AT&T Stock: AI-Led Productivity And Capital-Light Growth (Rating Upgrade) (NYSE:T)

After the market slump of the second half of 2022, Big Tech started slashing employee counts by the tens of thousands in highly publicized announcements to reduce costs and improve profits while rapidly adopting artificial intelligence to enrich their products. Two of these are Meta Platforms (NASDAQ:META) and Alphabet (NASDAQ:GOOG) whose stocks were net gainers during the last three years.

As for AT&T (NYSE:T), despite using artificial intelligence to boost productivity, and improve the customer experience while harvesting $6 billion of cost savings in the process with $2 billion more planned by mid-2026, its share price has suffered. This is abnormal and, by also factoring in its capital-light growth strategy which results in better free cash flow, this thesis aims to show that it is a buy.

First, I provide some perspective on why its YoY revenue growth is more than 35% below the median for the Communications Services sector.

Navigating the Intricacies of the Telco World

This is not only a highly competitive sector where there are integrated players like Verizon (VZ) which provides both fixed line and mobile services but also pure-play wireless providers like T-Mobile (NASDAQ:TMUS) without forgetting incumbent cablecos like Comcast (CMSA). Now, the U.S. is already a mature market for communications services, but, growing at 8.68% and 15.69% respectively, Alphabet (GOOG) and Meta Platforms (META) both exceed AT&T’s 1.4% in a meaningful way.

Thus, the telco should logically press on the accelerator, but it cannot continuously slash prices to gain market share as this would impact profitability and its net income margin which outshines the sector by nearly 300%.

In these circumstances, the only way to attract customers naturally is to continue improving the quality of the network for 5G and expand its fiber footprint nationwide, but this required over $140 billion of investments from 2018 to 2022. There is still work to be done, namely upgrade to 5G standalone which uses a dedicated core network instead of relying on older 4G LTE and increase fiber passings to homes and businesses.

However, spending another $140 billion at the prevailing interest rates, would only increase debt which stands at $185 billion as returns on investment take time to materialize in this capital-intensive sector and this is the reason a different approach is required, one which brings cost savings while at the same time optimizing operations, achievable through the use of AI.

Productivity Gains using AI

Even before the advent of Generative AI which has been popularized by ChatGPT, the company has been deploying other flavors of the technology notably machine learning to optimize workflows. One example is analyzing a problem situation before dispatching technicians on-site. Moreover, the way assistance is provided in AT&T’s care centers has been automated using bots (software applications) thereby contributing to “significant improvement in customer service and the cost side” according to its COO, Jeff McElfresh. He also adds that AI is one of the major contributors to the company’s $6 billion transformation cost takeout program. For investors, this program was started in April 2020 and has helped the company in posting better than expected EBITDA and free cash flow.

At the same time, digital channels are being transformed into self-service customer portals for more personalized experiences while the company’s new Gen AI tool helps to improve employee effectiveness as pictured below.

Going a step further, Generative AI is being used to migrate software programs on older generation servers (mainframes) directly to the cloud. Now, according to researchers at McKinsey, the use of Generative AI in software engineering should result in productivity gains of $580 billion to $1.2 trillion up till 2040 out of which $60 billion to $100 billion is earmarked for telecoms. McKinsey also adds that there should be productivity gains amounting to 2.3% to 3.7% of revenues, or a mid-point of 3% for the industry.

For AT&T, based on its FY-2023 revenues of $122.4 billion, I obtained an estimate of $3.67 billion (or 122.4 x 0.03) of productivity gains. Noteworthily, this is higher than the $2 billion additional cost savings program by 83.5% as it also encapsulates the productivity benefits of improving business processes. This should translate into augmenting cash from operating activities, which increased by 10% YoY during the fourth quarter of 2023.

Growing in a More Capital-Light Way

Now, productivity improvement and efficient capital allocation may be the reasons why the telco is managing to invest $14 billion in modernizing its radio network in partnership with Ericsson (ERIC) for the next five years while at the same time expecting FCF to increase to $17.5 billion (midpoint) this year from $16.8 billion in 2023. Moreover, the capex of $21.5 million guided for 2024 is down $2 billion on what was previously expected, with the ultimate aim being to bring in into the teens.

Now, coming back to the comparison with Big Tech, with their massive scales, Alphabet and Meta not only command better discounts from suppliers but can skew service providers like data centers toward what they specifically need instead of choosing from what is available. In this respect, AT&T seems to have done just that with the Ericsson deal I mentioned earlier as it is different from previous contracts since it is about 5G Open RAN instead of relying on closed proprietary technology as was the case previously. The objective is to be “open” to the possibility of dealing with a mix of suppliers and choosing the best solution in terms of quality/price instead of being restricted by vendor lock-in.

Thinking aloud, this is not something new in the telecom industry as DISH Networks (NASDAQ:DISH) has demonstrated by using Open RAN to meet the FCC’s coverage milestone while potentially reducing Capex by 40% compared to the more conventional way of doing things as I had detailed in an earlier thesis.

Along the same lines, instead of deploying fiber all by itself as is usually the case in the industry, AT&T has recently formed a JV with giant infrastructure investor BlackRock (BLK) called Gigapower, for investment across America. The telco is the anchor tenant and high-speed internet has already been provided in some states.

Valuing AT&T Amid Volatility Risks

This fiber JV is “picking up speed” while the company is on track to deliver $30 million in fiber passings in 2025 amid “insatiable demand” for high-performing internet which is also delivered through FWA or fixed wireless access. Again for investors, this is like building a high-bandwidth network on top of an existing 5G cellular connectivity in remote and under-connected regions.

At the same time, the company is being prudent and favoring locations where it obtains the most returns to avoid a growth-at-any-cost strategy. Thus, it has the potential to increase profits and cash flow, while its forward price-to-cash flow of 3.21x trades at a discount of 61% relative to the sector. This is also 453% lower than Meta’s 17.78x as per the comparison table below.

Therefore, in light of its efforts to modernize its 5G network while rapidly expanding its fiber footprint in a capital-light fashion, AT&T deserves better. Based on 3.21x being incremented by 15%, I have a target of $19.6 (17.05 x 1.15) based on the current share price of $17.05. This represents an upgrade on my previous neutral position on the stock back in March 2022 where I had compared its monetization strategy with Verizon.

This may appear as a moderate target, but it is fair, as the shared investment approach for fiber implies that not all the revenues will make their way toward AT&T’s income statement, without excluding the possibility of other tenants inking wholesale agreements with Gigapower. On another note, using Open RAN technology involving multiple suppliers setting up a radio site is not without risks since there is more likely to be a delay than when dealing with only one.

Therefore, while costing less, projects can take more time to deliver results. As a result, with a market that tends to mostly reward top-line beats and bright sales outlooks, in addition to earnings, the stock can be punished as was the case on April 20 last year when it went down by 10% following concerns about softer demand.

Furthermore, in contrast to Big Tech which was shielded against volatility by the AI rationale at the start of 2023 in a market averse to higher interest rates, few investors seem to realize that the technology has applications in telcos too.

Remaining Optimistic

Still, as a result of embedding AI across AT&T and improving customer service, the company wants to drive new revenue opportunities, but, this thesis focused primarily on the cost aspect. In this case, the capital-light approach to executing projects has resulted in the FCF margin (the yearly free cash flow generated divided by revenues) progressing steadily and is on its way to reaching 15%, and this, after navigating through the rather erratic period between the acquisition and disposal of Time Warner as highlighted in red.

This progression puts the management in a more comfortable position to spend cash for growth purposes. This can be both through modernizing its network to improve competitive positioning and even growing inorganically, somewhat analogous to Big Tech developing cutting-edge cloud computing and making acquisitions.

In conclusion, by going through its operating environment, characterized by competition and heavy spending, this thesis has emphasized AT&T’s capital-light growth strategy while innovating its business processes using AI to do more with fewer resources. This in turn releases more cash, both to meet the relatively high dividend yield and to boost the lagging growth metric.