Reality Check: What to make of Verizon and AT&T earnings

Editor’s Note: Welcome to our weekly Reality Check column. We’ve gathered a group of visionaries and veterans in the mobile industry to give their insights into the marketplace.

 

There’s a lot to cover this week and a short amount of reading time, so let’s cut to the chase: AT&T and Verizon reported earnings last week, and so did Apple, Amazon, and Microsoft. I listened to all five calls, and re-read the transcripts, and studied the schedules. We are living in two different worlds – one of debt-free growth, (Nexus One) experimentation and innovation; the other debt-laden deflation and survival.

 

It really hit me when I looked at AT&T’s 2009 annual report, where they prominently display their unadjusted five year trends. When they ended 2005, AT&T had 49.4 million in-region network access lines in service, and $30.6 billion of total debt. Then they bought BellSouth and at peak had 66.5 million access lines and nearly $60 billion of total debt. Today (end of Q1), they have 48.1 million access lines and $69.5 billion of total debt. The entirety of BellSouth and $90 billion in market capitalization lost in three short years – with $40 billion in additional indebtedness. If that isn’t a Reality Check, I don’t know what is.

 

New products continue to grow, but their revenues and profits are barely keeping their business unit growth afloat. Business markets growth is slow to recover and only marginally profitable. And new pre-paid wireless models are emerging that could reshape the telecom landscape. Capital is fleeing from the industry, and funding competitive, cloud-based models. Innovation is more associated with the applications that use the network, and the “app store” model completely cuts out the carriers. And more regulation may shut down the ability to cross-subsidize the next wave of growth.

 



How to combat this? Well, let’s see how AT&T attacked the problem: 

 

1. Grow the “smartness” of the devices sold. AT&T added 3.3 million “integrated devices” in the quarter, and now has 26.8 million “integrated devices” in service. Average revenue per user for integrated devices is 1.7 times higher than traditional devices. More integrated devices means more data revenues. Sequential data revenue growth was 6.5%; Q1 2009 sequential growth was 3.6%. The only offset to this is that the iPhone accounted for about 300,000 more net additions than AT&T’s total. The iPhone remains the device of choice across all of the distribution channels – selling anything else, except Blackberry in the enterprise channel, is going to take a lot of time and effort (hint to Dell and Microsoft – spend time educating AT&T sales reps on your products – old habits die hard).



 

2. Slow the project streams down (including 3G network upgrades), resulting in $3.3 billion in capital expenditures. This number is low, and AT&T’s reasoning that “we got started late because of our budgeting process” is inadequate.



 

3. Keep investors happy by paying out a strong dividend ($7.3 billion in Q1 2010 cash flow less $3.3 billion in capex = $3.9 billion – $2.5 billion in dividends = $1.4 billion). Note: If AT&T is going to spend $17-18 billion in capex this year, they have $14-15 billion left to spend. If they spend $4.5 billion each quarter for the next three quarters that leaves very little room for further debt repayment unless operating cash flow grows dramatically. There is $9.4 billion of debt that either needs to be paid or refinanced in 2010.



 

4. Grow non-traditional sources. Connected device growth will continue to be very strong for AT&T and they are clearly leading the industry in this area with three million net additions in the past four quarters. However, those three million additions will likely drive an incremental $200 million in annualized 2011 revenue at best (or about .5% of growth). That’s about 225,000 annual iPhone additions at $80 ARPU.



 

5. Milk the “cash cow” – wireless voice. ARPU for wireless voice is around $43-44, down a couple of bucks from 2008/2009 levels. But minutes are down faster, resulting in increasing yields. More minutes are terminating to other wireless providers, lowering cash cost per user. Retail wireless minutes are the new cash cow.



 

6. Cut headcount. AT&T has reduced 18,200 employees in the twelve months (they reduced 20,000 in 2009), more than the total employee base of Leap Wireless, MetroPCS, Global Crossing and Level3 combined. In two years, they have shed the total employee base of Qwest with 3,000 left over. AT&T still employs 276,000 people and they have at least 12,000 jobs remaining to shed this year.



 

7. Protect and preserve special access (specifically cell site backhaul) revenues. One of the revenues that continues to perform well is the “transport” line item which AT&T breaks out in their supplemental schedules. Transport represents about 25% of the business revenues, but more than half of the profit of the wireline division. If you exclude the revenue and profits of the transport line item, the wireline division earns about a 6% operating margin (vs. a total wireline operating margin of 11% – calculations available upon request).

 

AT&T also did a much better job than Verizon trying to shore up their DSL customer base, growing 41,000 DSL customers in Q1. However, if 2009 is any indicator, this figure will likely turn negative for the remainder of the year (in 2009, AT&T added 91,000 customers in Q1 but lost over 370,000 DSL customers for all of 2009). Bottom line: It would have been a disastrous quarter without the iPhone. Consumer access line trends are still down double digits, and the dependence on the transport revenue line is concerning. Relatively speaking, AT&T has more focus and less execution risk than Verizon.

 

Verizon tackled Q1 in a similar manner as AT&T:



 

1. Verizon generated strong and growing cash flow. $7.1 billion in Q1 2010 cash flow from operations – $3.7 billion in capital expenditures – $1.3 billion in dividends = $2.1 billion to pay down debt. Like AT&T, Verizon has $7.1 billion of debt maturing this year. Verizon clearly is growing their cash flow, and, with less gross additions, has an opportunity to improve their SG&A with lower advertising (there’s plenty of opportunities to signal lower advertising and marketing expenditures, and I expect that after the Apple launch this summer, we could see lower advertising expenditures).



 

2. Over 80% of Verizon’s net adds came from their wholesale channel. What a difference a year makes. In Q1 2009, Verizon grew their wholesale base by 422,000 customers, of which 420,000 came from the Alltel acquisition. Over 97% of the total additions were from retail channels. In Q1 2010, Verizon had 1.552 million net additions, of which 1.264 million came from non-retail sources (81.4%).



 

3. Cut headcount. Verizon cut 13,000 employees last year, and, thanks to a change in their agreements with the IBEW/CWA east coast unions, they should be able to cut “at least” 13,000 employees in 2010. Interestingly, the employees to be cut are those who joined Verizon after 2003. That’s some union logic there – preserve the longest-tenured, not necessarily the highest performing. Said differently, Verizon and AT&T cut out an entire Qwest worth of employees in 2009. Somehow, I don’t think they were replaced with a similar amount of productivity-improving systems … .



 

4. Preserve and protect the special access and wholesale wireline revenue streams. The wireline unit is struggling, but they would be in significant difficulty were it not for the wholesale unit performance. Overall operating margin for the wireline unit was 1.5%. Assuming a paltry 20% operating margin for the wholesale unit, the “rest of Verizon wireline” lost $300 million in the quarter (calculations available upon request). And, as many have pointed out, this operating margin is likely a negative number when you exclude the properties to be spun to Frontier.



 

Much has been written about the effect of a Vodafone/Verizon restructuring on their wireless unit. However, if you assume that at least $53 billion of the remaining debt is attributable to Verizon’s wireline unit, that leaves a debt to trailing 12-month earnings before interest, taxes, depreciation and amortization of 5.0. There are many quarters of recovery remaining for Verizon’s business unit, and, assuming West Virginia approves the Frontier transaction in May, we might see our first quarter of negative operating margin for the wireline unit in Q2.

 

Another thing that Verizon didn’t do well was convince customers to move to FiOS. In the past 4 quarters, 839,000 FiOS Internet customers have been added, but this has been offset by 454,000 DSL losses. In turn, FiOS video subscribers, which had largely tracked with the Internet additions, started to break lower (185,000 Internet vs. 168,000 video FiOS net adds).



 

Bottom line: It would have been a tough quarter for net adds without wholesale, specifically Carlos Slim’sStraightTalk product. This, combined with a significant decrease in inventories, were bright spots. The picture for the wireline unit is cloudy as they transition from circuit and frame relay to IP networks.

 

And these are the wireless leaders – the “healthy ones.”

 

Through April 23, the four horsemen (Amazon, Apple, Google, and Microsoft) have gained more than $36 billion in market capitalization. The “ground” companies (which include Verizon, AT&T, Sprint, Comcast, Time Warner Cable, Cablevision, Qwest and Clearwire) lost $7 billion for their shareholders (AT&T and Verizon together lost $22 billion, while the remainder have gained $15 billion) – $43 billion swing so far this year, on top of last year’s $346 billion differential. How AT&T and Verizon handle these changing business models will affect how much larger the gap gets in 2010.



 

Next week: Did Sprint, Comcast, and Time Warner Cable change the industry view? As always, welcome your comments and suggestions.

 

Jim Patterson is CEO & co-founder of Mobile Symmetry, a start-up created for carriers to solve the problems of an increasingly mobile-only society. He was most recently President – Wholesale Services for Sprint and has a career that spans over eighteen years in telecom and technology. He welcomes your comments at [email protected].