term revenue weakness remains concentrated in AT&T's Warner Bros. division (7% of sales). This business is one of the largest TV and film studios in the world and generates fees when its content is distributed across various channels.

The pandemic forced Warner Bros. to pause production earlier this year. Coupled with the temporary closure of movie theaters, this segment's earning power was constrained.

Warner Bros. experienced a 28% revenue decline last quarter, accounting for nearly half of AT&T's sales decline compared to the prior-year period.

Fortunately, management feels "much better" about the restart of production going forward.

AT&T said it had 180 productions underway before COVID and was back up to around 130 productions running as of last week, so perhaps the worst is behind Warner Bros.

Outside of content production, AT&T's pay-TV business (17% of sales) fell 12%, accounting for about half of the company's third-quarter revenue decline.

AT&T continues bleeding DirecTV subscribers as more customers switch to lower-priced streaming services such as Netflix.

On the bright side, AT&T's TV subscriber losses improved to their lowest level since the first quarter of 2019.

While this level of subscriber losses still represented an annualized decline rate of about 15%, it's better than the 20% clip recorded in recent quarters.

The company's AT&T TV streaming service, which launched in early 2020 as an alternative to DirecTV and is included in these figures, has presumably softened the pace of overall subscriber losses.

But pay-TV's secular decline seems likely to continue, so AT&T has bet big on its HBO Max streaming service which debuted in May 2020.

Management expects to invest $2 billion in HBO Max this year as it pumps out more original content to compete with Netflix, Disney, NBCUniversal, and other streaming rivals.

HBO Max activations roughly doubled to reach 8.6 million this quarter. But AT&T didn't disclose how many activations were from existing HBO customers who have free access to HBO Max (and thus wouldn't add incremental revenue).

Even if all 8.6 million HBO Max activations were new customers and paid $15 per month, this business would account for less than 1% of AT&T's revenue today.

The streaming wars have just begun, and it remains to be seen if AT&T can effectively manage its media assets to deliver a winning offering.

AT&T's telecom businesses provide a key source of stability as it addresses changes in media consumption while reducing debt and covering its dividend.

But based on AT&T's poor stock performance and depressed valuation, pressure could build to shake things up if investors don't buy into the firm's strategy soon.

Activist investor Elliott Management revealed a stake in AT&T in September 2019 and has questioned the company's shift into media, pushing for AT&T to become more focused.

Perhaps driven by this nudging, AT&T is rumored to be shopping its DirecTV business, receiving offers at a fraction of the price management paid in 2015.

We estimate DirecTV accounts for less than 5% of AT&T's EBTIDA. If AT&T sold all of this business, we believe its payout ratio would rise to around 65% to 70%.

That's about in line with AT&T's historical average, so a full divestiture wouldn't necessarily threaten the dividend.

However, if AT&T comes under pressure to shed more of its recently acquired media assets to refocus its strategy, that could change.

Similarly, management may need to adjust their capital allocation plans if they believe significantly more investment is required to compete in streaming. After all, Netflix expects to spend $17 billion on content this year alone.

With dividends and debt reduction using most of AT&T's free cash flow generation, there's less wiggle room to change directions.

For now, we'd be surprised if management deviated from their strategic plan and capital allocation framework until COVID's disruption has passed and they've had a cleaner shot to execute.

The pandemic has created challenges for some of AT&T's media businesses and slowed its pace of deleveraging, but these headwinds will eventually reverse. Meanwhile, AT&T's legacy telecom businesses remain in reasonable shape.

We will continue monitoring AT&T's progress returning to profitable growth and paying down debt. Based on what we know today, we are reaffirming AT&T's Safe Dividend Safety Score.

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