Markets & Finance

A Bullish Call on AT&T


S&P likes the telecom giant's rising market share in broadband and wireless, and rates the shares strong buy

From Standard & Poor's Equity ResearchAT&T Inc. (T; recent price, $38) will be hosting an analyst day in New York on Dec. 11, and we expect a positive message will be shared, including higher operating margin targets for 2008. With more than 30% of its revenues derived from wireless services and, in our view, opportunities to gain market share in broadband, we contend that AT&T is well-positioned to generate revenue growth in 2008 despite an economic slowdown. We also contend that as competitors face operational challenges, AT&T will gain market share in wireless and broadband.

In addition, we see opportunities for AT&T to expand its margins from additional cost synergies, including a migration of wireline data traffic to one network, and from improved efficiencies in the wireless segment. We expect AT&T will use its strong cash-flow generation to support a 10% dividend increase in December, 2007, and to fund growth opportunities with capital investment.

Despite expected increased competition in 2008, we view these high-quality shares as undervalued. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

Company Profile

AT&T Inc. combined SBC Communications with the acquired assets of AT&T Corp. in November, 2005. At the end of 2006, AT&T closed on its acquisition of BellSouth for $86 billion in stock, creating the largest U.S. telecom carrier. As of September, 2007, the combined company had 63 million in-region local phone lines (down 6.9% from a year earlier) and 13.8 million broadband customers. With the acquisition of BellSouth, AT&T took full control of Cingular Wireless (33% of projected 2007 AT&T revenues), the nation's largest wireless provider with 65.7 million subscribers, and expanded its wireline presence into the southeastern U.S. In early 2007, Cingular was renamed under the AT&T umbrella.

The inclusion of AT&T Corp. added voice, data, IP, and hosting services for enterprise customers as well as a national network. SBC expanded through a number of mergers of fellow Bell companies over the past 10 years. Meanwhile, Cingular Wireless began operations through the merger of the wireless operations of SBC Communications and BellSouth. Reported results in 2006 largely exclude BellSouth operations, including its 40% stake in Cingular.

Wireline: On the wireline side (54% of projected 2007 revenues), third-quarter 2007 results for AT&T reflected improved operating efficiencies that helped to drive an expansion of the overall operating margin to 23.7%. This occurred even as total access lines and revenues were restricted by competition from cable companies and wireless substitution. Thus far in 2007, AT&T has reduced costs in part by migrating the voice traffic of the former SBC and BellSouth businesses onto the legacy AT&T Corp. network and bringing its corporate head count down. AT&T expects an additional $5 billion in cost synergies from the BellSouth acquisition in 2008 on top of the $3 billion it should achieve in 2007.

We believe that after giving cable companies a head start in offering a triple play of services, telecom carriers such as AT&T are better positioned to defend their customer bases and expand the average dollar amount spent by a household in 2008 with the launch of higher-speed services and the inclusion of video services in the bundle. Over the longer term, we see telecom and cable companies competing rationally on price.

As of September, 2007, AT&T was providing broadband service to more than 32% of the consumer access-line base, a higher penetration rate than its peers, and we look for the penetration rate to rise to the mid-30% range in 2008. We contend that customers who receive broadband and other nonvoice services from their local telecom provider will be less inclined to churn and will look to the telecom carrier for additional services.

At the end of the third quarter, AT&T reported that 44% of its 13.8 million DSL customers in the consumer and enterprise market had download speeds four times as fast as its basic broadband service and in line with the speed of traditional cable broadband offerings, which we believe have lost some luster.

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.

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.


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