AT&T Earnings Preview: Margin Focus Amid Heightened Competition

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AT&T (NYSE:T) is scheduled to announce its Q1 2014 results on April 22nd. The second-largest wireless carrier in the U.S. has had a tough time holding onto its postpaid market share in recent years, with Verizon (NYSE:VZ) marketing its lead in LTE coverage to good effect and T-Mobile getting aggressive with its Uncarrier promotions of late. Last year, the carrier managed to hold its own by expanding its LTE network to narrow the coverage gap with Verizon and maintain its lead over the smaller carriers. However, the ongoing price war, ignited by T-Mobile’s aggressive ‘Uncarrier’ moves last year, has seen AT&T respond with promotions and discounts that could impede its service ARPU (average revenue per user) growth this year. With the wireless market maturing and price cuts likely to pressure top-line growth, AT&T is increasingly looking to cut back on subsidies and improve its profit margins.

Our $38 price estimate for AT&T is about in line with the current market price.

See our complete analysis for AT&T stock here

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Impact of Next Plans

While AT&T’s Q1 EBITDA margins are likely to see an improvement over the previous quarter due to the seasonal nature of smartphone demand, it will be interesting to see if the carrier’s decision to lengthen the smartphone upgrade cycle from 20 to 24 months has caused buyers to defer their purchases and shifted some of the subsidy impact to the first quarter. This might pressure margins but the impact could be offset to an extent by the increasing adoption of AT&T’s Next plans, which incentivize buyers to pay the full price of their devices through monthly installments. AT&T and T-Mobile have been more aggressive at pushing financing plans than Verizon and Sprint. But while T-Mobile was the first to launch these plans early last year, AT&T warmed up to the idea only towards the end of the year. As subscribers shift to the new plans, AT&T is likely to see its margins improve further in the coming months.

However, most of the near-term margin improvement will likely be due to an accounting change for Next plans that will recognize a bigger chunk of the device revenues upfront. In the more prevalent subsidy model, AT&T accounts for only the subsidized price of mobile device as revenue. For example, when a carrier subsidizes a $650 iPhone and sells it for $200 with a postpaid contract, it recognizes only $200 as device revenue and takes an upfront hit of $450. Under the new Next plans, AT&T will recognize more of the upfront iPhone cost as immediate revenue since the the buyer will be paying for the device over the duration of the contract period and the device isn’t being ‘subsidized’ in the traditional sense. However, this revenue recognition will not translate into higher cash flows in the near term, as the buyer usually pays nothing upfront and only trades in an old device to avail the Next financing plans. Therefore, while margins might improve a bit, Next could actually pressure AT&T’s cash flows in the near term by tying up working capital in financing installment plans.

However, the longer-term impact is likely to be insignificant since the monthly installments make up for AT&T’s upfront cash outlay. Also, because the subscriber is paying for the device separately, AT&T discounts the service portion of the monthly fees. All this essentially does is unbundle the device costs from service fees, and the long-term economic impact of the traditional and installment plans remains nearly the same.

Price Cuts Offset By Mobile Share Adoption

The introduction of Next was AT&T’s response to increasing competition from a resurgent T-Mobile, which has been aggressively marketing its Uncarrier initiatives and no-contract plans to gain subscribers. In the last two quarters, T-Mobile added 1.52 million postpaid subscribers, about 63% ahead of what AT&T managed during the same period. Moreover, a large chunk of AT&T’s new subscriber additions are coming from tablets and other connected devices rather than smartphones. Last quarter, over 77% of AT&T’s net adds came from branded tablets. Although service plans for these data-only connected devices have higher margins, they generate lower ARPUs than smartphones. Still, given that such connected devices are usually not the primary source of data consumption for most users and are mostly purchased as add-ons to an existing smartphone account, increasing adoption of these devices will help AT&T generate more revenue per account.

However, the impact of increasing data usage on ARPU levels could be offset by the aggressive pricing strategies that AT&T has had to employ to hold on to market share. In recent weeks, T-Mobile has come up with a revised data allocation for its postpaid plans, adding 500MB of data to its lowest two data tiers for the same price. In response, AT&T slashed the price of its 2GB Mobile Share Value plan by $15 to $65, and the price for two lines sharing the data by the same amount to $90. These changes came on the back of price cuts announced on its more expensive family data plans in February. To mitigate the impact of price cuts, AT&T will look to increase adoption of its Mobile Share plans, especially at higher data tiers, through promotions that incentivize purchases of bigger buckets of data to share across multiple devices.

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