AT&T Q3 2023 Beat And Raise: Fundamentals Still Intact, Bond Rout Offers Strong Entry

Summary

• AT&T Inc.'s Q3 beat and raise has effectively lessened concerns among its income-focused investors' base on the durability of the stock's near 8% dividend yield at current levels.
• The stock's underperformance this year, despite AT&T's consistently positive progress in driving free cash flow build, is likely the result of broader bond market declines and rising Treasury yields.
• The combination of AT&T's strong fundamentals and a proven recession-proof business model, alongside macro-driven dividend yield expansion towards 8% presents a compelling entry opportunity for fixed-income investors.

Justin Sullivan

In our previous coverage on AT&T Inc. (NYSE:T) stock, we had anticipated strong seasonality tailwinds in consumer wireless performance in Q3, partially due to better-than-expected demand for the premium iPhone 15 Pro (AAPL) lineup. And the company has delivered accordingly, while also achieving record-setting operating profitability in mobility during the quarter, underscoring a prudent balance between promotional activity spend and encouraging higher-dollar consumer subscriptions. The following analysis will dive deeper into AT&T's solid Q3 beat and raise, and the implications of both company-specific fundamental performance and broader macroeconomic factors on the stock's near-term prospects.

AT&T stock has traded against the broader market rally for steep double-digit percentage declines this year, with its dividend yield fast approaching 8% (T.PR.A: 6.75%/T.PR.C: 6.85%). But AT&T's solid Q3 performance, with free cash flow ("FCF") - a key focus area for its income-focused investor base - now tracking beyond management's previous guide for $16+ billion, has boosted the stock's uptrend in pre-market trading following the earnings release.

With AT&T's fundamental outlook intact, we believe much of the stock's underperformance is driven in lockstep with broader bond market declines. The long-end Treasury yield - a benchmark for the risk-free rate - has soared towards 16-year highs in recent weeks and is now nearing 5%. And AT&T stock has likely declined accordingly to account for the yield multiple relative to the risk-free 10-year notes (US10Y), in line with investment dynamics among fixed income investors.

Considering AT&T's strong performance in Q3 and anticipated seasonal tailwinds heading into year-end, the latest earnings results lessen concerns that industry competition and broader macroeconomic challenges could disrupt the company's full-year free cash flow outlook. And alongside its relatively recession-proof business model in the connectivity-first era, the current macro-driven valuation set-up on AT&T stock represents a compelling entry opportunity to take part in both an attractive fixed income return as well as longer-term upside potential.

Fundamentals Are Tracking Positively

AT&T delivered on expectations for a 2H-weighted free cash flow generation roadmap. The company reported free cash flow of $5.2 billion in Q3, outperforming management's previous guidance in the $4.5 billion to $5 billion range. This effectively alleviates stress on the previously anticipated $6 billion free cash flow needed to be generated in Q4, and lessens concerns over the achievability of management's earlier optimism for more than $16 billion in full year free cash flows. Management has also officially upgraded AT&T's full-year free cash flow guidance from "more than $16 billion" estimated in Q2 to now at least $16.5 billion.

Much of the progress was supported by solid subscriber net adds in both wireless mobility and fiber during the third quarter. The company added 468,000 postpaid net adds in the quarter for mobility, and 296,000 for fiber, representing continued expansion of market share.

As previously anticipated, resilient demand for the newest iPhone 15 Pro line-up as a driver for higher priced Unlimited Plan subscriptions during the quarter. And considering the quarter's solid beat and raise, iPhone-related promotional activity were likely efficiently deployed to ensure a net positive benefit, ridding AT&T from its previous reputation for margin-erosive discounts that had left a sour taste in investors' mouths. In fact, strong demand during the iPhone promotions in Q3 have likely led to growth in higher-priced Unlimited Plan subscriptions during the quarter, highlighting a positive value position viewed by AT&T's customers despite the mixed consumer spending backdrop. This is corroborated by strong postpaid phone ARPU expansion of 0.6% y/y to $55.99 observed during the quarter, which met with "historically low levels of churn" at 0.79% and has resulted in AT&T's "best-ever Mobility operating income," effectively alleviating pressure from promotion discounts on the bottom line.

Meanwhile, on the fiber front, net adds expanded by 296,000 during Q3, taking total subscribers to more than 8 million. Fiber has been a key focus area in AT&T's broadband business in recent years, diverging from peers' increasing focus on 5G fixed wireless to the home. In the latest development, AT&T has been chosen to extend its fiber capabilities to more than 1,200 homes in Lawrence County. The project is valued at more than $4 million, with AT&T contributing slightly under half the capital outlay required, with Lawrence County footing the rest. The project build-out is expected to be complete in the fall of 2025, and underscores incremental monetization for AT&T, reinforcing visibility on its fiber growth roadmap. Taken together, the company remains on track towards its ambitions to surpassing 30+ million fiber coverage locations by mid-decade.

The company has also recently stepped-up efforts in launching adjacent fixed wireless broadband offerings - namely, "AT&T Internet Air." This is expected to drive further monetization of AT&T's 5G investments in recent years, while also enabling margin improvements for the broadband segment, given the lower cost to beam connectivity into homes relative to fiber connections. Management has also clarified that its 5G fixed wireless strategy is aimed at "replacing the old [copper] line connections" and smoothen the "transition out of legacy infrastructure." The company is aiming to provide AT&T Internet Air fixed wireless coverage across more than 30 locations in the U.S. by the end of the year.

The combined broadband strategy going forward is already yielding positive results, as corroborated by net improvements in the segment's margins in recent quarters despite elevated "depreciation expense and higher network-related costs." This will likely continue to complement growth in wireless mobility, and help drive incremental scale to 5G deployments and improve relevant investment returns over time.

AT&T has also benefitted from gradual capex reductions in recent quarters. The annualized run-rate based on Q3 spending levels is inching closer towards pre-5G investment levels at about 14% of revenue, which is supportive of AT&T's deleveraging efforts and dividends. This is in line with expectations for the gradual wind-down of AT&T's multi-year 5G investment cycle, pivoting towards focus on generating returns as corroborated by active efforts in bolstering subscription volumes and expanding ARPU through the higher-priced 5G Unlimited Plans going forward.

Taken together, we believe the combination of continued growth in higher priced, higher margin subscriptions alongside moderating capex spend will be beneficial to AT&T's free cash flow roadmap critical to both deleveraging and dividends. In the latest update, management's potential consideration of selling AT&T's 70% majority stake in DirecTV will likely further free up the company's liquidity profile for supporting longer-term growth initiatives in wireless mobility and broadband. While management has not provided any detailed updates on the matter during the latest earnings call, we believe the eventual selloff of AT&T's stake in DirecTV would allow the company to better invest into expanding its market share in wireless connectivity amid intensifying competition in the industry. The partial spin-out completed two years ago, which had carved out a piece of DirecTV's stake to private equity firm TPG Inc., stipulates an option for AT&T to exit its stake after July 31, 2024.

While the final decision on the matter is still some time away, any updates supportive of the sale would likely improve sentiment on the stock, as it entails incremental cash inflow - especially as DirecTV faces secular declines, which has inadvertently lowered the cash distribution to AT&T in recent years.

Macroeconomic Impacts on Valuation

While AT&T's fundamental outlook remains intact, its valuation continues to face the overhanging risk of rising borrowing costs and surging bond yields. The stock's valuation multiple has faced substantial compression in recent months. This is in line with the selloff in U.S. Treasury since the Fed's reiterated commitment to a higher for longer rate environment in September, citing the need to tame an economy that continues to run hotter than expected.

The AT&T stock has historically traded at about a 2x to 3x yield multiple to 10-year Treasury - a key risk-free benchmark considered by fixed income investors. Both metrics have surged in lockstep in recent months, following the selloff in U.S. treasury in anticipation of higher for longer interest rates. And expectations for elevated long-end yield within the near-term is likely to unlock further pressure on the AT&T stock's performance. Despite slight moderation in the selloff of U.S. Treasury last week amid intensified geopolitical conflicts in the Middle East, which has encouraged a flight to haven assets, the 10-year Treasury yield has restored its upsurge in the last several days. The returning bond rout underscores market's bet on the Fed's steadfast commitment to keeping rates higher, as well as optimism over global government efforts in ushering the Israel-Hamas war to ceasefire.

This macroeconomic backdrop is likely to further limit near-term upsides on the AT&T stock, as income-focused investors continue to benchmark the company's dividend yield and risk profile against the risk-free alternative in Treasury. At close to 8% dividend yield, AT&T stock currently trades at about 1.6x 10-year Treasury yield, which is still slightly below the historical average differential. Paired with AT&T's elevated operational risk exposure due to its highly leveraged balance sheet still, the stock likely faces continued exposure to the macro-driven drag on valuations in the near term.

The Bottom Line

With its fundamental prospects and broader free cash flow generation outlook still intact, AT&T could be well positioned to benefit from an impending recession. In such a scenario, the Fed would likely head into quantitative easing. The subsequent normalization of U.S. Treasury yield would inadvertently unlock pent-up value in the stock driven by improvements in underlying business fundamentals. We believe the stock is nearing a set-up that would allow investors to both lock-in a risk-balanced fixed income at 8% dividend yield, alongside incremental valuation upside potential at current levels.