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Telecom’s Big 2 “Phone In”

By Roger S. Conrad, on May. 30, 2014

Few companies attract as much attention when they report quarterly earnings as telecom’s Big Two: AT&T (NYSE: T) and arch rival Verizon Communications (NYSE: VZ).

The investment case for telecom’s Big Two is pretty simple. They provide an essential service (communications) for which demand is rising. By effectively tapping into these revenues, they produce a reliably rising stream of income, augmented by modest capital growth. And that’s exactly what they’ve done in this now five-year-old bull market, with AT&T returning 12.7 percent annually and Verizon 15.5 percent. 



The first question I ask every earnings season is if they’re still capable of producing those returns going forward. And the keys are trends in sales, profit margins and capital spending—which is essential to staying on top of an industry that’s constantly innovating and demanding ever faster and more powerful networks.

Obvious takeaway number one from this earnings season is that both companies are still growing revenue. AT&T reported its best consolidated revenue growth in two years at 3.6 percent. Verizon’s total operating revenue was 4.8 percent higher, ahead of management’s guidance of 4 percent for all of 2014 and its fastest growth rate in five quarters.

“Both companies also reported solid margin growth.”

Verizon’s cash flow margin from its wireless operations came in at 52.1 percent, about 170 basis points above year-ago levels. Wireline cash flow margins, meanwhile, were 22.3 percent, up 90 basis points. 

AT&T’s cash flow margins from its wireless business were 45.4 percent, up 220 basis points from year ago levels. Wireline was 19.3 percent, up 40 basis points.

Third, both companies continued to spend on networks at a pace several times that of their rivals. AT&T forked out $5.72 billion during the quarter, while Verizon spent $4.2 billion. And once again, they generated free cash flow after those outlays, with both pulling in about $3 billion. That’s money to pay dividends, buy back stock and retire debt. 

AT&T used some of that to buy back another $1.2 billion of its stock during the quarter. Verizon reduced debt by roughly $5.5 billion with its plan to eliminate bonds with coupon rates above 5.5 percent. That kept the company on track for promised debt cuts made with the announcement of the purchase of Vodafone’s (LSE: VOD, NYSE: VOD) 45 percent stake in Verizon Wireless.

AT&T plans to spend around $21 billion on network in 2014, with Verizon second in the industry at $16.5 to $17 billion. That’s not only a huge dollar advantage over rivals Sprint Corp (NYSE: S) and T-Mobile US (NYSE: TMUS). But the industry’s No. 3 and No. 4 companies have also been going ever deeper in debt to stay competitive on quality.

“That capital advantage remains the single biggest reason AT&T and Verizon likely will dominate for years to come.”

As for bottom-line earnings, they were quite bullish as well. AT&T’s were $0.71 per share excluding items, up 11 percent year over year. Verizon’s, meanwhile, were $0.84 a share, up 23.5 percent.

Using those numbers as the basis for payout ratios, AT&T’s was a solid 64.8 percent during the quarter. That should easily support another $0.01 per share increase to the dividend in December. Similarly, Verizon’s 63.1 percent payout ratio should ensure a $0.015 per share boost in September. 

On a free cash flow basis, those ratios are 73.1 percent for Verizon and 79.9 percent for AT&T—meaning there’s plenty of cash left over after capital spending and dividends. 

Both AT&T and Verizon are going to deliver another year of reliable business and therefore dividend growth. And depending on market conditions, we’ll see another year of solid capital growth as well as these companies remain dominant and tap into the communications sector’s rising revenue stream. 

Staying Dominant 

The second question is if there’s anything in the news and numbers that could shift the equation. In other words, what could make AT&T and Verizon less dominant, less profitable and therefore not capable of delivering those steady returns for which we own their stocks?

There’s a new sheriff in town for the communications industry: Federal Communications Commission (FCC) Chairman Tom Wheeler. Unlike recent FCC chiefs, Wheeler has worked all sides of the industry in the US. And he’s consulted for companies outside the US as well, including NTT DoCoMo (NYSE: DCM), which I’ve recently added to my Utility Report Card.

Wheeler’s statement that a portion of the upcoming 2015 wireless spectrum auction should be reserved for smaller players drew an immediate retort from AT&T CEO Randall Stephenson, who stated his company may not participate. 

On the other hand, Wheeler has also proposed Internet rules that would allow network owners to strike deals for preferential capacity and speed with content providers such as Netflix (NSDQ: NFLX) and Google (NSDQ: GOOG) for the first time. 

That’s quite a departure from the more dogmatic FCC of previous chairman Julius Genachowski. And it’s a pretty good indication of Wheeler’s pragmatism and knowledge in navigating this intensely competitive industry. 

Spectrum rules have yet to be worked out fully. But there’s an emerging factor that may work in the Big Two’s favor when they are. That’s the ongoing shift in wireless marketing from a model featuring subsidized phones and long-term service contracts to one where consumers pay more for devices but less for service, and are not tied to contracts.

The prime mover here has been CEO John Legere of No. 4 player T-Mobile USA And it appears his company gained customers again in the first quarter, this time at the expense of the Big Two as well as other players.

Ironically, the Big Two are likely to wind up the biggest winners from Legere’s gambit. For one, the subsidy model has been expensive, primarily benefiting device makers like Apple (NSDQ: AAPL). Eliminating it shifts telecom revenue from service to equipment streams. But if first quarter results are any indication, it will boost overall margins and without increasing customer turnover or “churn.”

AT&T’s “Next” plan and Verizon’s equivalent “Edge” plans are still in relative infancy. Both companies, however, reported acceleration of customer interest in March. And while management was quick to caution about the impact on individual numbers (particularly Verizon CEO Francis Shammo), they did note continued success in April.

“Both companies are also seeing substantial operating cost reductions, revenue growth and reliability gains from converting traditional wireline customers to broadband.”

And they’re seeing some synergies from integrating fiber and 4G wireless, even as they wind down the heavy lifting for constructing both in coming years.

Verizon added 3.6 million postpaid customers gross in the first quarter of 2014. That was up 4.1 percent from the year earlier. Gains, however, were entirely due to additions of 4G smartphones, tablets and other advanced devices, as the company lost basic service customers to lower priced plans, such as T-Mobile’s. That was also the case for AT&T.

Obviously, all else equal, that’s a troubling sign for both companies. On the other hand, all else is definitely not equal in this complex industry.

Despite the loss of basic users, both AT&T and Verizon became more profitable than ever in the first quarter by focusing on their most valuable customers. A user with a smartphone, tablet and other services is far less likely to switch and probably will buy more data–where the real profit lies–than one using basic service and looking for the lowest-priced plan.

In addition, both companies’ long-run ability to compete on price increased during the quarter, as they realized efficiencies and strengthened balance sheets. 

Finaly, losing even basic customers is powerful evidence of how competitive communications has become in the US. That, in turn, can only help AT&T and Verizon work a deal with Wheeler’s FCC to let them bid on spectrum they need, which in turn will be a very big step to becoming even more profitable and dominant in the long haul.

In an industry this large, there are always new developments to stay on top of. But at least based on what we’ve seen in the first quarter, AT&T and Verizon are still very good bets for reliably growing dividends and moderate capital gains.


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