AT&T’s (T – Free Value Line Research Report) planned purchase of T-Mobile USA, owned by Deutsche Telekom, has made huge headlines recently. Size is part of the reason for this: the deal is valued at $25 billion. The other is that the deal considerably narrows the competitive field in the telecom sector. The proposed purchase also reveals much about AT&T’s longer-term strategic push, and in analyzing it one must examine the positives and negatives for AT&T.
The merger would increase AT&T’s subscriber count above that of fellow industry heavyweight Verizon (VZ – Free Value Line Research Report), a competitive advantage. But, perhaps more important, it will also bring additional wireless spectrum. Wireless spectrum is the “invisible” space around all of us that makes cell phone calls possible. It is also the same space that carries things like television and radio. Although there isn’t a short supply of spectrum, there is a short supply of available spectrum due to stringent government regulation.
AT&T felt the impact of a spectrum shortage, at least in major metropolitan areas like New York, after the introduction of the hugely popular iPhone with Apple (AAPL). Indeed, many complained that the phone was great, but the service was spotty, causing frequent “dropped calls.” Verizon, which recently began selling the iPhone, hasn’t had the same quality issues, but also didn’t have the same demand concerns—despite a still formidable customer count of over 90 million cellular users, a figure noted in the Business Description section of the Value Line research report for the company. AT&T’s quality problems have left it at a perceived disadvantage that the addition of T-Mobile wireless spectrum may alleviate.
So much for the deal’s positives. Although the AT&T purchase of T-Mobile may boost its spectrum and subscriber counts, the deal is likely to face material regulatory headwinds and is far from a sure thing. What is highly likely, however, is a long and complicated approval process. This could wind up distracting AT&T’s management team, giving Verizon an opening to chip away at that company’s subscriber count lead through better execution. As well, Verizon has not been hampered by the wireless spectrum issue; as AT&T wrestles with its acquisition Verizon is free to enhance its wireless infrastructure advantage further.
A distracted AT&T also gives Verizon more time to execute on its “everything-as-a-service” cloud strategy. In fact, the company inked a deal to purchase Terremark Worldwide (TMRK) for “just” $1.4 billion, as discussed by Kenneth Nugent in the Analyst Comment. This deal didn’t make as much of a media splash as AT&T’s, but it does offer a glimpse at some big differences between the two strategies of the telecommunications giants.
Clearly both companies have hitched their wagons to cellular technology and the transmission of both voice and data to wireless devices. At present, however, it looks like Verizon is working to integrate itself more into the cloud than AT&T, so that it is an integral service provider not just to end users, but also to those using the cloud to deliver services to those end users. So-called “cloud computing” is essentially the push to move computing functionality and storage to the Internet and off of individual computers and devices. Verizon’s move to enter this space is in line with its efforts to maintain a hold on wireline customers through the FiOS rollout, though some question if that effort has been as successful as Verizon claims.
To some extent, one can say that AT&T is doubling down on its cell operations while Verizon is working to be more involved in the plumbing of the Internet. Is one a better strategy than the other? That’s a tough call to make, but it is clear that Verizon is being more aggressive in some ways than AT&T. So which is the better investment? That’s another tough question.
AT&T and Verizon are numbers one and two in the cellular market, with some suggesting that a Coke (KO – Free Value Line Research Report) versus Pepsi (PEP) relationship is brewing. While AT&T is a larger company by market cap, a comparison that can be made by comparing the Capital Structure boxes of the companies, they are both massive entities. Moreover, they receive similarly high marks for Safety and Financial Strength, two proprietary Value Line measures; one is found in the Ranks box at the top left of each report and the other in the Ratings box at the bottom right. So, they can both be considered large and safe.
Where there is a divergence, however, is in Value Line’s expectations for growth over the next three to five years. Examining the Annual Rates box for each company shows that the respective analysts expect earnings growth at AT&T to be about double that of Verizon, despite slower revenue growth. (Note that the companies’ acquisitions will not be included in Value Line estimates until they have been consummated.)
Interestingly, the broader market has historically afforded Verizon a higher Price-to-Earnings multiple than AT&T, resulting in similar price gain projections for the two companies despite the difference in earnings projections. The respective P/E multiples can be seen in the Top Label section of each company’s report. Currently, Verizon’s P/E is around 16 and AT&T’s is 12. Both are trading in-line with their trailing P/Es. The difference between 16 and 12 is significant; it is the difference between Verizon trading in line with the market’s current P/E and AT&T trading with relative P/E of just 0.75, suggesting a 25% discount to the broader market.
Taking this difference further, as the Projections box displays, the price and total return (which includes both companies’ hefty dividend) outlook for both companies is virtually identical—largely because of the higher P/E historically afforded to Verizon. The company’s perceived lead in cellular over AT&T would seem to explain part of the valuation difference.
This is where the comparison gets interesting. Should AT&T be afforded a higher multiple by the market because of the current deal, Value Line’s total return projections would likely prove conservative. Too, if Verizon, which is already afforded a higher multiple, loses some luster in the market’s eyes, it could trade at a lower multiple.
As it stands today, AT&T’s multiple is expected to expand from 12 to 14 over the three-to-five year period, a 15% increase. Verizon’s multiple, meanwhile, is expect to increase from 15.9 today to 17.5, a 10% increase. (This comparison takes into account the figures from each company’s Top Label and the projections to the right of the row labels in the Statistical Array.) So there is already additional expansion potential for AT&T factored into Value Line’s projections. AT&T’s large purchase is likely to help close the perceived gap between it and Verizon, which would change this dynamic. Moreover, should Verizon’s bold gambit to become more involved in cloud computing falter, like some suggest its fiber to the home FiOS buildout has, its shares could trade lower.
All told, AT&T faces some challenges in the near term, perhaps making Verizon a better choice, but longer term, AT&T’s cheaper valuation may make it a better bet for those seeking three-to-five year capital appreciation.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.