AT&T: Will the Big Bell Keep Ringing?

It might be tough to repeat a 50% gain this year, but the union with BellSouth should help drive free cash flow and wireless growth

It's nice to be big Ma Bell, again. With the Federal Communications Commission (FCC) blessing of the union between AT&T (T; ranked 3 STARS, hold) and BellSouth, Standard & Poor's thinks the honeymoon between investors and the largest U.S. telecom company could last through 2007.

But as with all love affairs, there are likely to be challenges. Because AT&T's shares ignited portfolios with their outperformance in 2006, we at S&P think AT&T investors will expect the company to maintain this pace and to continue making money for them. On a total return basis, the stock appreciated 53.2% in 2006 (it hit a 52-week high of $36.21 on Dec. 29). Shareholders will expect the new Ma Bell to preserve her fundamental attractions in terms of value, dividends, and profit growth.

S&P revised its 2007 earnings estimate to $2.50 a share from $2.45, but reiterated its hold opinion on the shares on Jan. 3. Wall Street expects AT&T to earn $2.57 on average, according to Bloomberg, and 21 out of 30 analysts think the stock is worth buying.

A Dominating Force

S&P equity analyst Todd Rosenbluth expects the company's 2007 revenues to be $124 billion, with earnings improvements driven by cost savings from merger benefits. AT&T will continue to support its stock price with share buybacks, he says, adding that his opinion is supported by the stock's 4% dividend yield.

With the help of the nation's leading wireless provider, Cingular, which AT&T now fully controls as a result of the merger with BellSouth, AT&T dominates the telecommunications sector and the wireless industry in the U.S.

"We believe Cingular will be the primary revenue driver for AT&T in 2007 and—due to improved customer retention through its exclusive wireless handsets from suppliers such as Motorola (MOT; ranked 4 STARS, buy) and Samsung, and a denser network—the wireless segment should help to expand the company's operating margins," Rosenbluth says.

Win Some, Lose Some

He also expects AT&T's ownership of Cingular (which should generate 33% of its 2007 revenue) will result in greater wireline/wireless product integration. "In about a decade, the U.S. wireline industry has shrunk to just two dominant players, AT&T and Verizon Communications (VZ; ranked 3 STARS, hold), from 10 major entities," Rosenbluth says.

That alone may not be enough to keep AT&T on top. Household spending on communications services—wireless, wireline, Internet, and video services—keeps climbing as new subscribers join the network (the monthly bill for services was $175 as of March, 2006). However, increased consumer spending and regulatory changes have resulted in greater competition, and Ma Bell is likely to lose in some areas and gain in others, Rosenbluth believes.

AT&T is winning its share of Internet connection customers through its broadband offerings, but its traditional wireline customer base is eroding, as consumers substitute wireless for regular phones or choose a voice and video package from the local cable provider. Another challenge is keeping Cingular wireless customers loyal, according to Rosenbluth.

Ed Whitacre—who almost single-handedly orchestrated the consolidation of the telecom sector—and his leadership team have not managed to get this far without facing challenges. Under Whitacre, SBC had lost more than half of its value from 1999 to 2005 before merging with, and changing its name to, AT&T in 2005. During that time, the company piled up about $30 billion in additional debt, according to news reports.

Rewarding the Patient

As of Sept. 30, the new AT&T, including Cingular, had about $63 billion of debt reported, according to S&P Credit Ratings Services (which operates separately from S&P Equity Research Services), which rates the combined entity "A." S&P Ratings Services removed the debt from CreditWatch after the FCC approved the merger because it meant one fewer risk to the repayment of the long-term debt.

AT&T's chief financial officer Rick Lindner said in a conference call that AT&T's acquisitions and patience have finally paid off. Profits are expected to have improved more than 30% in 2006, while cost savings from the integrations and share buyback programs are rewarding holders of AT&T shares, he said.

While Rosenbluth believes that AT&T paid a premium for BellSouth to gain control of Cingular, the company should generate strong free cash flow, after capital investments, in 2007, through wireline cost reductions, wireless revenue growth, and an overall improving business landscape.

Rosenbluth has a target price of $36 on AT&T's stock (which closed at $34.50 on Jan. 4), based on a premium relative multiple to its peers. Among the risks to Rosenbluth's recommendation and target price are increased competition from cable carriers, regulatory changes, and weaker-than-projected wireless-services execution and rollout of its fiber-based video services. Although AT&T may not repeat the success of 2006, investors should find the shares to be a worthwhile holding.

Before it's here, it's on the Bloomberg Terminal.