AT&T Earnings Preview: Next Program, Margins In Focus

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AT&T (NYSE:T) is scheduled to announce its Q3 2014 results on Wednesday, October 22. The carrier reported a mixed set of results last quarter, with overall revenues growing just 1.6% year-over-year (y-o-y) and EBITDA margins remaining flat at 42.6%, owing to the transition to no-subsidy plans, which shift revenue recognition from service to equipment (handsets), and a higher proportion of bring-your-own-device (BYOD) gross adds. The country’s second largest wireless carrier added over 1 million postpaid subscribers during the second quarter, its strongest gain in nearly five years and almost double the figure from a year ago. The carrier’s strategy to combat T-Mobile’s ‘Uncarrier’ initiatives with equipment financing plans of its own worked well, as Next accounted for 50% of its postpaid smartphone gross adds and upgrades in Q2 – up from 40% in Q1 and 15% in Q4 2013. ((Q2 2014 Presentation, AT&T))

When the company announces its third quarter earnings, we expect revenues to grow in the low-to-mid single digits, owing to robust wireless postpaid subscriber adds, low churn, an expanding U-verse user base and its continued focus on margins. In a recent press release, the carrier said that it expects third quarter churn to remain under 1% and take rates of its Next plan to remain around Q2 levels of 50%. This is significantly higher than the 18% take rates of Verizon’s Edge plan in the second quarter. AT&T also expects about 58% of its total postpaid user base to be on its Mobile Share Value plans in the third quarter. Growing acceptance of the carrier’s Next program as well as its Mobile Share Value shared data plans is likely to aid robust growth in the carrier’s postpaid user adds in the quarter. [1]

We have a $38 price estimate for AT&T, which is about 10% ahead of the current market price.

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See our complete analysis for AT&T here

How Next Plans Impact Margins

AT&T’s Next plans are significantly different from the traditional U.S. postpaid schemes whereby subscribers get subsidized smartphones in exchange for signing a two-year contract. Under the Next program, much like T-Mobile’s Uncarrier and Verizon‘s (NYSE:VZ) Edge programs, a customer can choose to get a new smartphone every 12-18 months at minimal upfront costs and discounted monthly installments. The convenient monthly installments incentivize buyers to pay the full price of their devices, helping AT&T cut its subsidy expenses.

While T-Mobile was the first to launch these plans in early 2013, AT&T warmed up to the idea towards the end of the year. Owing to the growing user preference for no-contract plans, AT&T’s service EBITDA margins improved 220 basis points to 45.4% in the first quarter of this year. With the company expecting 50% of its total postpaid users to be on no-device-subsidy plans by the end of Q3, compared to 25% in Q1, its margins are likely to 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 up front. 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 buyers will be paying for the devices over the duration of the contracts, and the devices aren’t being ‘subsidized’ in the traditional sense. However, this revenue recognition will not translate into higher cash flows in the near term, as buyers usually pay nothing upfront and only trade in old devices 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.

Impact of Pricing Strategies on ARPU, iPhone 6 sales

In the first six months of this year, over 50% of AT&T’s net adds came from connected devices (other than smartphones). Although service plans for these data-only connected devices have higher margins, they generate lower ARPU (average revenue per user) 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 should 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.

Before the launch of the iPhone 6 last month, AT&T announced its iPhone trade-in deal, which offered a credit of up to $300 for old devices. Considering that AT&T has a larger base of iPhone customers on account of its initial exclusive deal with Apple in 2007, the carrier was bound to benefit from a trade-in deal. Unsurprisingly, AT&T registered record iPhone 6 pre-orders. It will be interesting to see how many units of the new iPhone model were sold by the carrier considering that it faced intense competition from all major carriers- Sprint (NYSE:S), T-Mobile as well as Verizon. Since the no-subsidy plans are rapidly gaining traction with customers, the iPhone 6 sales might actually provide a boost to AT&T’s earnings unlike earlier times, when subsidies had a significant negative impact.

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Notes:
  1. AT&T SEC Filing, Sept 30 2014 []