There has been a ton written about AT&T’s recent sale of Warner Media to John Malone’s Discovery communications, but much of the discussion has missed what really drove this transaction.
While there is some acknowledgement that the weakness of AT&T’s balance sheet was a principal driver, the role of management incentives in how they got to this position has not been widely understood.
We would start by emphasizing that we don’t think that the management of AT&T – past or current – have done anything fraudulent or had bad intentions. Rather, they have made decisions that were a combination of their particular corporate situation (owning a massive legacy business with slow or no growth) and the nature of existing compensation structures in the corporate world.
In particular, the Long-Term Incentive Plans at AT&T have been focused on ROIC (Return On Invested Capital). Now, in theory, this is not a terrible thing, but in practice it has led management to make the decision to often buy assets that might be facing challenges but that wre generating high returns – for example, the disastrous Direct TV acquisition.
On top of these poorly structured management incentives, though, AT&T has displayed poor or at least neglectful corporate governance. This is evident in the opacity of the financial disclosures and essentially the ridiculousness of the financial metrics reported by the company – in particular, their measures of “free cash flow.”
The net result was that AT&T had a management team making M&A decisions focused on the optics of the financial metrics, even as those financial metrics were being doctored to further benefit their ability to accomplish incentive goals.
Just like in the cases of General Electric and Tyco International, there will probably be business-school case studies written about this cocktail of financial and corporate governance mismanagement in the future.
Where does all that leave us today?
Well, the injection of US$ 42 billion of cash definitively helps the balance sheet situation. Additionally, AT&T’s decision to cut the dividend by half also gives them more financial flexibility. Finally, getting out of Warner Media at what is essentially what they paid for it has to be considered a win given their overall ineptitude.
All things considered, I give them credit for finally making a decision that is reflective of their reality.
The future, though, remains grim.
The company would like investors to believe that they will grow revenue above GDP. We would point out that this is something they have guided to in 7 of the last 11 years and failed to achieve every time.
The fundamental positioning of their telecom businesses and the acumen and execution (or lack thereof) of management has not changed.
Taking into account their (very necessary) investments into spectrum as well as their (very necessary) investments in FTTH (fibre-to-the-home), we see FCF coming in at around US$ 15 billion in 2023-2025. This is 25% less than the company’s guidance of roughly US$20 billion and also does not penalize them for any changes in tax regime.
Remember this company has paid essentially NO taxes for most of the last decade and has continually kicked the can on this issue.
On the face of it, this puts AT&T carrying about 2.5x net debt/EBITDA, but then again, their financial metrics are garbage. Properly accounting for the full slate of non-debt liabilities would put it at 3.8x net debt/EBITDA.
So ask yourself – what is the proper value for a slow/no growth business with massive capex requirements, huge debt load and competitors with much better capital and network positions?
The stock has consistently traded above a 6% yield, and we think that is where it SHOULD trade. Putting that yield on the new dividend, would see the stock going down at least 30% from current levels. That is our optimistic scenario for the equity.
Ultimately, until management is willing to really disrupt the business (eliminate the dividend and plow all of that cash into debt reduction and capex) we think that AT&T will continue to slowly bleed economic value. And if they do it, that process could take decades.
Bottom line: we would not touch this stock at almost any price, and it continues to be one of our favorite long-term shorts.
Enrique Abeyta is the editor of Empire Financial Research, founder of ecommerce/digital media company Project M and a former hedge fund manager.
