With subscriber growth slowing amid increasing saturation in the wireless market, AT&T (NYSE:T) is looking to cut capital expenses by moving its network to a software-defined platform that will use cheap, commoditized hardware instead of high-end branded equipment. The shift could result in savings worth billions of dollars in the coming years and allow AT&T to be more flexible while negotiating wireless transitions to new, more advanced network technologies in the future. The carrier is hoping that the new software-based approach will also help reduce its reliance on a few hardware suppliers in the future as the network infrastructure industry consolidates in the face of stagnating revenues and intense competition. Consequently, the carrier has awarded contracts to smaller companies such as Tail-f Systems AB, Metaswitch Networks Ltd. and Affirmed Networks Inc, in addition to existing partner Ericsson, which has the leading share in the wireless equipment market. It is also looking to partner with other smaller companies and startups whose help it wouldn’t have previously enlisted for projects of this scale.
However, changing the architecture and implementing it across the entire network could take years, and the carrier has therefore not lowered its CapEx estimate of $21 billion for the year. Going forward, it expects the project to put a “downward bias” in its capital expenses over the next five years as increasing use of SDN (software-defined networking) more than offsets the impact of rising data traffic. Our $38 price estimate for AT&T is about 15% ahead of the current market price.
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Slowdown in AT&T’s wireless revenues
AT&T’s move to implement SDN and virtualization functionalities on its network comes amid a slowdown in subscriber growth, driven by a saturated market where wireless connections exceeded the population back in mid-2011. Last quarter, AT&T added only 809,000 subscribers to its total wireless base, about 25% less than the same period in 2012. In the more lucrative postpaid segment, AT&T postpaid net adds of 566,000 last quarter were about 27% fewer than what it added in the prior-year quarter. Apart from a saturated market, rising competition from a resurgent T-Mobile has also contributed to AT&T’s declining postpaid net adds. T-Mobile’s aggressive ‘Uncarrier’ posturing in the wireless market helped it add 1.5 million postpaid net adds in the last two quarters combined – more than 63% ahead of what AT&T managed in the same period.
On the ARPU side, we also expect the carrier to feel the impact of rising T-Mobile competition and slowing growth in smartphone penetration. AT&T’s ARPU for smartphone subscribers is around twice that for non-smartphone ones. However, with its smartphone penetration having reached an all-time high of 77% of its postpaid base at the end of the fourth quarter, the carrier is likely to see its ARPU growth slow in the coming years as its postpaid smartphone mix hits a wall. AT&T’s smartphone penetration increased by only 7 percentage points last year – down from a growth of over 11 percentage points in 2012. Growing competition in the wireless industry, primarily due to T-Mobile’s aggressive moves, is also likely to adversely impact AT&T’s service ARPU. The carrier recently unveiled new Mobile Share Value Plans, which reduce monthly costs per line by about $25 for unsubsidized or off-contract phones, so long as families sign up for 10GB+ service plans. AT&T’s future ARPU growth will also feel the impact of growing adoption of tablets, which usually generate lower ARPUs than smartphones.
SDN to help keep network costs in check
As a result, we expect AT&T’s wireless service revenues to grow at a CAGR of less than 3% through the end of our forecast period, as compared to the growth rate in excess of 8% posted over the last six years. Given that the company has significant operating leverage, a slowdown in revenue growth could have an adverse impact on margins as well as cash flows in the coming years. One of the biggest fixed cost expenses for AT&T is its network spend, which accounted for almost half its EBITDA last year. Consequently, the carrier is looking for ways to control its capital expenses by moving its network to a new SDN architecture that will enable it to make use of off-the-shelf, commodity hardware to reduce costs. Currently, it sources network equipment primarily from big players such as Cisco and Juniper, who sell branded hardware with embedded, proprietary software at high prices.
Increasing the role of software in its network will also help AT&T become quicker and more flexible in adapting to changing technology trends in wireless. AT&T’s relatively late entry into 4G LTE as compared to Verizon saw it lose market share in 2011 and 2012, but the gradual decline in the coverage lag between the two carriers helped it stabilize its share last year. The carrier is therefore wary of any technology transitions that may come up in the future and is preparing its network to quickly adjust to new technologies. The transition to commodity hardware will also make it cheaper for AT&T to add data capacity and support the burgeoning future demand for data, as it looks to push subscribers to the higher tiers of its service plans and increase data ARPU levels.
We currently expect AT&T’s network expenses to drop from about $101 per subscriber in 2013 to the 2010-11 levels of $95 in the long run after the carrier completes its LTE rollout this year. However, if the SDN shift causes the company’s capital expenses to decline further to the historical average of $85 per subscriber, there could be an upside of 5% to our price estimate.