The Bull Case for AT&T

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AT&T just might make for the best stock even though it's not the best telecom company.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe. And the voice you just heard, that's Peter Cipino. He's an analyst at Wolfe Research, and he recently upgraded AT&T, which isn't all that popular on Wall Street, to an outperform rating. We'll hear why. We'll also collect Peter's thoughts on the Peltz proxy fight for Disney. There's a guy named Nelson Peltz. He's known for slashing costs in the cookie business, and he says that Disney is doing it wrong and he can do it better, and he wants a board seat. 2, in fact, and there's a vote coming up. We'll get into it. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

I want to get into AT&T, and I thought I would begin by describing the corporate history. And I opened up an infographic of that and I sent you a link. Do you see it there?

Oh, yeah.

I don't know. I don't know where to begin.

What do you—

how would you describe this thing?

This looks like one of those species, Origin of the Species chart that begins with like the single cell organism at the top and then you have the entire diversity of life on Earth.

It looks to me like, like I like to think that I understand the rules of football. Like, you know, there's, there you got some, some runny guys and there's some catchy guys and there's one throwy guy and you got to, you know, I know, I know some stuff. But then when I go to play Madden Football, the video game, they have diagrams of the formations and I realize I don't really know what's what. There's this documentary on Netflix called Quarterback, and they have a scene there where the various quarterbacks are talking about their play calling. And it sounds like you basically just took a barrel full of words and spilled them out on the floor.

Gun, east right slot stack, run past 3, jet, chip, X cattle, Y lock. F mo to trick, cluster right tuna, scram, X deal, Y cash, cannon to jacks left, Cash H.

Bronze.

Let me break this down as simply as I can. There once was a telephone monopoly in the United States called AT&T, and it was broken up in the 1980s into a group of phone companies called the Baby Bells. Jackson, do you remember the song that reminds us of the name of the Baby Bells?

No clue.

There's Ameritech and Bell, Atlantic Bell, South and IX, Pacific Telesis, and South—

There's no way, right?

There's no— there's not a cell. But if you look at the diagram of the phone companies, basically it gets real fat in the middle with a lot of phone companies, and then it gradually narrows toward the bottom as those phone companies recombine into fewer phone companies. Today's AT&T is the product of one of the former Baby Bells, Southwestern Bell Corporation, or SBC, buying its former parent, AT&T. Basically, we went from a monopoly to a lotsopoly with lots of companies to now an oligopoly with 3 main wireless carriers. There's AT&T, there's Verizon, which was also formed out of one of those baby Bells, and there's T-Mobile, which started as a low-cost insurgent but has done very well. One thing to know about AT&T is that in the past it has shown an antsy-ness to go beyond the phone business, to get into things like show business and satellite dishes on top of houses. We all make mistakes, right, Jackson?

I bought the wrong oat milk this week.

You see that? AT&T's mistakes just cost tens of billions of dollars in shareholder value. It bought DirecTV, which shed a lot of paying TV customers, and then it spun it off 6 years later in what Ars Technica called an awful transaction and timing. It fought the Department of Justice for years to buy Time Warner. Then it spun those assets off 3 years later. AT&T is under new management and hopefully done with financial misadventures for the foreseeable future. These days it's into wireless and wireline service, fiber, broadband, regular phone company stuff. It trades at 7 times free cash flow. There's a 6.5% dividend yield. There's also plenty of debt. And with that, let's switch to my recent conversation with Wolfe Research analyst Peter Cepino. Jackson, you want to make the call using, uh, quarterback lingo?

3T. I got— I gotta listen to these.

Red sauce, red sauce, clams casino, mocha twang, blue 27, electric scooter. So AT&T, cheap stock, gigantic dividend. What's the reason to get excited about it now? What's the reason why the stock is going to begin behaving, do you think?

Telecom is a saturated industry. Everybody who needs a cell phone has one. There's a little bit of subscriber growth from kids getting phones at younger ages and businesses adding second lines, subsidizing lines for employees. And there's population growth in the United States, and actually it's higher than the reported figures because of immigration. But ultimately, volume growth isn't why you'd ever buy a telecom stock. And the reason to own telecom is cash flow. If you look at telecom markets around the world, the primary driver of cash flow is pricing. There's a given level of asset and cost you have to have to be in the telecom business, and the more you can charge for that commodity, the higher your profits are going to be. The number one variable when you look at a global sample of telecom markets, higher margins, higher prices usually corresponds to fewer competitors. So what I'm getting at is the number of competitors in the market determines how much you can charge, and how much you can charge determines how high your margins are. In the United States, the level of telecom stock prices suggests that there's a problem with competition. What's happening in the real world looks much more conservative and quite profitable. There are 3 networks like you alluded to: T-Mobile, AT&T, and Verizon. There used to be 4. The government let T-Mobile and Sprint combine. And If that were the only thing that had changed in the last 4 years in the telecom business, I think life would be great because going from 4 to 3 was a really good thing for the incumbent competitors. So today T-Mobile, which is twice as big as it was 5 years ago and experiencing growth slowdown that comes with being bigger, is behaving much more like an incumbent. And the big 3 are acting like an oligopoly.

How does this manifest itself if you're a customer? I got a new phone. Like 3 years before the last one that came out in the fall. And when I got that phone, the deals were like— I switched carriers because it's like there was a carrier out there, it felt like they were handing me a suitcase full of cash. They were basically saying, we'll do anything to bring you in as a customer. Then I went around for a new phone this past fall when the new models came out, and it wasn't such easy pickings this time. Like, there were deals. I switched to it I switched carriers again. I mean, there was a deal, but it wasn't like a giveaway like a few years ago. Is that the way you would see it as a consumer, the little bit stingier subsidies on the phones, or how would you see it?

I agree with your characterization, and maybe what you experienced is that right after the Sprint and T-Mobile merger, AT&T set off a round of heavy, heavy promotions for new subs. And the reason we think that they did it is because they saw a one-time opportunity to attract Sprint subscribers before T-Mobile locked them all down in new contracts and improved the network and, and reduced the churn rate of that Sprint portfolio. There's still big promotions to be had, and the ones you see in the window are usually pretty splashy, but these companies reduce the value of those promotions with the fine print, and they've been tightening up the fine print for the last couple of years. Issues like trade-in requirements, and also they make you subscribe to a premium plan to get the big promotion, which works out well for their lifetime revenues from your account.

So there's anything but a price war that suggests that everyone ought to be enjoying a period of pretty good profits right now. Is AT&T the most attractive one of the bunch for a stock investor, or have you just decided that it's more attractive than it was?

AT&T just might make for the best stock even though it's not the best telecom company. T-Mobile has, as you alluded to earlier, had the best results in the industry for a decade. They've grown from being perceived as a quasi-prepaid urban option that was inferior on every basis except price to competing with AT&T and Verizon on quality and continuing to grow because they do so. They offer lower prices and peer quality. If T-Mobile stands for improving network and lowest price and Verizon stands for best network at the highest price, AT&T seems to stand for maybe I'll get a free phone and otherwise somewhere in between the two. But that's not the only variable that matters. With AT&T, they have the highest debt in the industry. And like Verizon, their CapEx, the money that they spend below the line on the cash flow statement to build network capacity, antennas, computers, spectrum, that number is falling. Year to year because AT&T and Verizon and T-Mobile in different ways spent in aggregate almost $300 billion to upgrade their networks for the 5G cycle. And AT&T is exiting that investment phase as is Verizon with CapEx going down, the free cash flow after everything that's available to pay back debt or pay dividends is going up. And so with AT&T having the most debt and the most leverage to the financial dynamic I just described, it just might be the best stock even though it's the best telco.

The dividend yield is gigantic. Sometimes when you see a big yield, that reflects investors' concern that the company might not continue to make those payments. What do you think of when you look at AT&T's dividend and what you expect its cash flows to be in the years ahead? Is this a slam dunk? You think that dividend is rock solid safe?

I do think that dividend is rock solid safe. So to give you some numbers, the company has guided to just over $17 billion of free cash flow for 2024. And so the way we see the cash flow is $10 billion of total dividend commitments, including the preferred and the common against $17+ of 2024 free cash flow and over $18 of 2025 free cash flow. And that 60-something percent payout ratio, it leaves them a lot of scope to deal with business volatility.

We've talked about the phone service and the investments in the phone network, but there is more going on here than just the phone service. You mentioned fiber. What's, what's to like there? What should investors know about the fiber business?

The fiber business is a real growth business within AT&T. It's growing for two reasons. One, because they extend their footprint. Today, they pass about 25 million homes and businesses. They extend that footprint by over 2 million locations per year. And when they show up in a new neighborhood, they usually get about 25% of the customers in the first year. The second reason that fiber business is growing is because more consumers in our Wolfe Research consumer telecom surveys, about two-thirds of consumers think that fiber is better. And that business is hidden within a reporting segment at AT&T called Consumer Wireline. And the reason I flag this is because the Consumer Wireline's profit margin is about 30, and businesses that are pure-play home broadband businesses tend to have EBITDA margins over 50. The reason the Consumer Wireline segment at AT&T has such low margins is because there's an unprofitable copper telephone business lumped into the same segment. And we think that over the next 3 years, the company will shut down a significant portion of those networks and the margins in the segment and the growth of the segment will look much more like the fiber story we just told you instead of the encumbered blend of fiber and legacy networks that they're reporting today.

What about this business that Verizon has? It's a fixed wireless broadband to the home. One or all of those words might describe it, but it's basically a box where you get a a 5G phone signal and that's your broadband service. I, you know, I understand they're selling that. How do you think that's doing for Verizon? Is that a threat to AT&T on its broadband service at all?

Fixed wireless access or fixed wireless broadband to the home, which was a perfectly fine way to describe it, is red hot. Consumers like it because it provides perfectly adequate service. It's an easy 5-minute installation. You just put a 12-inch square box on your windowsill, plug it into an electrical outlet, download an app, and answer a few questions. And suddenly that little box is sending a Wi-Fi signal all around your house and giving you broadband service, 200 to 500 megabits per second, that looks a lot like mid-speeds offered by cable and fiber providers. So it's a very, very tough competitor that has been gobbling up almost the entire number of net additions to the broadband market annually. And yet telecom or wireless networks have limited capacity. They feel like they should have infinite capacity because they're wireless, they're unbounded, they're ethereal. But actually wireless networks transmit bits through the air in channels of radio frequency, which are finite in nature. They're legally defined by the government and the telcos license these channels that have limited size. And so the pipe itself is physically constrained and those airways lead to towers and antennas. That are also physically limited. And so as much capacity has been created by this 5G upgrade cycle, which we talked about earlier in relation to AT&T and how much CapEx they have spent, how their CapEx is going to go down, the additional benefit of all that spending for the telcos is they have more capacity in their wireless networks today than they need. And selling home broadband is a really good way for them to use excess capacity that they otherwise wouldn't sell and generate more revenue for it, get more sales for it. When the wireless networks become busy over the next several years, those networks are gonna face harder choices about how they allocate their capacity. And those fixed wireless connections, like the ones you asked about at Verizon, and AT&T has the business too, T-Mobile does, those are all gonna be network hogs that the telcos have to look at again and decide whether they wanna be allocating what will someday be scarce capacity to that business that generates much, much less, about 1/30th of the revenue for every gigabyte or, or unit of data that goes through the networks.

Interesting. Okay, so to put a bow on the case for AT&T, what will be the thing that gets the stock working? In other words, what will investors— what will be the catalyst? I buy the stock, I'm going to be pleasantly surprised that they keep making my dividend payments. I'm going to see some robust free cash flow, and that's going to be, you know, stable, rising. And so I'm going to say, you know, maybe this stock is too cheap. Is that it? It'll just take time for investors to come around to the view that AT&T is shifting higher in profitability and is stronger and more stable? Is it that they'll pay down debt and that will unlock a higher stock value? What's going to happen from here?

In the next year, we expect AT&T to pay down about $7 billion of debt and the EBITDA ought to grow by several billion dollars. Anyway, AT&T can hold its multiple debt's going to fall, CapEx is going to fall, and the equity almost can't help but go up if those things happen because the starting multiple is so low. As the debt goes down and the free cash flow goes up, the equity just naturally rises in its place. So that's kind of the base case for AT&T. Where it gets more exciting is if investors start to embrace this argument that I've made today, that telecom pricing is actually gently positive and the cost of getting subs is stable. If investors get more comfortable that this industry continues to behave like a mature, orderly, profit-seeking oligopoly, these multiples could expand a lot because these double-digit free cash flow yields, which is the sum of the dividend plus the money that's available for paying down debt or buying back stock, they have no peer in the S&P 500. The average stock in the S&P trades for a 5% free cash flow yield.

Thank you, Peter. Peter has a price target of $21 on AT&T stock, and it was recently trading at just under $17. That works out to upside of 23%, 24%. You add the dividend, that's about a 30% total return that he foresees. In a moment, we'll come back to Peter on the subject of Disney and its activist investor. That's next after this quick break.

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Welcome back, Jackson. I've got a question for you, and I'm going to tell you up front, it's a toughie. Who is Ludwig von Drake?

I'm getting maybe there was a Snow White and the Seven Dwarves spinoff and this is some sort of antagonist.

Your answer is cartoony. And so that makes it partially right. But other than that, you're not even close. Ludwig von Drake is a cartoon duck. He is the uncle of Donald Duck. If you're wondering why Donald isn't also named von Drake, Disney has a backstory for that. Apparently Ludwig is Donald Duck's father's brother, and Donald decided to adopt his maternal surname, Duck, when he got into show business. That's according to Disney. Why do I mention Ludwig? Professor Ludwig, really. He has a lot of advanced degrees. It's because there's an upcoming shareholder meeting at Disney, and there's a fight for a couple of the company's board seats. And Disney is fighting back on two tracks. One of those tracks is cheerful. It has enlisted the help of Professor Von Drake, who I must say does not get a lot of face time with the audience. He explains in print and video materials how to vote the Disney way.

Professor Ludwig, why don't you tell our shareholders how they can vote? Yes, yes.

Today we're going to use the Von Drake method.

The other track is that this past week it released a 67-page investor slide deck that blasted many of the claims made by activist investor Nelson Peltz in his own earlier 133-page presentation. I should explain. Nelson Peltz is co-founder of an investment company called Trian Fund Management, and he's an activist investor, which means he takes stakes in companies and then he argues for change. Some of his current and former targets include Unilever, Mondelez, Procter Gamble, PepsiCo, Wendy's, Heinz, DuPont, and Comcast. These closing arguments in the Peltz-Disney fight are the subject of a story I wrote this past week in Barron's magazine, and I'm not going to go through all of its points here. Suffice it to say that Peltz argues that Disney should have been better positioned than other media companies in the shift to streaming because it makes all of that money in theme parks. But he says that Disney has been slow to move. In particular, he says the company has not articulated a clear digital plan for its ESPN Sports assets. He says that Disney squandered money on its big acquisition of Fox assets. He says Disney's board has failed in its oversight role, that it has allowed Disney CEO Bob Iger to make too much money. Above all, he says that Disney's stock returns have stunk and that his own record when he gets on the board of companies has been one of outperformance on behalf of shareholders. Now Disney has thoughts on this. I'll tell you up front that I reached out for comment from both Nelson Peltz and Bob Iger Trian and Disney declined to make them available. Disney says that it has cut costs, that it's unlocking more free cash flow, and that shares are responding. The shares, in fact, have underperformed over the past 10 years, but over the past 6 months, they have solidly outperformed the U.S. stock market. Peltz says that's because of his arrival. Disney says if you look at the stock's reaction to news of Peltz's stake in the company, it was kind of muted compared to the big one-day jumps after Disney's past two quarterly financial reports. In other words, investors like what they're seeing from Disney results. That's its argument. Disney says that some of Tryan's suggestions it's already following, some of them are vague, and some of them it calls inane. I'll give you two quick examples that Disney cites. One, Peltz says he wants a board review. Of Disney's creative efforts with himself, of course, on the board. Think about that for a moment. Imagine sought-after showmakers. Here comes this octogenarian investor best known for slashing costs in the packaged food business. And he says, all right, let me tell you all about what audiences really want to see. You can imagine that those creative people basically polishing their resumes. One of the other ones has to do with the digital strategy for ESPN. Peltz said in a slide deck, basically either scrap it and keep managing ESPN, the legacy cable business, for cash, which would seem to be at odds with this recent acceleration in declines for cable subscriptions. Or he says you should consider bundling it with a partner like Netflix. Think of that for a moment. Disney takes its cash cow ESPN and shares the economics with its chief rival Netflix. Thereby missing out on some of the digital money and accelerating the decline of the legacy business. The title of Peltz's presentation is Restore the Magic. I'm not feeling the magic on that one. Now, a lot of the stuff is fair. Disney says it wants to find $7.5 billion of cost cuts. Tryan basically says, how does a company get in the position of being able to find that much in cost cuts? It's a good question. Tryant also says that Disney's board has botched its efforts to find a successor for Iger. That seems pretty clear based on how his replacement lasted about 5 minutes and Iger is back. Two last things I want to note. There is some pretty stark disagreement about Nelson Peltz's past investment success. Peltz says he has a winning record in cases where his portfolio companies have given him a board seat. Disney says that in cases where Peltz has served on the board, the median company has sharply underperformed the market. How could both be right? Well, there are a lot of different ways to measure returns for activists. You have different starting points, different ending points, average versus median, and a lot of nitty-gritty details. I have argued that activist investors as a class have had iffy investment success. That was the subject of a past episode in this podcast. I think it was titled Activist Schmacktivists, right, Jackson?

Exactly.

Yeah.

And the last thing is that Disney says that Peltz and his partners have basically reason for sour grapes. It says it fired Tryant as a pension manager in 2021, citing poor returns. That's Nelson's grapes. Now, most of the shares that Tryant controls belong to a person named Isaac Perlmutter, who sold Marvel to Disney. Disney says that Perlmutter was sidelined from oversight of Marvel while at Disney over clashes he had with creative folks. He was let go last year amid cost cutting. That's Perlmutter's grapes. There's a third fellow named Jay Rasulo. He was once chief financial officer at Disney. He quit after being passed over for the job of chief operating officer. He's the one that Peltz wants to serve with him on the board. That's Rasulo's grapes. And so the implication here is that there's more motivating Triad than just profit. That's Disney's argument anyhow. Peter Cepino at Wolfe Research, who we heard from just a moment ago about AT&T, also covers Disney. I asked him about the board fight.

Peltz's presence in the Disney stock showed up sometime late in 2022, and it was evident from the beginning that Peltz was focused on profitability and accountability over everything else. The company's on a much better path in this regard, and I give Peltz a lot of credit for that. And I give Iger a lot of credit for that because he's shown he's willing to change. And one of the hardest things to do when you're a very successful executive is to change. And the great ones do, they evolve. And so Disney today is in a much better position. I give Peltz some credit for that and Iger tons of credit for that. And I, I think that at this point, uh, the, the triad slate— Nelson Peltz and Jay Rasulo— stands a really low chance of, of getting elected, but not because their ideas did not have merit, more because many of those ideas have been put in motion. Um, and what has to happen from here is the company's creative engine needs to start turning in ways that it hasn't, and then it needs to continue to be accountable and responsible for, for profitability.

And from what show business people have explained to me about creative engines and, and the moviemaking and that sort of thing. It just seems like you need 3 years to see the results of anything. I mean, people have to make decisions on funding, people need to do the shooting and the acting and the editing and so forth, and it just, it takes so long before something comes out the other end. I mean, you could do some cost cutting now and see immediate results from that, but in terms of better hit-making, if you will, is that a years-long process?

I agree with you that it's a multi-year process, and the 2024 output from the studio really won't tell us what's ahead. Much of it was decided and funded and put in motion before Iger's return. And of course, Iger's return didn't— shouldn't have immediately changed the course of the creative engine. It is something that involves, you know, tens of thousands of people and, and long multi-year development cycles. And so while there are reasons to be optimistic about the '24 movie slate because it includes Deadpool and Moana, which are two franchises that really are not tired. So much of the Marvel and Star Wars portfolio at this point has been run kind of hard and not hung up wet, but run pretty hard and looks tired, that it'd be concerning if there was more of that in the '24 slate. But with things like Moana and Deadpool, they've got a good chance of having a couple of big ones this year. Still, that won't tell us about what's ahead because of the multi-year planning cycles that you alluded to. And really, Peltz for all of his insights and power as a leader in boardrooms, doesn't have or even claim any credibility in thinking about creative and managing creative organizations. He's, he's a brand guy and an efficiency guy.

I don't know what the overlap is between the Deadpool audience and the Moana audience, but I think I'm pretty sure I'll see both. The television business and specifically ESPN, is Disney doing the best things that it can do with that business, do you think? And is it a case where, hey, ESPN was so profitable during the golden era of cable that you just can't hope to sustain that or match that, but you gotta do the best you can? Or do you think it's a case where, you know, maybe they can make a go of this thing and by doing different things, maybe involving, you know, betting and stuff you can add to that business, maybe they can get back to or sustain that, that peak level of profitability for ESPN. What do you think about the future of that business?

It'll be exceedingly hard and it's probably too much to hope that ESPN of the future is as profitable as ESPN was in the past. However, the other, the other thing we believe is that ESPN continues to bring enough value to the market that it should have a profitable business. We did a survey of consumers about 9 months ago and asked them if there were no linear TV at all, How many of you would pay for an ESPN direct-to-consumer streaming service? And we listed off a bunch of price points. I think we started at $20 and went up to $40 or something like that. Every $5, we said, would you pay this? Would you pay this? And an interesting number is that 40% of the panel said they'd pay $25 a month for ESPN. 40% of the country is 40 times 130 million households. It's a big number. And so that's an interesting starting point for revenue. And then, of course, everybody's going to watch advertising on ESPN. And so we think extrapolating that survey that it's easy or realistic to think about a number of subs at an ARPU or revenue per month of about $40 comprised of $25 of subscription revenue, $15 of ad revenue that multiplied by 30 or 40 million homes gets you to $12 to $15 billion of revenue, which is about the neighborhood ESPN exists in today. So I think I've just built what looks like a really successful future for ESPN. And then I'll get to the problem, which is a lot of those subscribers who say they'll pay will sign up for football season and cancel for the other 6 months. And so 40 million subs, the number I proposed, might average out to be more like 30 when you factor in churn, cancellation, etc. And that's, that's where the pinch in the profit margins might come from is the churn rate. And that's really a problem that's endemic to streaming.

Is there, can I, are you, you have a positive rating on Disney?

We call it our favorite neutral. We have a neutral rating on it because we think that the Disney, the virtuous cycle, the Disney flywheel, so to speak, that starts with the creative is still something we're really unconvinced about. And the stock price has run up ahead of that fundamental, but the cost cutting is real. And we've been believers in that opportunity for quite a while now.

Thank you, Peter. And thank all of you for listening. Jackson Cantrell is our producer. Jackson, What I'm confused by really on the whole, um, Ludwig von Drake matter is, uh, is where Huey, Dewey, and Louie fit into things. You know the little guys, Huey, Dewey, and Louie? Yeah, they're the nephews of Donald Duck, and I know they're the grandnephews of Scrooge McDuck, but where does that put them in relation to Ludwig? He shows up with them sometimes. Yeah, this is more complicated than that AT&T diagram we talked about at the top of this episode. Part of me feels like I need to get to the bottom of this and And part of me feels like that's one of those things that's not a really efficient use of my time.

Multipart podcast series.

I'll let you know which way it shakes out. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple, we would love for you to write us a review, probably. Thanks and see you next week.

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