A Bullish Call on AT&T

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From Standard & Poor's Equity Research

We see opportunities for AT&T to widen its wireless segment operating margins further into the low 40% range due to the closing of acquisitions and an expansion of ARPU (average revenue per user), which rose 2% to approximately $51 at the end of the third quarter.

Other Segments: The remaining 13% of AT&T's projected 2007 revenues is largely derived from its directory operations, which remained stable throughout 2007 after the assumption of the BellSouth assets, and from ownership of Sterling Commerce and customer information services such as operator assistance.

Company Outlook

We expect revenues of $123 billion in 2008, up from a projected $120 billion in 2007, including full ownership of wireless and the acquired BellSouth wireline assets. Pro forma revenues for the entity in 2006 were $117 billion. We see wireless revenue growth of 11% in 2008 from customer additions and wireless data service, and smaller gains in wireline data and regional business, helping offset competition in consumer voice and enterprise operations.

We believe that wireline operating margins will be helped by workforce reductions and network integrations. On the wireless side, margin improvement should stem from improved customer retention and higher revenue per user. We see an operating margin of 23.9% in 2007 and 24.8% in 2008, up from 18.2% in 2006. The addition of BellSouth assets should continue to be a large contributor to the expansion in margins.

For 2008, we estimate operating EPS (earnings per share) of $3.13, up from an expected $2.78 for 2007, before one-time integration and amortization adjustments and reduced share count from buybacks. We expect AT&T to increase its EPS by 9% annually over the next three years.

In the 18 months ended June, 2007, AT&T spent $9.6 billion to repurchase shares that on average were bought back at a 15% discount to recent levels; we expect modest repurchases in the fourth quarter of 2007 and in early 2008. We see capital spending for the combined entity (AT&T and BellSouth) of approximately $17 billion in 2007 and up modestly in 2008, though still below the $18.8 billion spent in 2006. We see AT&T as more focused on spending to support its wireline broadband and fiber services, with a capital investment reduction in wireless. The company also plans to leverage its scale over suppliers and reduce spending.

We expect AT&T to announce a dividend increase in December, 2007, consistent with a practice made by the company and its predecessor SBC Communications for the past 20 years.

Valuation

Our 12-month target price of $44 is based on our relative analysis, which assumes a price-earnings of 14 times our 2008 EPS estimate, in line with peers, and an enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple of 6.2, a slight premium to peers to reflect the stronger EBITDA prospects we see. Our peer group consists of the three largest telecom carriers and four midsize telecom companies that face less competitive pressure, have wider margins, and, as such, trade at higher EBITDA multiples. Telecom carriers such as AT&T have traditionally traded at a discount to the broader market due, in our view, to their slower growth and the overhang of the regulatory environment. We believe that starting in 2006, the regulatory risks have diminished and reduced the overhang for the industry.

AT&T's total return potential is bolstered by its dividend yield, which was recently 3.7%, a slight discount to peers. As mentioned earlier, we expect the company to announce a 10% dividend increase in December that should bring its yield more in line with peers.

Corporate Governance

Overall, we view AT&T's corporate governance policies favorably relative to its telecom carrier peers. Among the positives we see are that the board of directors is controlled by a supermajority of independent outsiders; the directors are elected annually; and the company has not restated financial results for a prior period or been the subject of an enforcement action due to backdating of options during the last 24 months.

Among our concerns is that the roles of chairman and CEO are combined, and that the board can amend certain provisions of AT&T's bylaws without shareholder consent.

Investment Risks

Risks to our recommendation and target price include a change in regulations for the telecom segment, increased competition from cable carriers, weaker-than-projected wireless services execution, the failure to smoothly integrate acquired assets, and a more expensive and less successful rollout of its fiber-based video services.

Analyst Rosenbluth follows shares of telecommunications services companies for Standard & Poor's Equity Research Services .