AT&T: When Good News Is Bad News

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I am well aware that in most months, Seeking Alpha readers are fairly awash in AT&T (NYSE:T) articles. For that reason, even though it is right in my core competency of media/telecom, I try not to write on it too frequently, and I never want to bore readers with something they’ve already read ten times.

I write today, however, because there’s been some news and my interpretation of it is a little different than most. AT&T is expanding its wireless network service in a new direction. In doing so, it is matching its competitors offerings in an area it had previously come up short in.

Ordinarily, that would be outstanding news. In this case, however, I’m less sure. And it goes back to why I don’t always agree with what I read about AT&T’s improving balance sheet, either.

Internet Air Hits The Airwaves

The news in question, first. AT&T has announced that it is taking a new 5G fixed-wireless service, AT&T Internet Air, out of limited beta and into proper retail availability. This is basically 5G home internet like T-Mobile (TMUS) and Verizon (VZ) have been offering for well over a year now. Like its two competitors, AT&T will continue to impose certain network priority rules that will give mobile customers priority access over home broadband in times of network congestion. It will also limit how many homes can sign on based on regional and local network utilization trends.

In other words, AT&T’s 5G home internet strategy now looks almost exactly like the rest of the industry’s. And it will finally start offering the same services that Verizon and T-Mobile do.

It’s quite an about face, considering that as recently as January of this year, management had indicated there had been “no change” in their views about fixed wireless. That is, that they didn’t think it was a viable strategy owing to the massive capacity requirements of home broadband compared to mobile service. In telecommunications, one of the few unchanging constants is that there is a tradeoff between mobility and capacity, with fixed wireline networks enjoying a massive advantage in the latter.

But apparently, views are changing inside AT&T.

Author's History

Readers should know going in, I’ve been something of a permabear on AT&T for years, before shifting to a very weak Hold when the stock fell so far I thought maybe all the damage had been fully priced in. In hindsight, even that was a mistake - I should have stayed short longer.

I usually prefer to do deep dives on each division or business line of a company’s performance, each in their own article. With AT&T, I’ve done precisely that over the past several years. I’ve been a consistently bearish voice as first its disastrously misguided, newly-acquired satellite division and then its core wireless division came under competitive attack from far more nimble and innovative competitors such as T-Mobile and Netflix (NFLX) while even its fellow incumbent Verizon at least managed to resist the temptation to plunge cash and shares greater than the market cap of the company into whole new - and utterly unprofitable - business lines.

I long ago noted that the DIRECTV acquisition was likely to force AT&T to cut its sacred dividend, so bad would the financial carnage be from acquiring scale in pay-TV without regard for its inability to transition to broadband like cable competitors Comcast (CMCSA) and Charter (CHTR) could. And eventually that was exactly what happened. Don’t believe management’s claim that they “right-sized” because they sold Warner; the $60 billion loss on the DIRECTV deal was the real catalyst.

So, my bearish take has a whiff of self-confirmation bias, to be sure. Take it for what it's worth

A Break From My Usual Method

One thing I don’t like to focus too much on, though, is company balance sheets. Not because I don’t think they’re important - they absolutely are - but because over time balance sheets tend to conform to operational performance more than the other way around.

A company with a bad balance sheet but strong performance will generate profit and pay down its debt. A strong balance sheet will inevitably become weak if the company cannot execute. Analyzing operational performance is therefore a better use of a limited resource like an investor’s time.

Usually, after operational analysis and calculating an Enterprise Value, I’ll simply look up and subtract the total net debt outstanding, and divide the remainder over the share count. Quick and clean. Only when a company’s corporate structure seems likely to bifurcate, and the question arises of how much of the debt the good part of the company has to cover, do I like to do deep dives on debt.

But AT&T management has made much of its “strengthened balance sheet” the past few years, and continues to offer it as a counter thesis to the market’s increasing pessimism. I wanted to explain why I think AT&T’s shrinking debt is more than a little deceptive in this case, since the way in which the company is shrinking it not only may not be sustainable… but may even swing into reverse at some point.

The Lifeblood Of Wireless

While there is a lot that goes into creating and maintaining one of the nation’s now only three owned-and-operated wireless networks, increasingly prominent on the expense list is the wireless spectrum itself that the transmissions run on. Once given out by the Federal Communications Commission to “deserving” operators for almost-free, in a sort of quasi-Communist central planning system, most newly available airwaves today are assigned pursuant to a market-based auction system, usually with some sort of cap or ceiling on how much spectrum any one bidder can win. And generally speaking, each step up in wireless operations, from 2G to 3G to 4G to now 5G, has required adding to wireless operators spectrum haul.

This means that wireless operators need to have the kind of balance sheet that can bid the large sums necessary to acquire spectrum, the very lifeblood of wireless service, as it periodically becomes available. So, of course, if AT&T’s balance sheet really is improving, it only boosts its ability to do that.

But there’s more to the story than that, in my opinion. AT&T’s superior debt reduction in recent years compared to Verizon is in my view as much a sequencing differential as an operational one.

Vital Historical Context

Sprint Merger

I don’t want to turn this into a book-length exposition of the entire history of wireless. The important part of the story for our purposes goes back to 2018, when two pivotal events took place, one of which was appreciated immediately for the earthquake it was and the other of which was somewhat of a wolf in sheep’s clothing.

The biggest one you can probably guess: in April 2018, Sprint and T-Mobile announced their plans to merge, transforming the three and four players into the new top dog in wireless. The merger was delayed by judicial process and in my opinion one can make a strong argument even now that consumers would have been better off if it had been blocked - although certainly investors have no cause for complaint. Which is the way most mergers work, I suppose.

Regardless, the deal went through, eventually. The significance of which was that by acquiring Sprint’s priceless and unparalleled treasure trove of spectrum, T-Mobile essentially solved whatever spectrum challenges the 5G transition might have imposed on it overnight. From the day the deal finally closed, the 5G roadmap for T-Mobile was basically set. So now Verizon and AT&T needed to match it.

C-Band Auction

The second historical event is the C-Band spectrum auction a year and a half after the merger. Briefly, the government made available a massive haul of new midband spectrum and put it up for bidding.

T-Mobile was widely seen as being in pole position for midband spectrum, so Verizon and AT&T logically figured to duel it out for the new cornucopia. Therefore, expectations that C-Band auction proceeds would be modest never quite made sense to me. I wasn’t surprised when stiff competition blew the lid off of auction prices. Ordinarily, one would expect that AT&T would try to get itself a viable spectrum roadmap to 5G, and would come away with at least half the haul.

But I didn’t really expect that, again because of the debt load at Ma Bell. And when the results were announced, it was Verizon who had run away with the competition. On average, of the 280 MHz of spectrum, Verizon secured 160 MHz of it, twice what AT&T had.

This failure to close the gap by AT&T was made worse by the fact that T-Mobile had added to its impressive haul with about 40 MHz of its own. On a net basis, then, Verizon had closed the gap with T-Mobile by 120 MHz, roughly 80% of the amount T-Mobile acquired from Sprint. AT&T, however, had only gotten 40 MHz closer, still trailing by triple digits.

What’s more, Verizon had also acquired a much larger number of mmWave licenses to close whatever gap remained. AT&T had not. So now instead of a two-way tie for second place, AT&T found itself indisputably far in the rear.

Of course, Verizon had also spent a lot more; $45 billion in auction bids and perhaps $8-$10 billion more in clearing costs to help incumbents relocate to other blocs. AT&T’s costs were roughly half that at $23 billion plus relocation fees.

Today's Spectrum Map

I am well aware that Verizon’s counting on mmWave spectrum to remedy its midband shortage relative to T-Mobile is a controversial strategy that has more than its share of skeptics. I am regularly reminded of it every time I write on Verizon, though I am more sanguine on mmWave’s prospects than some. Regardless of its outcome, however, Verizon management has at least offered a plausible explanation for why it thinks it can compete with T-Mobile despite a (small) midband spectrum shortfall, and it has moved to remedy it where it can.

AT&T, meanwhile, is trailing far behind in both the mid-band and high-band sectors. And now Verizon and T-Mobile are both threatening to leave it in the rearview mirror. But AT&T management insists it remains optimistic on its network. Up until now, one argument it has routinely advanced in support to that view has been that it is not providing wide-scale FWA service, which it insisted could not be a durable profit stream and would only waste precious spectrum.

The Hot Air Of Internet Air

There are only three possibilities: either AT&T has

1) found a way to offer equal or superior service using far lower amounts of bandwidth

2) deferred spectrum purchases it intends to catch up on later, at either a higher or lower price

Or,

3) it’s so levered up it has no intentions of purchasing the missing spectrum blocs to close the gap with its competitors, despite the fact that it does not yet know how to offer comparable service on such a confined bandwidth.

Extreme Bear Case

Option 3 is hardly worth discussing; while it is not at all inconceivable in AT&T’s leveraged state that option 3 is precisely what has happened, such a finding would be so catastrophic for its long-term competitiveness in the industry that there’s no point in really analyzing it in any great detail. If you believe 3 is what happened, stop reading here. Your investing strategy is obvious; dump it and don’t look back.

The Holy Grail Argument

Option 1 would obviously make AT&T the hands down deal of the decade for buyers at its current depressed price, since that is basically the holy grail of wireless engineering. But I’ve seen nothing to suggest that AT&T has accomplished such a thing or even claims to have. The only plausible way to make that claim might - I can’t stress the might part enough - have been to argue that FWA was a colossal waste of spectrum and that refraining from it would leave AT&T free to deliver a superior mobile experience with less airwaves.

But now AT&T is diving into 5G Home Internet, just like everyone else, and apparently doesn’t think there are real spectrum savings to be had by not doing so. Not surprising, since the argument about FWA’s uselessness is only superficially reasonable and collapses pretty quickly on closer analysis.

The Real Bull Argument

Option 2 is about the best that AT&T bulls can reasonably hope for, now that AT&T Internet Air has launched and put paid to the notion that FWA rationalization was the reason for the missing spectrum. This in turn means that AT&T’s future hinges far more than T-Mobile’s or Verizon’s does on what spectrum will sell for in future, and from what source. AT&T’s decision to defer spectrum purchases only works if the savings are sufficiently large to justify the inferior network performance in the meantime.

The Next Spectrum Wave

I am not convinced it will find cheap spectrum. Certainly, one could construct plausible scenarios; a DISH Network (DISH) bankruptcy might leave its 80 MHz-plus spectrum hoard available for a song; if Verizon and T-Mobile didn’t enter the bidding for it, but I can’t quite see why they wouldn’t. For that matter, DISH might not leave the field at all, just recapitalize with a debt-to-equity conversion and keep right on going.

The FCC might decide to override incumbent objections and make available a massive swath of additional spectrum available, although political connections of incumbent spectrum owners make that complicated and, again, why wouldn’t its competitors at least bid enough to drive up the price, even if they didn’t plan on taking ownership?

The more likely scenario, I submit, is that AT&T will indeed acquire more spectrum at some point… but will pay little less for it than its competitors have. That almost certainly means that its much-vaunted “balance-sheet improvement” is mere mirage; it is a function solely of delayed network investment, and cannot last longer than the date of the next major spectrum sale.

Financial Implications

The exact size of the “shadow debt” that will reveal itself when AT&T finally matches at least Verizon, if not T-Mobile, in spectrum is a little harder to calculate precisely. We don’t know what frequencies with what incumbent operators it will be buying.

But AT&T bought only half the spectrum of Verizon at the C-Band auction while spending half as much. If it merely closes that gap at the same price, it will spend another $25 billion-plus on acquisition and incumbent adaptation.

But since it also lacks Verizon’s mmWave holdings, it may need to move even closer to T-Mobile’s position in mid-band to compete, which could easily as much as double that number. Even pencilling in some free cash flow in the intervening period, AT&T may well end up with higher, not lower, debt in the years to come.

Baby Bonds Aren't Good For.... Anyone

It has been suggested by some that the way to play this is to shift from buying AT&T stock proper towards buying its preferred shares or even its baby bond issues (NYSE:TBC) (NYSE:TBB) due to their superior position in the capital structure. With respect, I would avoid these also. The baby bond strategy seems to me particularly ill-suited to the exigencies of the moment because of its relatively low yield.

For those who are new to the stock or unfamiliar, there are already some excellent Seeking Alpha authors who have written some concise rundowns of AT&T’s baby bonds and how they differ from the common. I’ve provided links to one of them here, and here also is the SEC prospectus for the baby bonds. But I still wouldn’t buy them.

AT&T baby bonds were sold before the Fed began its rate-hiking campaign, and as a result they carry a relatively meager 5.625% yield. With the Fed already at 5.25% and looking more and more like it is not through raising rates yet, a short-term Treasury bond will provide comparable yield for far less risk.

What’s even worse, as the prospectus makes clear, AT&T’s notes are subject to early redemption at the option of the company, so even if somehow rates fall again with an investors acceptable time horizon, it will yield far less in appreciation than a comparable long-term Treasury bond.

Anyone who wants only safety and is willing to accept a limited upside can simply buy short-term Treasury bonds, or if their principal account balance is low enough even just find a regular savings account. Meanwhile, anyone who has the stomach for AT&T’s risk profile might as well buy the common stock itself and ensure that they share in the full upside for the risk they’re taking.

I just don’t see how AT&T’s bonds are a good bet at this point. Buy the common or don’t - I recommend you don’t - but regardless I’d stay away from the baby bonds.

Investment Summary

Wireless operators who decline to invest in spectrum can absolutely outperform competitors on debt for a little while as their competitors pony up for the vital spectral resources they aren’t buying. But such behavior is unlikely to produce a meaningful long-term boost in shareholder value in my view. Spectrum is simply too vital to operations, and eventually the bill comes due. Whatever faint pretense AT&T had of already having enough spectrum was shattered by the news that it will launch a proper FWA offering after all. It has bought less spectrum because it had less cash, and while that is financially sound it is operationally unsustainable. Ultimately it needs the spectrum to satisfy its customers.