AT&T: Brace For Turbulence

In our post-earnings coverage on AT&T's (NYSE:T) stock, we had discussed the appeal of its discount on both a relative and absolute basis at current levels, attractive dividend yield (annualized expectation: 6.1% T; 5.96% NYSE:T.PA; 5.97% NYSE:T.PC), as well as robust support from improving fundamentals as management diverts focus back onto the company's core connectivity businesses. And much of this optimism was reflected in the stock's post-earnings rally, before succumbing mildly to market-wide weakness through the past month.

Considering mounting macroeconomic uncertainties and added turmoil from the recent financial sector crisis, market confidence remains in limbo. And the stock's recent weakness shows that it is not immune, despite its relatively recession-resistant nature thanks to a robust dividend yield supported by mission-critical services offered in the digital-first era. Although the market has priced in incremental optimism in recent months on AT&T's better-than-expected free cash flow guidance, and consistently positive progress on restoring market share gains in wireless connectivity, we believe the company's core fiber focus, specifically, faces elevated execution risks in the near-term due to added uncertainties from macro-driven challenges. This will likely heighten the stock's exposure to near-term market-driven weakness.

While we remain optimistic on AT&T as an attractive income investment over the longer term, considering its current discount to both its historical levels and the broader peer group, with a well-supported dividend yield of more than 6% at current levels, the upcoming months will likely be a tug-of-war demonstration between optimism on improving company fundamentals and risk-off market sentiment from deteriorating macroeconomic conditions. We look to the stock's potential return to the sub-$18 range as a result of anticipated near-term market-driven weakness, which would optimize dividend yield to compensate for looming market risks amid an impending recession, and improve longer-term returns on the investment as AT&T continues to realize progress on its longer-term growth strategy.

Relatively Recession-Resistant, but Not Immune

Despite rapidly deteriorating financial conditions that have waged acute uncertainties on the broader economy's outlook, management has repeatedly reaffirmed remarks that they have yet to observe any material impacts to telco and communications spending among its customer base that would derail the company's 2023 fundamental targets.

I will say from the health of the consumer or enterprise customers, we haven't really seen anything that is dramatic. It's been relatively stable over the course of that capital last year. But we're watching it every day as you would expect us as operators to do, we look at intake quality, credit levels. We look at churn. We look at those metrics on a daily basis as leading indicators.

And so far we don't see anything that's going to change the way we are going about with our operating plan for 2023. And I'm here to reassert that the guidance that we offered in the fourth quarter still holds.

Source: AT&T Morgan Stanley Technology, Media and Telecom Conference Transcript, March 2023

But in addition to the combination of declining household savings and an increasing debt burden among consumers based on recent economic data points discussed in our previous coverage, AT&T's operating environment now faces incremental pain from a failing financial sector that threatens to thwart the Fed's trajectory on restoring stability to the economy.

While management has previously said lengthening payment cycles observed earlier in 2022 have shown signs of improvement, the combination of declining household savings and an increasing debt burden based on recent data points to a continuation of exposure to higher-than-usual churn and payment collection risks through 2023.

Source: "AT&T Q4 2022 Earnings: Executing The Post-Media Era To A 'T'"

Risk of Further Market-Driven Declines

Specifically, inflation remains at 6% based on the latest economic data, which is still a far cry from the Fed's 2% target range. Meanwhile, the labour market remains tight despite nominal improvements observed in recent data, with unemployment still at a multi-decade low of 3.6%, while vacancies continued to beat median estimates at 10.8 million - or 1.9 job openings per unemployed American. And despite the slowest pace of monthly payroll growth in a year during January, recent labour data continues to indicate "upward pressure on wages and therefore inflation".

While this continues to support further monetary policy tightening - which aligns with Fed Chair Jerome Powell's latest hawkish commentary to the public - the recent blow-up in the global banking sector is adding complexity to the picture.

On one hand, markets are expecting another 25-bps rate hike - or even a potential pause - at the upcoming policy meeting later this week, given the need to stabilize liquidity in the financial system. This has inadvertently fuelled optimism for a pivot to rate cuts before the end of the year on the expectation of a recession, which has buoyed valuations for the tech-heavy Nasdaq 100 that is composed primarily of companies valued on cash flows further out in the future for now (recall that lower rates translate to a lower discount on future cash flows, thus supporting growth valuations).

Meanwhile, on the other hand, loosening policy too soon would risk derailing the Fed's trajectory on stabilizing prices and preventing inflation from becoming entrenched. Specifically, the central bank has already provided $165 billion in emergency loans to institutional lenders following the latest banking sector crisis, reversing "several months' worth of the Fed's campaign to shrink its balance sheet". And the potential need for policy loosening in the near term to stem a further spiral in the banking sector could risk overturning aggressive efforts in the past year on taming runaway inflation, posing a tricky dilemma for markets today.

Taken together, market risks remain skewed to the downside. And the impact on AT&T? The stock faces a potential downward valuation adjustment in tandem with the potential for broader market declines as discussed in the earlier section, while fundamentals also face elevated execution risks.

Risk of Entrenched Inflationary Pressures

Specifically, AT&T's fiber roll-out is already seeing a higher bill than management had initially forecasted as costs of everything from raw materials to labour soar on persistent inflationary pressures:

Simon Flannery

You've really ramped your fiber build plans the last couple of years and you've got a big - you've got a 30 million goal here ahead of you. What are you seeing in cost per passing, cost to connect?

Jeff McElfresh

Yes. They're - they've increased from where we thought they would be when we started, but I think that is probably fairly intuitive. Gas prices are up, labor prices are up, we've had supply chain disruptions.

Source: AT&T Morgan Stanley Technology, Media and Telecom Conference Transcript, March 2023

Although fiber has continued to demonstrate robust share gains, with average revenue per user on the service "about $10 above non-fiber broadband customers", it is only partially compensating for the impact of near-term roll-out and ramp-up costs, as well as compounded pains from stubborn inflation. This continues to corroborate a revenue-oriented business in the near term as management had cautioned, with lower margins that could potentially bode unfavourably with investors' "profit first" preference under today's market climate:

Running a fiber-optic line through a typical residential neighbourhood costs about $1,000 per home. Connecting a home is at least another $1,000 on average.

Higher interest rates, inflation and economic worries have made that a riskier proposition.

Source: Bloomberg News

Right now, even though, we've experienced some slightly better EBITDA performances over the last several quarters, I just say, point to our guide, we expect that here in 2023, it's going to be high single digits decline on EBITDA. And that's in part, because of the transformation that we're making…We've curated out all the products and services that we're revenue oriented and low margin.

We're investing in expanding our fiber and our performance and our fiber selling of our owned and operated services. And as we get that volume of that increased is when you'll see the stability of the EBITDA curve.

Source: AT&T Morgan Stanley Technology, Media and Telecom Conference Transcript, March 2023

Risk of Near-Term Demand Softness

But as much as management remains optimistic on compensating near-term margin erosion with consistent revenue growth, the foundation of such appears to be facing looming shakiness too. Although management has guided for more than 5% of growth for broadband sales in the current quarter, which will be primarily driven by its "North Star", fiber, to compensate for continued secular declines in legacy broadband connections, softening housing data marks another risk to "denting the pace of (AT&T's) fiber roll-outs".

While taming housing prices is crucial to the Fed's campaign for bringing inflation back to the 2% range, rising interest rates and limited inventory in the market as a result of ensuing declines in home values "will continue to be a hit on affordability". Specifically, a fixed rate 30-year mortgage is rapidly approaching 7% on average, the highest since mid-November. This has put continued pressure on new home sales, as corroborated by a persistent decline in mortgage applications to levels not seen since 1995. With home sales being one of the critical drivers of fiber connectivity TAM expansion by encouraging upgrades from legacy broadband, weakness in the housing market could hurt AT&T's near-term fiber aspirations, making it another immediate headwind to consider.

The Bottom Line

Although we remain optimistic on AT&T's longer-term ability in capitalizing on secular growth momentum supported by connectivity and digitization trends, the capital-intensive nature of the business paired with rapid deterioration of macro conditions are likely to cool the stock's latest rally. This continues to make AT&T's commitment to achieving $16 billion in free cash flows alongside $6 billion in annualized cost savings by the end of the year all-the-more critical in rebuilding and maintaining investor confidence in the company's next phase as a connectivity-focused business. But for now, we are shifting to a hold rating in anticipation of another downtrend in the near term for further optimized dividend yield and upside potential.

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