To The Moon

Summary

• AT&T has multiple tickers trading on the market, including "baby bonds" which offer a lower yield compared to common stock.
• The baby bonds are now callable, and with the potential for falling interest rates, may not be a good investment option.
• AT&T's balance sheet improvements may be illusory due to "spectrum skimping," making the common stock a more risky investment than it appears.

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One of the things about the stock market that spectators don’t often realize but that any investor learns very quickly is that with many of the larger companies, there are multiple different tickers trading on the market pertaining to it. Ma Bell is no exception, and I want to examine the so-called “baby bonds” ticker (TBC) which perhaps gets less attention than the common stock of the parent company.

I also want to return to the main ticker, however, for the first time in a year. I am well aware that Seeking Alpha readers don’t exactly lack for articles on AT&T (NYSE:T) as a matter of course; while I used to write on the ticker quite often, for the past few years I have tried not to write articles that cover points readers have already been adequately informed of by other authors; and as often as Seeking Alpha publishes an AT&T article that’s really not that often. I think it’s the right time, though, to cover some points that are perhaps running a little bit below the radar.

Ma Bell And Her Baby Bonds

I want to start with the bonds. These are relatively recent additions to the AT&T capital structure, having been issued in 2018. That was back in the heart of the post-GFC, pre-COVID rock-bottom interest rate era, and AT&T, a company that was already struggling with massive losses on its newly acquired DIRECTV platform, somehow managed to convince the bond market to give them a 5.625% interest rate - at the same time that AT&T’s common stock, which unlike bonds has no upside limits, was trading with a 7% dividend yield.

Perhaps novelty played some small role. Unlike most bonds, which trade in four-figure increments or higher and are usually only available to investors through bond brokerages, these bonds are traded in $25 increments and listed on the New York Stock Exchange, making them far more accessible to everyday investors who may not have the capital or know-how to trade with Wall Street’s investment bank bond trading departments.

From the moment they went live, they didn’t make a whole lot of sense. But in 2018 there was one argument to be made in their favor, though to my mind it didn’t justify all the downside: AT&T was struggling. DIRECTV was an absolute disaster, TimeWarner’s upside wasn’t panning out, T-Mobile (TMUS) and to a lesser extent Sprint were stealing their wireless customers, and international was at best a question mark.

While the yield on the common stock was higher, it came with the very real risk of capital losses; in fact, from my first bearish AT&T article in mid-2016 through my article a year ago, AT&T’s common stock had declined more than all the dividend payments the then-Dividend Aristocrat had sent out, making the dividend yield more of a sick joke than a real gain.

One Year On, They're Just As Ugly

But as little as it made sense to buy those bonds in 2018, it may make even less sense now. The only real argument for them was protecting from the decline in AT&T’s common; but now the company has rebounded sharply from the lows it was plumbing a year ago. In fact, AT&T since my last article is up 37%, compared to a 23% gain for the broader market. The dividends are still pretty nice, too, almost another 10% of gain with reinvestment. Meanwhile, TBC is up only 5% with a 6% dividend gain.

In other words, the only real argument for the baby bonds no longer applies, unless you think the stock is about to dive again.

But it doesn’t stop there. These bonds are also now “callable,” meaning that AT&T can redeem them early without penalty, paying only principal and unpaid and accrued interest up to the redemption date. This option went live late last year.

AT&T, of course, has no reason to redeem them right now; the Fed Funds rate stands at 5.25% and AT&T is paying 5.625% on these bonds; essentially, AT&T is being allowed, at least for purposes of this bond, to borrow at almost US government risk-free rates, despite still carrying one of the largest debt loads in corporate America. AT&T has no intention of looking that gift horse in the mouth so long as rates stay anywhere near where they are.

It is becoming more and more clear, however, that the Federal Reserve intends to begin reversing its rate hike campaign and, almost certainly, will begin trimming short-term interest rates at its September meeting. That means that the delta between the baby bonds and the risk-free rate should soon begin to grow.

While AT&T still probably won’t redeem the bonds so long as the yield spread remains relatively low, a sufficiently high spread that looked like it was going to last sufficiently long still might impel early redemption at some point.

Baby Bonds Belong With The Bathwater

So, to summarize, what TBC offers is a chance to buy bonds, not stock, in AT&T which are yielding barely more than the risk-free rate and, being bonds, do not give any rights to share in the upside of the company if it continues to outperform going forward. What’s more, even if they do begin to gain more spread in the months ahead, the bonds are effectively capped in how good a yield they can offer before AT&T cuts off the flow of funds with an early redemption which would send investors back into the market at precisely the time that falling interest rates will have presumably made stocks and bonds alike more expensive to buy into.

The Common Stock Alternative

So clearly, the bonds are not the way to go. I stand by what I said a year ago; either buy the common shares or don’t buy at all. If you’re going to take a chance on AT&T you might as well get the maximum upside possible.

This still leaves the question, though, of just whether buying AT&T is even all that “chancy” at this point; after all, it has climbed substantially the past year. Has the company, after a decade of staggering red ink, finally turned the corner?

My concerns about AT&T a year ago stemmed from two primary things: the possibility that its balance sheet improvements were only illusory, because they were secured by “spectrum skimping” in FCC spectrum auctions that would later have to be made up at the same or higher price, and the fact that it still owned, even after the spinoff, 70% of DIRECTV, from which it derived over $4 billion in free cash flow at the time and which looked like a rapidly decaying asset, owing both to the natural pace of cord-cutting and, particular to DIRECTV, the potential outflow of millions of additional subscribers when NFL Sunday Ticket bolted for YouTube TV.

Satellite Operations

I still have my concerns about DIRECTV, but frankly, there isn’t a whole lot more I can say about it. The Sunday Ticket situation, in particular, is an especially frustrating issue to try to get any kind of handle on. Most major pay-TV players report - albeit a lot of them in rather opaque and slanted ways - how their pay-TV operations are performing, which allows us to monitor how cord cutting as a whole is behaving.

By the way, it's behaving badly; while the recent Q2 reports finally showed a decline in the absolute number of cord cuttings, the cuts as a percentage of TV viewers continue to rise; the 166,000 fewer households lost compared to Q2 of 2023 is not enough to compensate completely for the fact that those losses are spread each year over roughly five million subscribers fewer than the year before.

So DIRECTV’s business is still dying. We just can’t see how quickly it’s dying; because DIRECTV, ever since being spun off, has not filed any publicly available reports about its subscriber count. Even more frustrating is that Alphabet’s (GOOG) (GOOGL) YouTube also does not regularly report its YouTube TV subscriber totals, which means that we cannot even extrapolate DIRECTV’s losses on the Sunday Ticket switch from the recipient’s data.

Glimpses Under The Hood

We are not completely in the dark. Sports fans across America took a great interest in Sunday Ticket’s fate, and then there’s the fact that it’s a management team’s job to boast when they have good news. So secrecy notwithstanding, we were treated to NFL Commissioner Roger Goodell announcing that, prior reports notwithstanding, Sunday Ticket has doubled its number of subscribers since transitioning from DIRECTV to YouTube TV, which would pencil it out to somewhere between 3-4 million subscribers based on my DIRECTV math - and suggests that DIRECTV’s traditional video bundle’s decline may have accelerated even further.

Not long after we got YouTube TV announcing that it has hit eight million subscribers - presumably there’s a link between those two things, and it suggests that the decline for DIRECTV’s video bundle may have been substantially accelerated last year.

But without an update from DIRECTV itself, it is hard to say for sure. What’s more, management has been clear that Sunday Ticket was not really generating a net profit after subtracting its $1.5 billion rights fee from the revenues.

In fact, DIRECTV has indicated that by the end of the contract, they were losing as much as $1 billion a year on Sunday Ticket. That number, I have argued before, is somewhat deceptive because it does not include indirect profits, only direct ones, but you can read my previous article for that point.

Altogether, knowing that DIRECTV is saving on Sunday Ticket rights fees but losing out on both direct and indirect profits from former subscribers, as well as the general pace of cord cutting, it’s just hard to put any kind of firm estimate on DIRECTV.

Balancing Spectrum And The Balance Sheet

The other issue was whether these balance sheet improvements are real, or just passing illusions.

AT&T, like all wireless carriers, requires radio spectrum over which to transmit its signals if it wishes to operate at all; it’s no exaggeration to call these spectrum licenses the very lifeblood of the industry.

But for precisely that reason, they can get expensive. And it’s vital that a wireless carrier keep its balance sheet relatively clean in order to be able to afford them. It was no coincidence that AT&T abandoned ship on media in 2021, and it wasn’t just because it was around then it became crystal clear the massive ramp up in cord cutting that had started in 2019 was more or less permanent. It was because a new auction for wireless spectrum had just taken place, and AT&T had spent considerably less than its rivals; in fact, at 80 MHz it acquired only half as much spectrum as its top competitor, Verizon (VZ) did. Meanwhile, market leader T-Mobile had scored 40 MHz, so AT&T barely closed the gap between them at all.

Management put the best spin on it that they could, but it was pretty clear that its balance sheet had hobbled it somewhat, even though AT&T had already sealed the deals to spinoff DIRECTV and WarnerMedia and likely wouldn’t have been able to bid even as much as they had if they hadn’t. Still, it left the rather high-stakes question of where AT&T would get the rest of the spectrum it needed.

The whole idea here seems to be to pass on high-priced mega-auctions, or at least scale back in them, and wait for a series of smaller opportunities to present themselves to acquire more modest caches of spectrum which can essentially be stitched together to match Verizon’s massive one-time haul.

AT&T's Spectrum Hunt

I was skeptical of AT&T a year ago in part because I had questions about this strategy. Despite AT&T’s rebound, I still feel that way.

Admittedly, part of AT&T’s strategy may have already been vindicated. Barely eight months after the final C-Band results were announced, they got their chance to make up some lost ground. The FCC moved faster than expected to clear another cache of mid-band spectrum and less than a year after C-Band, all the big players were back at the auction house again.

At first, it looked like AT&T might get away with an absolute steal. Even though this spectrum was nearly C-Band’s match in 5G, bidders simply didn’t seem to be interested in the 100 MHz in the lower band at first. Concerns grew that it simply wasn’t going to sell, since a reserve price of $15 billion had been established for it. It later emerged that a major bidder, almost certainly Verizon, had pulled out of bidding early in Round 10 of the auction, causing pricing dislocations and a temporarily depressed market.

They needn’t have worried, though. By November, the 3.45 GHz auction total was settled comfortably above $21 billion, not too far from where it ultimately closed just under $22 billion net and well over the reserve price. And it turned out AT&T had scored, securing another 40 MHz of spectrum while Verizon came away with none.

I wouldn’t call this proof positive of a winning strategy just yet, though. In the first place, T-Mobile got another 30 MHz in the same auction, so once again the gap closing was minimal despite the haul. AT&T remains far behind the other two in spectrum. But also, the expectations of a “steal” proved somewhat premature; AT&T got its spectrum but wound up having to pony up $9.1 billion - while that is 20% less than Verizon paid per MHz in the C-Band auction, it’s hardly the massive savings that AT&T’s strategy would seem to require.

Quantifying The "Phantom Debt"

Even assuming that in fact AT&T continues to buy up spectrum at 20% less than Verizon did through its “multiple small hauls” strategy, it is still 40 MHz short of Verizon’s C-Band haul alone, and considerably more than that short of Verizon and T-Mobile when factoring in the former’s mmWave spectrum and the latter’s market-leading position.

Assuming conservatively that AT&T needs another 90 MHz to be truly on a network par with its peers, even at the lower rate, roughly $21 billion of AT&T’s “balance sheet improvement” still comes down to spectrum skimping. At minimum, investors should assume that amount of debt is basically “phantom debt” right now, to spring to life whenever another major FCC auction rolls around. The alternative, that AT&T simply never acquires the missing spectrum and its network operates at a permanent spectrum deficit vis-à-vis its competitors, is probably even worse.

Investment Summary

I am impressed with the rise in AT&T stock over the past year. Management has more or less successfully pivoted away from a disastrous media bet and refocused on the core competency of the business. But the financial carnage of the media disaster continues to linger; in the long run skimping on spectrum is almost certainly not a viable strategy, and AT&T will have to pony up. For these reasons, I remain unwilling to dive into AT&T’s common shares - and I certainly am not touching the baby bonds.

I rate AT&T a strong Avoid or a weak Hold.