Homebound April greetings from Lake Norman, where North Carolinians are beginning to come out for Chick-fil-A (pictured is the drive-thru at the Mooresville location last Friday evening). So much for sheltering in place. This week, we’ll examine the earnings of two telecom leaders, Verizon and AT&T, and see what insights they provide for the remainder of the group.
As a reminder, here is the updated list of earnings reports for the Fab 5 and the Telecom Top 5 (excluding those who have already reported):
Needless to say, next week will be very busy analyzing any and all commentary since most companies did not see COVID-19 impacts until March. Of particular interest will be trends heading into March. Before we analyze earnings, we will also evaluate the initial sales of the iPhone SE which started shipping this week (and first available in stores last Friday).
The week that was
Relatively speaking, this was a quiet week for both the Fab 5 and the Telecom Top 5 with most stock price values finishing up where they started the week (AT&T, which lost $11 billion this week and Facebook, which gained $31 billion this week, being the exceptions). AT&T’s loss occurred as investors reacted to earnings and Randall Stephenson’s decision to step down as CEO on July 1 and as Executive Chairman on Jan 1, 2021.
Facebook received a boost in part from their decision to invest $5.7 billion in Reliance Jio in exchange for a ~10% stake in the Indian telecommunications provider. This investment is the largest made since the acquisition of WhatsApp in 2014 and uses a small fraction of the $55 billion in cash and marketable securities on the FB balance sheet as of the end of 2019. More details on the Facebook acquisition are available from Bloomberg here and from the New York Times here.
On a week-over-week basis, the Fab 5 gained $16 billion in total capitalization while the Telco Top 5 lost the same amount. Overall, the Fab 5 had added an additional $278 billion so far in 2020 to their $1.58 trillion gain in 2019, while the Telco Top 5 are still in the red but still hanging on to 57% of 2019’s increase. It’s highly likely that we will see shifts in market capitalization after each of the Fab 5 and two more Telco Top 5 announce earnings this week.
iPhone SE – maybe small is beautiful after all
The most understated iPhone launch in Apple’s history occurred on April 15th when the Cupertino giant launched their 2020 version of the SE. Powered by the A13 bionic chip, this phone screams Hotspot more than it begs for streaming video (resolution is 1334 x 750 with 326 ppi, the same pixel density as the iPhone 11).
We took a quick peek to see if there was any backlog (most analysts see the iPhone SE as necessary but not a flagship for most current iPhone customers). Well, unless Apple guessed wrong, there seems to be a remarkable trend – larger storage sizes are in short supply across each carrier. Here’s the slide outlining the backorder period by color and storage size:
iPhone SE devices with 64GB storage appear to be in the most plentiful supply. Higher storage options, however, appear to be on at least a two week backorder, especially at AT&T and Verizon. This could incidate one of two things: a) Supply chain constraints on Apple’s part (possible but volumes should be less for the SE), or b) upgrade demand is high for “same device” that now sells for $400 before trade-in credits. If b) is true, it’s likely that upgrading customers are downsizing (although the only things less powerful are the screen size and the camera) and larger screen sizes are a reasonable tradeoff for a lower price for certain segments of the consumer population. (One colleague also suggested that white is a more popular color for women who might be more attracted to the smaller size overall).
Our hunch is that this “small is beautiful” trend continues. For a really good review of the iPhone SE (and comparison to the iPhone 11), check out CNET’s take here.
AT&T Earnings – Stephenson Exits Early, Free Cash Flow After Dividends Dries Up
AT&T led off the earnings parade with a Wednesday announcement that highlighted the complexity of being a premium content producer, distributor, and broadband provider (transcript here). The entire strategy of AT&T depends on a vision of a) growing demand for premium content, and b) growing demand for continually faster (especially mobile) networks that provide them.
As we have noted in our previous pre-COVID 19 commentary, AT&T was downright bullish about their prospects. Network deployments were yielding positive results, supply chain impacts from the contagion were going to be able to be overcome in weeks, and the consumer was still strong. And yes, early Q1 political advertising was very good. The extent to which Mike Bloomberg helped AT&T (specifically Time Warner’s CNN division) have a strong quarter will never be known, but without the torrid pace of ad spending, the quarter would have certianly been weaker.
Perhaps the best summary of the pre-COVID 19 world (to use a previous Sunday Brief term – the “before” state) is found in Randall Stephenson’s summary in their fourth quarter 2019 earnings conference call at the end of January:
“As you know, smartphone upgrades across the industry have been down for a while now. In fact, we’re coming off a record low upgrade rate for any fourth quarter in our history. But fast forward to the back half of this year when popular 5G smartphones and devices should be more available at scale, you can expect higher upgrade rates and equipment revenue growth. The timing for this upgrade cycle couldn’t be more perfect when you consider that we’ll be offering HBO Max on our highest ARPU wireless plans with features tuned for premium media consumption and at a time when people are coming into our stores to upgrade. It’s a natural opportunity to further the distribution of HBO Max, while adding new mobility subscribers and improving our wireless ARPUs.”
Everything was perfectly orchestrated – consumer upgrade demand, strong economic confidence, 5G device (specifically Apple iPhone) availability, 5000+ retail stores, strong brand messaging, and premium HBO Max.
Then came the COVID-19 shutdown and impacts shown to the left. Despite assurances made on the conference call, there will be increases to the $250 million bad debt figure – it may not be run-rated, but $250 million reflects an increase of 2-2.5 million in wireless disconnects due to inability to pay or about 3% of their total retail prepaid+postpaid base. Alternatively, ARPUs could be lowered as customers downgrade from unlimited to metered plans (and correspondingly reduce disconnection) Either way, the cash flow forecast is negatively impacted well past the $250 million reserve.
Premium content is most valuable when it’s fresh, and the production shutdown costs shown to the left remind shareholders that nothing is being produced (as we note below, content production is not a focus item for Verizon). The NCAA Basketball Championship Tournament (a premium content jewel) was cancelled, and baseball is delayed indefinitely.
All of this places a lot of stress on dividend sustainability. AT&T reported $3.9 billion of free cash flow after spending $5 billion on capital deployments in the quarter, and $3.7 billion in dividend payments – a 96% payout ratio. While AT&T executives assured shareholders on both the earnings call and in Friday’s shareholder meeting that the dividend was safe, one has to wonder how the bond rating agencies feel about that statement (telecom analyst Craig Moffett has written a terrific analysis on various dividend payout scenarios, and I highly recommend that you contact them to discuss).
Here’s the “debt tower” slide from AT&T’s earnings presentation and their dividend payout ratio discussion:
One of the more interesting cash flow adjustments in the quarter was the lack of either an actuarial gain or loss on the value of the pension. The adjustment had been trending higher throughout 2019 ($5.1 billion total year adjustments) following market trends toward lower interest rates. Then along came 2020 (shown is the 10-yr yield since Jan 1):
Lower interest rates place pressure on the pension asset’s ability to grow enough to cover expected pension and postretirement benefits. While management was emphatic both on the earnings call and in the shareholder meeting transcript that the pension was fully funded, it’s very hard to understand the basis of that statement should interest rates remain at historic lows.
Using intermediate Treasury notes as a benchmark, the 10-yr note ended 2018 at around 2.7% and fell throughout the year to 1.8%. This was a contributing factor to over $5.1 billion in actuarial losses on the pension in 2019. So far in 2020, the same benchmark rate has fallen by 120 basis points (30 basis points more than in 2009), yet no adjustment. As AT&T indicated in their latest 10-K (released Feb 20):
“We expect only minimal ERISA contribution requirements to our pension plans for 2020. Investment returns on these assets depend largely on trends in the economy, and a weakness in the equity, fixed income and real asset markets could require us to make future contributions to the pension plans. In addition, our policy of recognizing actuarial gains and losses related to our pension and other post-retirement plans in the period in which they arise subjects us to earnings volatility caused by changes in market conditions; however, these actuarial gains and losses do not impact segment performance as they are required to be recorded in other income (expense) – net. Changes in our discount rate, which are tied to changes in the bond market, and changes in the performance of equity markets, may have significant impacts on the valuation of our pension and other post-retirement obligations at the end of 2020.”
Interestingly, AT&T recorded $800 million in other income in Q1 2019. It is puzzling how a drop in interest rates, coupled with a drop in equity market values, could result in no change to the value of the pension asset, especially when Verizon reported a $182 million mark-to-market loss (more on VZ below). This is something we will keenly follow when AT&T releases their 10-Q and determines the overall pension funding level in 4Q 2020 (more on that process, the 7.0% long-term return assumption and impact of 2019’s interest rates can be found on page 46 of their 2019 10-K report here).
Bottom line: Randall Stephenson’s decision to move to Executive Chairman of AT&T on July 1 is very perplexing. John Stankey is extremely qualified to be CEO, John Stephens is a seasoned CFO, and Jeff McElfresh is a good technologist and leader. But, absent some disagreement with the Board (or Elliott Management), less steady hands guiding the ship through post-COVID 19 waters leaves investors scratching their heads. While we can only guess at what Randall’s reasoning is, something is askew.
This is going to be a very turbulent year for AT&T. Some combination of the following will occur in the next five months: a) borrowings will go up (including a small draw on the revolver); b) capital spending will tighten ($2 billion of 2H 2019 capital reductions/ deferrals is not out of the question); c) expense reductions will accelerate, as then-COO John Stankey outlined in the earnings call; d) post-COVID 19 marketing and promotion spending will decrease; e) advertising revenues will remain weak; and f) prices will increase (fiber/ broadband as well as access pricing to other carriers will likely be the first areas where this is seen). Not on the list (unless there are asset divestitures): New spectrum purchases (participation in CBRS and C-Band auctions will likely be muted).
AT&T has a lot of poorly underutilized fiber, copper and other assets. They need these assets to perform precisely at the time when discretionary spending is at decade lows. Something’s gotta give.
Verizon’s earnings: “No V recovery” reality sets in
Verizon announced muted earnings last Friday. Like AT&T, Verizon took a $228 million increase in bad debt reserves in the quarter (and, unlike AT&T, left the door open for further revisions in 2Q and 2H 2020). Also like AT&T, Verizon had a very low (sub 4.0%) upgrade rate which kept equipment revenues (and costs) down. Driven by Northeast concentration of the contagion, Verizon’s business performance was stronger than AT&T’s. Nearby is the earnings slide showing impact by segment of COVID-19.
Of particular note is the significant increase in enterprise postpaid gross additions (+163%) and device activations (+80%). Also Monthly Active Users (MAU) up 95% with Yahoo! Finance and up 58% with Yahoo! News. AT&T did not provide commentary on enterprise activity into April, but, assuming other trends hold, there is probably a similar retail impact (think 50% reduction in gross adds for consumer) and an equally dramatic increase in enterprise activity.
Verizon also sounded the alarm about small and medium business (SMB) suspensions. This has ramifications for the cable business division revenue growth for the rest of 2020 (which had been mid to high single digit annual growth for both Comcast and Charter).
One of the interesting trends we track is the “other – consumer” line which houses wholesale revenue growth (+19% from Q1 2018, -4.5% from 4Q 2019). This trend could be occurring for many reasons, with the most likely being that March wholesale volumes were probably lower as customers sheltered in place. Several articles have recently appeared (Mike Dano’s from Light Reading is here) which back up a thesis that Wi-Fi offload volumes continue to grow. As Verizon noted, this not only kept MVNO revenues down, but also reduced highly profitable overage fees from customers who subscribed to metered plans.
The combined impact of lower fees as well as less overage revenue and increased disconnect churn will likely result lower revenues in Q2 2020 and beyond (management estimated 3-5% lower than original expectations). As they reemphasized with repeated responses on the earnings call, core service revenue (think base plan) seems to be very solid, but overage, roaming revenues from other carriers, late fees, and other high margin items are disproportionately impacting profitability. As mentioned earlier, there continued to be a heightened risk of SMB suspensions.
While Verizon did address advertising slowdowns, they did not have to address the issue of premium content development and distribution. Verizon does not worry about the future of theaters or the production delays outlined by AT&T above. Their concerns center around bringing the New York/ New Jersey/ Northeast areas back to life as soon as possible. The reality of a long recovery is setting in.
As a reminder, here’s the timeline slide we discussed in the March 22 Sunday Brief (5 weeks ago). There’re some things that need to be refreshed (and we will do it in two weeks after Fab 5/ Telco Top 5 earnings are complete), but there’s a lot of reality here. As you review this document, we’d like to suggest you watch two very informed CNBC interviews from last week: Larry Fink (especially his comments starting at 15:30 on devaluation and inflation) and Leon Cooperman (about the impact of government loans and increased spending on the future of capitalism).
That’s it for this week. Thanks again for your readership. Please keep the comments and suggestions coming, and, if you have time, check out the new and improved website here. If you have friends who would like to be on the email distribution, please have them send an email to firstname.lastname@example.org and we will include them on the list (or they can sign up directly through the new website).
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