AT&T Inc (T) — Q4 2015 Earnings Call Transcript

Thank you. Good afternoon, everybody. Welcome to our fourth quarter conference call. It's great to have all of you with us. Joining me on the call today is Randall Stephenson, AT&T's Chairman and Chief Executive Officer, and John Stephens, AT&T's Chief Financial Officer. Randall will provide some opening comments and then he'll close with 2016 guidance. John will cover our results and we'll follow all of that up with a Q&A session. Let me remind you, our earnings material is available on the Investor Relations page of the AT&T website. That's att.com/investor.relations. Before we begin, I need to call your attention to our Safe Harbor statement. Some of our comments today may be forward-looking and as such they are subject to risks and uncertainties. Results may differ materially and additional information is available on the Investor Relations page of AT&T's website. So with that, I'll turn the call over to AT&T's Chief Executive Officer, Randall Stephenson.

Thanks, Mike, and good afternoon, everybody. Before John steps you through the results, I want to take just a couple of minutes to reiterate the strategy we are pursuing to be the premier integrated communications company in the world. This is a strategy that we are pursuing in every single market segment, from our largest multinational customers to the most price-sensitive consumer. Looking at 2015, it was an eventful year where we've put together a lot of the pieces required to fulfill this objective. Primarily, we closed on the DIRECTV acquisition, and we secured a very deep spectrum footprint in the government auction, which is providing us network capacity for our TV Everywhere plans. We also acquired two Mexican wireless companies with extensive spectrum holdings and distribution, giving us access to one of the best emerging market economies in the world. We financed the DIRECTV and spectrum purchases at very attractive rates, exited 2015 with a strong balance sheet, and our dividend coverage has returned to a level consistent with our historic norm. Our strategy's core involves getting the basic connectivity element right, as becoming an integrated solution provider requires world-class, high-speed, secure connectivity. It can't be just wireless or broadband alone but involves all connectivity types integrated together. For example, DIRECTV is accelerating our introduction of next-generation TV. Our content agreements combined with our networks create a powerful synergy. Recently, we launched a nationwide solution that combines our TV entertainment packages with unlimited mobile data, allowing customers to stream video without incurring overage charges. This is just the beginning; the customer experience will only improve as we progress through 2016. Additionally, we launched a number of integrated solutions for businesses, such as our Network on Demand service which lets customers adjust their bandwidth as needed. We're seeing strong performance in Internet phone services, providing secure access to data from mobile devices over VPN to major cloud providers. The foundation of all this is our network, which now covers 355 million people and businesses in North America with plans to reach 385 million by year's end. We're building out our GigaPower footprint, now delivering speeds up to 1 gig to over 1 million customer locations. We're expanding our fiber network to more businesses and believe we possess the industry's most comprehensive capabilities. Competing in today's market requires global solutions aligned with our multinational customer base. We connect 3.5 million businesses, including nearly all Fortune 1000 companies, across almost 200 countries. We've extended our wireless network into Mexico, and our growth there is exceeding expectations. Moreover, we built on our global leadership in the Internet of Things (IoT), where our solutions are not limited to the U.S. We've set up over 26 million devices on our network, emerging as a leader in Connected Cars with recent deals to connect 10 million vehicles with Ford. We're also making significant investments in network architecture, driving down service costs through software-defined networks. We're on track to achieve at least $2.5 billion annually in DIRECTV-related synergies by 2018 and invested $18 billion in spectrum auctions. This deep spectrum footprint significantly lowers our network operation costs. Looking ahead, we believe software-defined networks and DIRECTV synergies will provide an industry-leading cost structure, allowing us to move the most traffic at the lowest cost per bit. Presently, we consider ourselves without peer as we have a nationwide TV and wireless footprint. Our IP broadband footprint reaches nearly 60 million customer locations. We have end-to-end capabilities, world-class distribution, and a highly respected brand. Despite all these transformative moves, we executed well in 2015. As you can see in our reports, adjusted EPS growth was strong, cash flows were up, margins expanded, and consolidated revenue growth was in line. We ended 2015 with 137 million mobility subscribers, 45 million video subscribers, and 13 million IP broadband customers. Our LTE network covers 355 million people, showing positive growth across key product categories. In summary, our strategy is working, and we have the necessary capabilities to continue executing it. I'll now hand it over to John, who will provide more information on our financials, and I’ll return later for a full-year outlook for 2016.

Thanks, Randall, and hello everyone. It's great to have you on the call. Let's look at our financial summary. We finished the year strong with double-digit growth in consolidated revenues, adjusted earnings, and free cash flow, while we continued to see margin expansion across all domestic business segments. In the fourth quarter, reported EPS was $0.65, while adjusted EPS was $0.63, reflecting a more than 12% increase from last year’s fourth quarter, which includes adjustments for merger and integration costs and annual mark-to-market changes to our benefit plans. This strong growth persists despite earnings pressure from our Mexico wireless operations and delays in video revenue recognition. Consolidated revenues grew to $42.1 billion, up over 22% year-over-year, largely due to the DIRECTV acquisition, even amidst lower equipment sales as customers opted to keep their smartphones longer. We adjusted DIRECTV's revenue recognition for new customer promotional offers to align it with AT&T's practices, leading to a $300 million reduction in booked revenues during the quarter and a subsequent impact on income, margin, and EPS by $0.03. Cash flows present a great story: free cash flow exceeded $3 billion in the quarter and nearly $16 billion for the year, resulting in a free cash flow dividend coverage of about 64%. Now let's delve into our operational highlights, starting with Business Solutions. The most notable news in this segment is our significant margin improvement, with EBITDA margins increasing by 360 basis points year-over-year as cost efficiencies outpaced declines in equipment revenue. While equipment sales decreased because fewer handsets and less wireline CPE were sold, higher-margin service revenues were largely flat, reflecting growth in strategic services that mitigated legacy declines. Our wireline data revenues are stabilizing, now comprising nearly 60% of wireline business revenues, with advanced product growth matching declines in legacy services. In 2015 alone, we signed more than 300 new Internet of Things business agreements, maintaining our leadership in IoT. We've partnered with Ford and BMW to advance our Connected Car initiatives, reflecting our position within this industry. Our investments in network infrastructure provide us with a significant advantage in cost, enabling expansions into emerging markets and creating a comprehensive offering. We're confident in our ability to generate value while navigating a challenging economic landscape. Now, let's transfer to our Entertainment Group results. This quarter shows the benefits of integrating DIRECTV, with revenues more than doubling year-over-year. U-verse revenues also exhibited solid growth. We observed exceptional margin expansion driven by the merger's synergies, achieving over 22% EBITDA margins, an increase of 800 basis points from the previous year. We're delighted with the growth since integrating satellite and mobility, indicated by a strong performance in subscriber acquisition. Our marketing is now focused on enhancing satellite growth while bundling broadband services. Sales have surged, reflecting the demand for combined offerings. The introduction of our unlimited wireless data plan for combined wireless and TV customers has already attracted over half a million sign-ups. These unique offers and integration strategies foster stronger customer relationships, ultimately improving subscriber retention rates. Additionally, we are establishing leadership in delivering online video and enhancing customer experiences across platforms. Moving to our U.S. Mobility results, I want to highlight the solid operational performance in overall net additions, as we added 2.2 million new subscribers across customer segments during the fourth quarter. This marks the third consecutive quarter with net additions exceeding 2 million, demonstrating our focus on branded customers, particularly through Cricket, which has energized our prepaid space. We added more prepaid subscribers than any other carrier in 2015, and Cricket churn rates have remained low. Our investment strategy remains robust, optimizing resource allocation between wireless and wireline operations. Thus, we anticipate strong performance while focusing on long-term growth. Now I'll turn it back to Randall to discuss our outlook for 2016.

Okay. Thank you, John. Last summer, we provided long-term guidance after closing the DIRECTV deal, and it hasn’t changed. For 2016, expect double-digit consolidated revenue growth, adjusted EPS growth in the mid-single-digit range or better, stable margins across segments, and a capital spending plan around $22 billion, emphasizing cost efficiencies through software-defined networking. We aim for a free cash flow dividend payout ratio in the 70s and intend to grow free cash flow this year. In conclusion, we’ve built a strong foundation for growth, and we appreciate your participation. Now we’ll move to the Q&A session, and I would like to turn it over to Tony.

John, maybe just a comment on the service revenue in overall wireless should be lapping the big mobile share value push last year. Just trying to get a sense for the trajectory on the year-over-year decline. It looks like it continues to get better. I'm assuming we should expect that throughout the year. And then secondly on the Entertainment segment, I guess looking at sequential margins versus year-over-year, it looks flatter sequentially but there was the impact of the revenue recognition change. Just trying to get a sense for what we should be thinking about with margin trajectory there, particularly as you go in there and get more wireless rights for content and maybe where those content costs flow through the model?

Let me give you a couple of insights there. For service revenues in wireless, we have to wait for 2016, but we expect to improve year-over-year trends as we see demand optimism increasing. On Entertainment margins, the $300 million revenue deferral did affect margins this quarter. Margins would have been a couple points higher without that recognition. We also anticipate merger synergy savings integrating into margins this year, with expectations of seeing $1.5 billion in run rate savings by year-end starting to come through in the Entertainment Group.

John, just as you sort of progress on getting more mobile rights for content, how should we think about where those incremental costs for the rights should flow through, is it entertainment or is it on the mobility side?

We expect it to flow through in the Entertainment Group.

Can you remind us, John, what the deferral is and will that impact revenue any further or is this the most you'll need to defer? And then second, Randall, since 2009 you've been known as a bit of an economic savant. Can you give us an idea of what you're seeing from your customers in the U.S., both consumer and enterprise, and do you see any signs of economic weakness?

On the revenue deferral, this was based on one of our major contracts where a customer signed a two-year agreement. Previously, we had recognized revenue equally over each month of the contract. We now align our recognition to reflect amounts billed over time. That $300 million is not lost revenue; it’s just deferred and does not change cash collection. We report expenses consistently; no deferral for expenses.

And that’s mostly only going to impact 4Q, right?

There will be some further impacts throughout next year, but by next year, the pieces will offset each other.

You're economic savant; I’ve never been called that. But we are seeing softness in enterprise among those linked to the oil and gas industry. Companies are defensive. We also see weakness in exporters with exposure to foreign currencies, particularly with a strong dollar. Despite that, revenues on the business side have held steady as we are capturing share with NetBond and Network on Demand. The consumer continues to spend. The holiday season was decent amid competition, but spending has remained consistent. I anticipated a more robust Christmas season due to low energy prices; however, spending did not spike as expected. Looking to 2016, we've built our plan around a 2% GDP growth rate in the U.S. While this has been common historically, I am cautiously optimistic about potential downside risks, given prior consumer benefits may not persist.

The first question I wanted to ask was around your strategy in the mobile area. As you noted, Randall, during the prepared remarks, you unveiled your plans integrating mobile and video solutions. How should we think about your go-to-market strategy going forward? It seems like you're not as promotional as some competitors, and I would love to hear your thoughts as we progress through 2016.

We closed DIRECTV on July 24, implementing plans for initial integration. We incorporated TV capabilities in our retail stores, resulting in positive lift as mentioned in John's remarks. In January, we introduced the unlimited data plan for TV subscribers. Expect ongoing integration to enhance customer experiences throughout 2016. While I won't detail specifics now, we're securing critical content deals and will roll out unique offerings soon. It will be an eventful year as we present new capabilities and programming options for mobile devices.

Thank you. If I can switch gears to the video side, you note continued benefits from the integration. Are you rolling out more converged offerings with broadband and video, and how should we perceive those opportunities?

We are in the early stages, and sales channels are starting to improve selling satellite alongside mobility. Installation operations are ramping up following recent agreements. Subscriber numbers should improve as we progress. The strong satellite additions in Q4 reflect ongoing efforts to shore up the U-verse base, addressing churn through pricing adjustments. We're optimistic about churn rates improving as we enhance subscriber engagements through unique data offers.

John, a question on cash flow outlook for this year. You provided insights regarding revenue, EBITDA, and CapEx impacts. I am curious if deferred CapEx related to Mexico is included in guidance, and any updates on cash taxes with bonus depreciation?

Deferred payments in Mexico have been planned; they are included in guidance. Regarding bonus depreciation, we incorporated assumptions in our guidance. Yet, we would maintain this guidance even if it hadn’t been extended. The ballooning benefits from bonus depreciation are mostly offset by reversals of prior benefits.

Just to confirm, this year’s CapEx includes some deferred payments in Mexico, hence achieving free cash flow guidance even though recognition occurred early?

The working capital impact of last year’s payments informs our guidance. We will adjust expected costs accordingly.

For the first time in a while, we see a comfortable headroom on the balance sheet, with leverage at 2.3x, compared to your historical limit of 2.5 turns. Given the upcoming 600 MHz auction and potential acquisitions, how do you prioritize using the available headroom relative to deleveraging?

With strong cash flows, we're committed to investing in networks while prioritizing the quality and customer offerings. Our focus remains on maintaining a strong balance sheet while aligning with shareholder interests. We aim to balance investment, share buybacks, and debt reduction. However, the immediate goal is to lower debt levels after previous acquisitions.

We remain open to opportunities, particularly in the upcoming auctions. We aim for a 2x10 spectrum, which is important. We'll see how the market evolves, but we’ll actively explore viable options.

Can you provide more insights on the DIRECTV integration revenue upside? Now that you have track records on unlimited data, how do you expect bundling will affect revenue? Also, what’s the status of sponsored data?

Regarding DIRECTV integration, we see encouraging initial results, especially with unlimited data attracting strong interest. However, we must navigate through training personnel and enhancing sales experience for optimal bundling results. Giving revenue guidance at this stage would be premature, so we remain optimistic about future potential.

On sponsored data, leveraging our extensive content library through DIRECTV and Otter Media is our strategy. We plan to deliver content across various platforms while blending premium media with sponsorship opportunities. Though plans haven't been publicly announced, we believe this will be vital as we rollout our premium content offerings.

Could you provide 2016 guidance regarding realized synergies? Additionally, any insights on your joint venture with Chernin and whether there are intentions to expand content ownership more broadly?

By the end of this year, we aim to reach a run rate of $1.5 billion in synergies, approximately $125 million monthly. We expect to escalate integration efficiencies throughout the year. Integration costs are incorporated into the anticipated $22 billion capital guidance, and I don’t foresee significant merger integration costs, as many savings stem from operational efficiencies. The partnership with Otter Media is progressing. We plan to leverage mobile-centric content derived from our Fullscreen acquisition to foster viewer engagement. Expanding ownership in content is possible, depending on market dynamics and lessons learned through integrating existing acquisitions.

Can you elaborate on your mobility partnerships with Ford and others? Is this limited to new vehicles, or are you extending into used cars as well? Additionally, what do you envision for video opportunities in Mexico?

The Ford deal currently focuses on new cars rolling off the production line, targeting connectivity from 2016 to 2020 for approximately 10 million vehicles. However, our strategy also includes addressing the large used car market equipped with technology for Internet connectivity. This represents a significant opportunity given the average age of cars on the road today. Regarding Mexico, we firmly believe merging mobile and video will be instrumental as consumer preferences shift toward integrated services. We have a minority stake in a satellite company and will pursue partnerships that enhance our combined offerings.

With discussions of investments in broadband, can you quantify the upgrades made in your wireline footprint? What do you hope to achieve by increasing penetration rates? Additionally, could you outline the segmentation of capital expenditures in 2015, noting how these allocations may differ in 2016?

Approximately 60 million locations enable IP broadband, with around 15 million current customers. This gives us a 25% penetration rate. Previously, these broadband locations lacked a video product, but following the DIRECTV acquisition, we intend to leverage our offerings to increase market share. We're experiencing growth with our expansion plans and are optimistic about boosting our presence in the market as our sales teams enhance customer engagement. In 2015, our capital spend was roughly split between wireless and wireline operations, and we anticipate similar distribution going forward, emphasizing efficiency and quality network expansions.

Don't forget that software-defined networking plays a crucial role in further reducing capital requirements over the coming years.

A couple of follow-ups. Can you provide color on cash tax rates? Verizon mentioned high 20% rates, while AT&T’s have been closer to 35%. Is mid-20% reasonable? Secondly, with technological advancements, how focused is AT&T on cost reductions?

We typically do not provide guidance on cash taxes. However, I can understand how similarly situated companies may achieve lower effective rates given current tax structures.

The current technological shift enables enhanced operational efficiencies. Our initiative, Project Agile, aimed at streamlining operations, shows promise. We are focused on maximizing network capabilities while reducing operational expenses. We believe that the convergence of high-speed networking, cloud services, and big data analytics can lead to significant operational improvements, and we are committed to investing strategically to seize these opportunities, regardless of broader industry trends.

Our strategies to implement software-defined networking combined with ongoing efforts to enhance efficiency will position us to capitalize on the opportunities available within our fiber and service networks as they expand.

We are proactively investing to ensure we are positioned well for future growth while remaining committed to cost-effective operations and strategic investments in network capabilities.