AT&T Inc. (T) Q2 2014 Earnings Conference Call July 23, 2014 4:30 PM ET
Susan Johnson – SVP, IR
John Stephens – Senior EVP and CFO
Ralph de la Vega – President and CEO, AT&T Mobility
Mike McCormack – Jefferies
John Hodulik – UBS
Joe Mastrogiovanni – Credit Suisse
Simon Flannery – Morgan Stanley
Amir Rozwadowski – Barclays
Mike Rollinswtih – Citi Investment and Research
Phil Cusick – JPMorgan
Timothy Horan – Oppenheimer
Ladies and gentlemen thank you standing by. And welcome to the AT&T Second Quarter Earnings Release 2014. At this time phone lines are in a listen-only mode. We will have an opportunity for question-and-answer session later on. Operator Instructions]
At this time I would like to turn the conference over to our first speaker Senior Vice President, Investor Relations, Susan Johnson. Please go ahead.
Thank you, Nick. Good afternoon everyone. And welcome to our second quarter conference call. It’s great to have you with us today. I’m Susan Johnson, Head of Investor Relations for AT&T. Joining me on the call today is John Stephens, AT&T’s Chief Financial Officer; and Ralph de la Vega, AT&T’s President and CEO for Mobility. John will cover our consolidated and wireline results and Ralph will give us an update on our wireless business. And then we’ll follow 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 www.att.com/investor.relations. Of course I first need to draw your attention to our Safe Harbor statement before we begin which says that some of our comments today maybe forward-looking. As such they are subject to risks and uncertainties, results may differ materially. And additional information is available in our and DIRECTV’s SEC filings and on the Investor Relations page of AT&T and DIRECTV’s websites. I also wish to direct your attention to the information regarding SEC filings that is included on the slide.
Before I turn the call over to John, I would like to provide some additional context for the quarter on Slide 4. We talked with you the last few quarters about how we’ve been transforming our business for growth. This quarter we saw a significant progress, particularly with our repositioning of the wireless business model. First on the network front. Our Project VIP investment plan continues to deliver or transforming our network to a premier IP video-centric network and the results have been impressive.
Our 4G LTE build now covers more than 290 million people and we expect to complete our deployment by the end of the summer. And our fiber build out to cover more businesses is going well. We’ve now passed more than 500,000 business customer locations since we first announced Project VIP. At the same time we are investing in our network, we are investing in our customers by repositioning the wireless value proposition.
Several years ago we successfully led the transition to usage base to data pricing and now more than 80% of our postpaid smartphone subscribers are on those plans. Now we are making another successful pivot away from the traditional device subsidy model with AT&T and our Mobile Share Value plans. Customers can now pay directly for their devices and exchange for lower service pricing. That’s an equation that really works for our customers, as you can see with this quarter’s record subscriber metrics. And it’s an equation that works for us.
With this an important strategic shift away from device subsidies which has historically netted out to be a multi-billion dollar cost each year. This move away from the subsidy model it’s happening quickly and bringing about many of the expected changes in our financial results.
The shift in revenues from service to equipment and the moderation of quarterly margin trends as we achieved increased savings in device subsidies in the back-half of the year, which as you know historically is our strongest device sales season. But the key point is that we have made a deliberate discussion to go down this path and with the results we are seeing, we believe the strategy is clearly working. We see it in our results and we hear from our customers.
With that, let me turn it over to John to discuss our second quarter results. John?
Thank you, Susan. And hello everyone, thanks for joining us today and as always thank you for your interest in AT&T. Let me begin with our consolidated financial summary which is on Slide 5. Consolidated revenue grew to $32.6 billion up $500 million or 1.6%. This was driven by continued wireless growth as we change our business model. Solid consumer wireline growth once again led by U-verse and growth and strategic business services.
Revenue this quarter was impacted by the shift to no device subsidy plans and wireless. Reported EPS for the quarter was $0.68, as you know during the quarter we sold our equity position in América Móvil. After-tax we had a gain of about $0.08 on the sale. The gain was taxed at a higher effective tax rate due to accounting for deferred tax assets related to foreign tax credits.
While these accounting rules will acquire this high tax rate, we are confident we will be able to utilize existing capitalized carryforwards to maximize the after-tax cash proceeds from the sale. When you normalize to the side, our consolidated effective tax rate is about 34% or about a 100 basis points higher than last year.
Also we had $0.02 of pressure from our Leap integration cost, including our non-cash items such as the amortization of customer list. You may recall that we close that transition in March, so this is the first full quarter with these integration costs. When you exclude these items earnings per share was $0.62 compared to an adjusted $0.67 a year earlier.
Consolidated margins continue to be pressured by our investments both in Project VIP and Agile and our shift away from the subsidy model to wireless. These well for our investments are expected to drive stronger growth in the second half of the year. Cash from operations continues to be strong. Cash from operating activities in the quarter totaled to $8.1 billion and capital spending was $ 6 billion with strong investments in Project VIP. Year-to-date our free cash flow is more than $5 billion and that after are more than $1.5 billion investment in our customers through AT&T Next.
Solid churn to our operational highlights on Slide 6. As you can see, we continue to execute a high level even as we transform our business. In wireless the growing popularity of AT&T Next and the Mobile Share Value plan is having an impact on our results.
The customer transition to these plans is driving a major shift in the subsidy model and at the same time helping to reduce churn increased postpaid subscribers drive strong growth of large voice data and improve our net promoter scores or our customer satisfaction results.
However, Ralph will give you the details in just a moment. But we are very pleased with what we are seeing from our wireless repositioning and confident in our strategy. In wireline U-verse continues its steady performance of subscriber gains and increasing revenue.
It’s now approaching $15 billion in annualized revenues, growing at about 25% year-over-year. Strategic business services also continues to grow at more than 13% and is an annualized $9 billion revenue stream. We also reached a milestone in the second quarter when our U-verse high-speed broadband reached 70% of our total broadband base. Clearly the transition is underway.
While we have made great progress, we still have a lot of room for growth, as we expand our base through Project VIP and continue the bundle broadband with other valuable services. And of course in the second quarter, we announced our intention to acquire DIRECTV.
This will take our video and bundling strategies and our cost structure to a whole new level. We’re really excited about what this transaction can do. Service bundles are a proven winner for us, and we believe the ability to bundle services nationally will be a big plus. Overall, we are on track with full year guidance and look forward for trends to improve in the second half of the year.
We’d now like to turn it over to Ralph de la Vega, who will provide more insight on the strong wireless performance and the repositioning of the wireless business volume. Ralph?
Ralph de la Vega
Thank you, John and good afternoon everyone. It’s great to be with you today. I’ll start on Slide 7, as John said this was truly a remarkable quarter for our wireless business with results coming in better than expected. We’ve been very successful in repositioning the business model and it’s happening and break next speed.
The shift is in no-device-subsidy model is unmistakable, more and more customers are choosing the simplicity of Mobile Share Value plans and AT&T Next. This model shift is driving impressive results. Postpaid churn was a record low 0.86%, the best ever for AT&T and likely and industry best this quarter.
This customer loyalty help drive our largest postpaid subscriber gain in nearly five years more than a million postpaid net adds in the quarter including very strong smartphone net adds. The shift in Mobile Share Value and Next has been dramatic in transitioning our smartphone customer base. Half of our smartphone sales in the second quarter were on AT&T Next and nearly half of our smartphone subscriber base has moved to Mobile Share Value plans since we first introduced value plans in February.
Even better when customers do switch to Mobile Share they are moving to larger and larger data buckets. We now have more than 41 million connections across 15 million accounts on Mobile Share with half on plans of 10 gigabytes or higher. And the number on larger data plan continues to grow. As more and more customers move to usage-based data plans data use is increasing.
We’re still seeing nearly 50% year-over-year data usage increase on smartphones and we continue to add more smartphones connected devices and tablets. We’re also starting to see the NextWave of wireless growth Digital Life is gaining momentum and had its best net gain quarter. Connected car growth is accelerating with new models entering the market such as the Audi A3 as well as 10 GM models that will grow to 30 by the end of the year. These are in addition to those are already in the market such as Tesla, BMW and others. We feel these are incredibly good results in a time of transition. Let me give you more details starting with our strong postpaid net adds and churn on Slide 8.
The move to Mobile Share Value plan has really solidified our customer base and this is critically important, retaining our smartphone base is the basis for future growth. Postpaid churn was there an all time low and churn for Mobile Share and smartphone customers were even lower. That was even more remarkable in a noisy competitive environment.
This help to drive more than a million postpaid net adds with more than half of those being phone customers as significant improvement from the past several quarters. Overall, we had more than 600,000 total net adds and that includes prepaid declines due to the second quarter seasonal pressure and continued migration of session-based tablets to postpaid.
We also saw expected second quarter pressure from our Cricket integration. We expect this prepaid pressure will moderate in the third quarter and in fact we have already seen our prepaid trends improving. Branded tablet net adds for the quarter were 250,000 and that includes 366,000 postpaid tablet net adds in the quarter.
We also saw pressure in reseller and connected devices, as we transition of the old 2G network, all this drove total return higher even with our record low postpaid churn. We continue to grow our smartphone base including migrations, we added nearly 1.6 million in the quarter. We had more than 700,000 net adds in the quarter and more than 90% of our postpaid phone sales in the second quarter were smartphones.
Sales of LTE devices also continued at a strong clip which is great for both us and our subscribers. LTE devices provide the best customer experience well also be the most network efficient, almost two-thirds of our postpaid smartphone base now have LTE phones. You see the dramatic impact Mobile Share Value plans on churn and postpaid net adds.
Now let me show you the impact on the subsidy model and revenues. Those details begin on Slide 9. Total wireless revenues for quarter were up nearly 4% as revenues continue to shift to equipment from service. Equipment revenue growth was strong in the quarter up 45% but also we expect that service revenues were impacted. We also saw revenue pressure from promotional activity early in the quarter from a change in the recognition of revenue with the sales of phones through our agents due to the AT&T Next offering.
Together these two items are about a 200 basis point impact on total wireless growth. We’re also seeing significant increases in the number of customers who bring their own devices. This is a good thing for us, as it takes all the subsidy expense out of our model and brings on a profitable customer.
We’re continuing to see customers choosing Mobile Share Value plans in unprecedented numbers. In just five months about 24 million smartphones or about 44% of our postpaid smartphone base have moved up to subsidy model. That includes about 2 million subscribers on a limited data plans who chose to move to Mobile Share plans.
We now have less than 10 million subscribers on a limited plans; our lowest level in years. At the same time, customers who are ready to upgrade are increasingly turning to AT&T Next. More than half of our smartphone sales in the quarter are 3.1 million were on Next, as you can see on the pie chart on the left of the slide, we have about 7 million AT&T customers who are Next customers at the end of the quarter. But the total number of subscribers on non-subsidy plans is about 24 million.
This gives us a large number of subscribers who will move to AT&T Next when they buy a new device. By the end of the year, we expect the percentage of Next sales to increase considerably as customers begin to upgrade their phones. And in fact we are already seeing customers do this, virtually all of our pre-Next customers are choosing AT&T Next when they upgrade in our company-owned stores.
And we expect sales to increase with our agents and in national retail where we’re just beginning to ramp up Next. The change in the device subsidy model is driving a shift in our wireless mix, but it is also driving higher value with improved churn and more sustainable margins.
I’ll turn it back to John, so he can give you those financial details on Slide 10. John?
Thanks Ralph. Ralph talked about the great results we saw in wireless in the second quarter. Let me take just a minute dive deeper into the financial and customer value impacts. If you look at the overall customer value that shift away from the subsidy model is very positive. Churn plays a big role in this.
Take a look at the customer value illustration on the upper left of the Slide 10. With the year-over-year 16 basis point improvement in postpaid churn, the average life of each of our customers is extended by 18 months. With Mobile Share Value pricing servers ARPU is to drop on a comparable basis. But when you factor in the average life of a customer’s lifetime service revenues actually increased and example percentage that have increased $400 per customer when you are AT&T with over 50 million phone customers. That’s a real opportunity to generate great value.
So in short, the customer value increases with Next and this doesn’t even take into account the reduction in equipment subsidy. Going to AT&T Next also takes way most if not all of the net subsidy cost. That’s why can’t just look at service ARPUs anymore to get a comprehensive view of our business.
Phone-only service ARPU is down for the quarter, but when you add in Next billings you get a more accurate idea of what an average customer pays us each month. The average monthly Next billings for the equipment are about $27 per month, driving our phone-only ARPU higher with Next.
When this $27 per month is spread over the entire base it adds about $2 in ARPU per customer in the quarter. As the Next base rose, so will this impact on ARPU. We’ve actually already seeing this. Service ARPU with Next improved throughout the second quarter and for June was more than $65, are almost $1 higher than the quarterly average as equipment purchases increased throughout the quarter.
Another benefit of moving off the subsidy model which is at the previous highs and lows of our margins become more stable. We did in this business a lot of time and we’ve seen two big drivers to sales upgrades. That’s a holiday season and the introduction of new devices. In the past we usually have mixed feelings about those events was great for sales, with that subsidy cost pressured margins and financial results.
Now with about half of our smartphone subscribers already are in non-subsidy plans and that number going up every day. We’re feeling really pretty good about the position we are in. If you look at our expectations for the rest of the year, we anticipate service margins to be more than 40%, while postpaid phone-only ARPU with Next billings will continue to increase as more customers upgrade their phones.
Our wireless repositioning story is definitely work in progress, but it’s definitely working. The benefits are clear, lower overall churn, higher postpaid net adds, customers buying larger buckets of data and a shift away from the unlimited plans.
First of all, customers like it, they like the clear and simple pricing and we feel really good about where we are and we’re excited and look forward to the second half of the year. Those are our wireless highlight; I would now like to discuss our wireline business starting with consumer on Slide 11.
U-verse has been a solid and consistent story for us; we continue to see solid subscriber and revenue growth. This help drive 3% revenue growth in consumer, total U-verse revenues are now approaching a $15 billion annualized revenue stream and they are growing at about 25% year-over-year.
U-verse now represents 62% of consumer revenues. They had a 11.5 million broadband customers after adding almost 500,000 in the quarter. That’s more than 70% of our total broadband base that compares to just 40% two years ago. We also added a 190,000 TV subscribers in the quarter, which gives us 5.9 million total U-verse TV customers.
The big factor in the success of U-verse is our ability to bundle. More than 97% are virtually all of our video customers had some kind of bundle with us. And two-thirds of our U-verse TV subscribers take three or four services with us. ARPU for U-verse triple play customers continues to be more than a $170 a month.
Now to drive growth while reducing churn, in fact triple play bundle customers has significantly lower churn than standalone customers. We see continued opportunity here, our market penetration stands around 20% for U-verse broadband and TV. But that penetration increases the longer we are in a market, plus this Project VIP expands our customer reach, we believe we can achieve much more.
We also continue to deploy GigaPower as part of our Project VIP build sales of our Ultra-fast broadband service have exceeded expectations at Austin and we’ve announced our intention deploy in Dallas and North Carolina.
Now I’m taking to our business wireline results on Slide 12. Wireline business continues to be a story of the economy and the shift to IP data and away from legacy services. Strategic business services, services such as VPN, Ethernet, Hosting and other advanced IP services grew by more than 13% in the quarter and more than 14% year-to-date. And now represent more than $9 billion annualized revenue stream.
And that now make up more than 27% of business wireline revenue and for the first time strategic business service revenues are now more than half of our total wireline business data revenues.
Overall wireline business revenues were down to 0.9%, service revenues were down a little more than 2% in the second quarter. But that’s on track with recent trends and the slow economy. When you look at each of the business components that make up our wireline business, you’ll see some different stories and different trends. Enterprise service revenues were actually up about 1% year-over-year.
And this was its fifth consecutive quarter of year-over-year growth rate improvement and our enterprise channel continues to provide significant sales opportunities for our wireless services. Wholesale again was challenged by network proving of some of our wireless customers. And we also saw in the impact of our acquisition of the Leap this quarter as those previous external wholesale revenues now are internal to AT&T.
While our small business is benefiting from wireless bundles and continued U-verse broadband growth. The lack of new business formations is still impacting the business opportunity.
Now let’s look at our margin story on Slide 13. You can see the margin impacts from changes in the wireless subsidy model and Project VIP on our margins. In the second quarter when adjusting for Leap integration expense wireless EBITDA service margin was up slightly to 42.6%. That’s a strong performance especially when you consider our very strong postpaid and smartphone net adds in the quarter.
Adjusted EBITDA was $6.5 billion stable year-over-year, the total EBITDA margin was down due to the impact of the 24 million smartphones moving to Mobile Share Value pricing, some promotional activity we had in the first half of the year. And new business investments and things like Cricket and Digital Life.
For the quarter our adjusted consolidated margin was 17.7% compared to 19.1% in the year ago quarter. As Ralph said, the shift to Mobile Share plans ahead of equipment purchases pressure our results.
Wireline margins were down from a year ago, but essentially flat with first quarter levels. The decline in revenue from legacy services was part of the impact, but at the same time success-based video content cost retransmission price increases and expenses for project Agile and VIP also cause pressure.
For example overall content cost increases for more than double, the total increase of wireline operating expenses for the entire quarter. But this wireline pressure was partially offset by growth of consumer revenues gains in strategic business services and solid execution of cost initiatives.
We expect project Agile and are moved to software defined networks to provide margin help, project Agile drive efficiency and speed to market as we transform how the company organizes and operates all around our customers.
As we’ve said before, we are reinvesting in savings at this point, we feel real opportunity to reduce cost through this effort. We expect run rate in savings in the $3 billion range by 2017.
Now let’s move to cash flow, our summary is on Slide 14. In the first half of the year, cash from operations totaled nearly $17 billion and about $8.1 billion in the second quarter. Capital expenditures were up $11.8 billion for the six months and 16 for the quarter. Free cash flow before dividends was $5.1 billion year-to-date on track with full year guidance even with investments in Project VIP and our wireless customer base.
We did monetize $800 million of our Next receivables in the quarter and there continues to be great interest at additional sales. But even after that our net investment in customers increased by more than $1.5 billion during the year. So we expect to meet our free cash flow guidance even with the substantial working capital invested in AT&T Next customers. And net debt to adjusted EBITDA was at 1.71 as we maintain the best credit rating major U.S. telecom company.
In terms of cash, I think you know the story, dividend payments remain our first priority and year-to-date total $4.8 billion and we continue to be opportunistic with our share buyback program.
Our asset sales including América Móvil also strengthened our cash position and balance sheet. We ended the quarter with more than a $11 billion of cash about 4.6 that has already been used for debt redemption leaving more than 6 billion of cash on hand at the current time.
We have balance in flexibility to pay down more debt and position ourselves for the upcoming spectrum auctions and DIRECTV acquisition, while investing in the growth of our business. In fact I believe we’re continuing to maximize our balance sheet efficiency. We expect another $3 billion of asset monetization by the end of the year, with the sale of our Connecticut wireline property and remaining proceeds from our América Móvil sale.
The DIRECTV transaction continues to move forward, Brazil’s antitrust regulator has approved it without restrictions and we have completed the reviewing process at the state level without conditions, which included Arizona, Louisiana and Hawaii. We also received good news today when the Department of Labor’s approval notice allowing us to fund our pension plans with the preferred equity interest in América Móvil was posted in the federal register website.
Now let me close with a quick summary and a recap of our full year 2014 expectations.
There continues to be a lot of moving parts in this quarter and throughout the remainder of the year. We’re confident; we’re heading in the right direction. We staked out our course in our plan for the year and we are confident that we are on the right track. First we expect consolidated revenue growth at the low end of the 5% range to define that, but said that, we will say that the range is, we define that range as 4.5% to 5.5% and expect the numbers of the AT&T Next upgrades to ramp substantially in the second half of the year powering that growth.
Second, we see stable consolidated margins as we’ve begun to realize greater benefits, as more customers shift away from the subsidy model to the back-half of the year. We continue to expect adjusted EPS in a low end of the mid-single digit range even with the pressure from Leap integration cost and loss of the América Móvil equity income. We’re still targeting capital spending in $21 billion range even as we accelerated investment in the first half of the year. And we expect free cash flow in the $11 billion range even with strong AT&T Next sales.
I now will turn it back to Susan to take your questions.
Thank you, John. Nick I’m going to return the call back to you for instructions for our Q&A session.
Earnings Call Part 2: