Lofty Subsidies Hurt AT&T's 4Q

AT&T Inc. (T - Analyst Report), the second largest mobile service provider in the U.S, reported fourth quarter 2011 adjusted earnings of 42 cents per share lagging the Zacks Consensus Estimate by a penny and 23.6% down from the year-ago quarter.

Despite solid smartphone sales, earnings slipped due to high churn rate and lofty subsidies associated with Apple Inc.’s (AAPL - Analyst Report) iPhone.

Adjusted earnings in the quarter exclude non-cash charges of 65 cents related to pension benefit plans, 48 cents in asset impairments and 44 cents associated with the termination of the T-Mobile acquisition, partially offset by a one-time tax settlement gain of 3 cents.  Including these special items, AT&T generated a loss of $1.12 per share compared with the year-ago earnings of 18 cents.

In fiscal 2011, adjusted earnings, excluding special items, reduced to $2.20 from $2.29 in prior year.

Revenue grew 3.6% year over year to $32.5 billion in the fourth quarter, outpacing the Zacks Consensus Estimate of $31.99 billion. Improved performance in the quarter was driven by continued mobile broadband sales, strong wireless network performance and improved wireline revenue trends. Revenue for fiscal 2011 increased 2% year over year to $124.3 billion.

Operating income was $4.4 billion in the fourth quarter compared with $5.6 billion in the year-ago quarter.

Segment Results

Wireless revenue, including service and equipment, climbed 10% year over year to $16.7 billion in the reported quarter,  primarily on the back of robust smartphone sales and strong postpaid additions. Wireless data revenue leaped 19.4% year over year to $5.9 billion, driven by multimedia and text messages.

AT&T added 2.5 million wireless customers in the reported quarter totaling 103.2 million. Strong additions were attributable to the rapid adoption of smartphones including iPhone 4S launched in mid-October, healthy prepaid and reseller subscriber count coupled with growth in tablets and connected devices such as automobile monitoring systems and security systems.

The company recorded the largest increase in retail post-paid additions of 717,000 in the last five quarters. Retail-prepaid additions were 159,000, connected device additions were 1,029,000 and reseller additions were 592,000 in the reported quarter. AT&T added 571,000 branded computing subscribers (including tablets, aircards, MiFi devices, tethering plans and other data-only devices), thus bringing the total to 5.1 million. The branded computing subscriber shot up 70% year over year and represented the best ever quarter in the company’s history.

The company sold a record 9.8 million smartphones in the fourth quarter, which doubled from the prior quarter and up 50% from the previous quarterly record. Out of these, 7.6 million were iPhone sales and the rest were Android and other smartphones.

Total churn (customer switch) increased slightly to 1.32% in the fourth quarter from 1.15% in the prior-year quarter and 1.28% in the prior quarter. Post-paid churn increased to 1.21% from 1.15% both annually and sequentially. Post-paid ARPU (average revenue per user) grew 1.4% year over year to $63.76, driven by healthy data growth.

Wireline revenues dipped 1.4% year over year to $14.9 billion in the fourth quarter. Lower voice and other revenues offset strong data revenues.

Revenue from residential customers inched up 0.5% year over year to $5.3 billion, driven by AT&T U-verse services, while business revenue slid 1.4% year over year to $9.3 billion reflecting economic weakness in voice and legacy data products. Strategic business services such as Ethernet, Virtual Private Networks, hosting and application services, spiked 16.4% year over year.

AT&T's total video subscribers, which include U-verse TV and bundled satellite customers, touched 5.6 million at the end of the fiscal 2011 (representing 23.9% of households served). Total U-verse TV subscribers reached 3.8 million with net addition of 208,000 customers on continued high-speed Internet attach rates.

Total consumer connections plunged to 41.3 million as of December 2011 from 43.4 million in the year-ago period, due to a drop in traditional voice access lines, partially offset by higher U-verse TV and VoIP (Voice over Internet Protocol) connections.

Cash Flow

AT&T generated $34.6 billion cash from operations in fiscal 2011, down from $35 billion in 2010. The company’s expenditure increased slightly to $20.1 billion from $19.5 billion a year ago.

Free cash flow (cash from operations minus capital expenditures) was $14.4 billion versus $14.7 billion in 2010.

Guidance

For fiscal 2012, AT&T expects consolidated revenue, including postpaid ARPU, to grow 2% year over year. Consolidated and wireless margins are expected to expand further keeping wireline margin stable. As a result, the company expects earnings per share to increase in the mid-dingle digit range, leading to further earnings acceleration in the years ahead.

Further, AT&T expects capital spending to be flat year over year at $20 billion while free cash flow in the range of $15-$16 billion. 

The company currently has 300 million shares under its new share repurchase authorization that it expected to be bought back shortly.

Our Take

We believe AT&T will generate strong revenue and earnings growth on the back of healthy iPhone and smartphone sales coupled with growth in tablets and connected devices that will accelerate subscriber gains while reducing churn rate. The launch of 4G LTE networks in September last year, expanding U-verse services, and entry into cloud computing and hotel WiFi businesses are expected to boost the company’s profitability further.

In addition, AT&T was the first wireless carrier to provide mobile social gaming options on its smartphones and tablets, thus differentiating and making it superior from other operators. However, persistent declines in traditional voice access lines, hefty iPhone subsidy, competitive threats from rivals Verizon Communication (VZ - Analyst Report) and Sprint Nextel Corp. (S - Analyst Report) and the loss of iPhone exclusivity in February last year keep us cautious on the stock.

We are currently maintaining our long-term Neutral recommendation on AT&T. The stock retains a Zacks #3 (Hold) Rank for the short term (1-3 months).

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