A Bullish Call on AT&T

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From Standard & Poor's Equity Research

Fiber Offerings: To enhance the speed of its broadband offerings and offer customized video services, AT&T is deploying fiber-to-the-node (installing optical fiber to within several hundred feet of the home and then using traditional copper wires to connect the service). The company is building out this network in numerous locations and was providing AT&T U-verse services, including U-verse TV, to 125,000 customers as of September, 2007. Approximately 5.5 million homes in 23 markets were able to purchase the service. AT&T expects to have the capability to offer service to approximately 17 million homes by the end of 2008. We contend that technology is not yet available to offer fiber to the less densely populated rural market the company serves. We believe that cost savings will offset increased fiber-related expenses in 2008, enabling margin expansion.

While most U.S. wireline carriers have seen weakness in their broadband customer growth due to the impact of a housing slowdown and high penetration rates, AT&T has had greater success due to the expanded rollout of its fiber offering, U-verse. We look for the company's broadband penetration rate to rise to the mid-30% range in 2008, up from 32% as of September, 2007. Cost savings should offset increased fiber-related expenses in 2008, by our analysis, enabling margin expansion.

Much of investor focus related to AT&T has been on the rollout of U-verse, which has been slower than originally expected. We believe the company plans to stay committed to its approach as we head into 2008 rather than make an acquisition of a video provider, as has been discussed in the media in recent weeks. However, given the company's acquisition track record, its success in bundling wholesale satellite video services, and the possible cost synergies from a national video offering, we do not rule out a deal at a favorable price.

Other Wireline Services: On the enterprise side, consolidation and migration to IP services has moderately reduced competitive pressure, helping AT&T to sign longer-term deals with corporate customers than in the past. In the third quarter of 2007, while overall enterprise growth was sluggish, the company had success in winning business for data services such as VPNs (virtual private networks) and hosting. We believe the company has used its broad suite of offerings to target smaller regional business customers. In 2008, we expect AT&T to further penetrate the regional business market and increase the segment's revenues.

Wireless: We believe AT&T's wireless segment (33% of projected 2007 revenues) has differentiated itself by focusing on enhancing its network quality and increasing data services usage to improve both gross additions and customer loyalty. AT&T's post-paid monthly churn (customer turnover) rate of 1.3% is below the industry average, and we expect it to remain at similar levels in 2008 as the company has success with the help of new products. For example, at the end of June, 2007, AT&T became the exclusive service provider for Apple's (AAPL) iPhone, and through September, more than 1 million customers had signed up for the service. Churn will be more important in 2008 than in years past, in our view, as with more than 70% of U.S. consumers having wireless service, we contend gross additions will be harder to come by and the industry winners will be those that can retain existing customers.

In the third quarter, AT&T and Verizon Wireless remained the top two carriers in terms of market share at 28% and 27%, respectively, aided by new handsets and a focus on network quality. Competitors Sprint Nextel (S) and T-Mobile USA have lost market share and, in our view, face operational challenges. We look for AT&T to grow its customer base at a percentage in the mid-single digits in 2008.