AT&T Stock: Lower Debt And Higher Margin Ahead (NYSE:T)

AT&T Advises Its Over 200,000 Workforce To Work From Home, As Coronavirus Continues To Spread

Ronald Martinez

Thesis

AT&T (NYSE:T) completed the spinoff of its WarnerMedia unit in early April. The spinoff also provided T with approximately $43 billion of total proceeds in a mix of cash and debt securities. Overall, the completion of the spinoff made T better focused and better positioned on its core businesses.

And this article will concentrate on two aspects – its leverage and margin. The company used the proceeds to pay down about $40 billion of debt and also reduced its bank loans and bond obligations. To wit, this sizable deleverage will shrink its interest expenses by about $1.5 billion. Such a lower interest rate itself is sufficient to expand its margin by more than 100 basis points. Its expanding 5G network and the fiber network will further boost the margin, as to be elaborated below.

Lower debt

As aforementioned, with the proceeds from the WarnerMedia spinoff, T paid down about $40B of its debt. Furthermore, it also paid down over $10B in bank loans and redeemed an additional $12.5B of bonds. Also, more than 90% of debt is fixed rate as you can see from the following chart. As a result, T now enjoys substantially better capital flexibility.

It can better focus on its capital investment in core areas like 5G and fiber. And it indeed has earmarked $24B in Capital Investment in 20022 and 2023. At the same time, it can also further reduce its debt. Management aims at reducing the debt-to-EBITDA to the 2.5x range by end of 2023, which is a very feasible goal in my view. To put things under historical perspective, the debt-to-EBITDA ratio has fluctuated in the past years between 1.5x to about 5x (shortly before the spinoff) with an average of 2.9x. Its leverage ratio stands at 3.5x, not far away from the historical average.

Going forward, such capital allocation flexibility will also translate to higher margins, as to be elaborated below.

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AT&T earnings report

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Higher margin

Looking forward, the capital flexibility will help margin in at least two ways.

The first way is simple and direct, and it is because of the lower interest expenses going forward. T’s effective borrowing rates are around 3.8%, and therefore, the $40B debt reduction itself will cut its interest expenses by about $1.5B. Its projected revenue will be on the order of $125B to 130B in the next 1 or 2 years. As a result, a $1.5 billion cut in interest expenses would translate into a margin expansion of more than 100 basis points (about 115 bps to be precise) in terms of EBIT or EBITDA margins.

Again, to put things under historical perspective, its EBITDA margins in the long-term are shown in the chart below. As you can see, it fluctuated from 19.3% to about 39% with an average of 29.5%. Its current margin of 32.4% is already above the long-term average. And the 115 bps expansion will push it to about 33.5%, getting closer to the top quartile of its long-term range.

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The way is less direct but probably more fundamental and hence also more important. As aforementioned, the reduced debt level will give it the capital flexibility to focus on its core business such as 5G and fiber. At a certain point, the cost will be relatively fixed once the main infrastructure is completed. After that, the margin will improve, and quite possibly improve rapidly as ARPU climbs. The following Q&A exchange during its recent earnings report probably best captured such dynamics (abridged and emphases added by me):

Question from John Hodulik (UBS)…. A couple of questions on margins, if you could. First, maybe on the consumer side, numbers were a little bit better than we thought. I mean if you look back to 2019, you guys were generating margins in the sort of 39%, 40% range. Given the change in the business and the mix there and the higher ARPUs, do you think you can eventually get back to those kinds of levels?

And then I guess on the other side of the ledger, consumer – or the business segment continues to be weaker than expected, thanks for the color there. But how much visibility do you have in the improvement in the margins and the declines there?

Answers from CEO John Stankey… Consumer Wireline first, let’s – the thing to keep in mind is in repositioning this business, we had – over the last several years, we’ve been investing in our Fiber footprint and investing and launching in new parts of our footprint. What happens going forward is as the business add subscribers, we expect margins to continue to improve. And our cost base is relatively fixed once we’ve laid fiber out, so we do expect improvements over time. We haven’t guided in terms of specific margins expected to generate, but we feel really good about the long-term view of this business. I mean you look at others in the space, margins are really attractive.

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AT&T earnings report

Valuation

Despite the positives mentioned above, T is for sale at discounted valuations both relative to the overall market and also its peers. As can be seen from the following numbers in the table, T is discounted by more than 10% compared to Verizon (VZ) in terms of PE. PE comparison to T-Mobile (TMUS) is more complicated and probably merits a separate article. Given T’s high leverage, let’s look at valuation adjusted for leverage. Its EV/EBITDA multiples are 7x in TTM terms and 8.7x in FW terms, still at a discount when compared to both VZ and TMUS (about 8x+ and 10x+ respectively). Finally, in terms of cash flow, the discount here is even more dramatic as you can see.

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Final thoughts and risks

The completion of the Warner spinoff provides T with the capital flexibility it sorely needed. Looking forward, the proceeds from the spinoff will help its margin in at least two ways. The lower debt cuts its interest expenses by about $1.5B, directly adding about 115 bps to the margin. In a more indirect way, the reduced debt enables it to better focus on 5G and fiber. So, it reaches the pivotal point of infrastructure layout more quickly and harvests margin improvement. All told, I expect these effects combined to add about 200 to 300 bps to its EBITDA margin from the current 32.4% level, thus pushing its margin into the top quartile of its historical range.

The main risks I see are macroeconomics at this point. There is a realistic chance of a recession at this point which can impact all stocks including T. It is also possible that inflation persists and interest rates climb much higher from here, thus canceling off a portion of the interest expense cut mentioned above.

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