AT&T and Verizon Communications: A Near-Term Surprise and Long-Term Promise

Many investors love to hate the two largest US telecom companies, AT&T (NYSE: T) and Verizon Communications (NYSE: VZ). But these behemoths beat expectations and posted impressive subscriber additions in the second quarter, sparking a sharp rally in their stock prices.

Verizon Communications gained 614,000 net wireless contracts, reducing churn in the post-paid segment to 0.7 percent. Rolling out an unlimited data plan to rival T-Mobile US’ (NSDQ: TMUS) offering helped to reverse a first-quarter decline in the company’s wireless subscriber base.

All told, Verizon Communications’ retail post-paid connections ticked up 1.2 percent year over year, while the number of prepaid accounts (4.7 percent of its total base) increased by 1.4 percent. The company also reported that 75 percent of its wireless contracts involve unsubsidized pricing and called for “an improving trend” for service revenue in the second half of the year.

The launch of unlimited data plans helped AT&T to pick up 127,000 net new wireless customers, reducing churn to a record-low 0.79 percent.

T-Mobile US’ second-quarter results included solid customer additions, but the numbers suggested that many of these defections came from Sprint Corp (NYSE: S) and other marginal players. AT&T and Verizon Communications’ strong second-quarter results confirm this notion.

Back to Funding Growth

These wireless additions flowed right to the bottom line, with Verizon Communications growing its revenue and earnings after a disappointing first quarter. Meanwhile, AT&T’s second-quarter earnings per share increased by 10 percent year over year.

More important, both companies generated enough operating cash flow to cover their dividends and industry-leading capital-spending plans.

AT&T’s free cash flow came in at $3.7 billion after $5.2 billion worth of network investment. And in the first half of the year, Verizon Communications generated $12 billion in adjusted cash from operations, leaving $5 billion in free cash flow after factoring in $7 billion worth of capital expenditures.

These telecom titans’ ability to cover their huge capital investments with cash flow has driven their rise to the top since the industry deregulated in 1996. Maintaining this competitive advantage will be critical to dominating the next leap forward: data-intensive 5-G wireless networks and the rise of machine-to-machine communication.

Verizon Communications has launched pre-commercial trials of its 5G wireless network in eight cities, and the $3.1 billion acquisition of Straight Path Communications (NYSE: STRP) will give the company a huge swath of spectrum for launching wireless applications.

As for machine-to-machine communications, telematics contributed $220 million to Verizon Communications’ top line in the second quarter. Overall, the company’s revenue related to the internet of things increased by 20 percent, excluding acquisitions.

Heading into earnings season, we harbored a niggling concern that near-term pressure on wireless revenue would challenge Verizon Communications’ ability to deliver on its debt-reduction goals without scaling back capital spending or dividend growth. The company’s second-quarter results alleviate this concern, at least for now.

Down the line, this pressure should alleviate as the company feeds recently acquired content into its rapidly integrating wireless and fiber-optic networks, machine-to-machine applications continue to grow, and the full rollout of its 5-G network approaches. All these upside drivers make Verizon Communications a worthwhile long-term holding.

Still Focused on Wireless

Rest assured, the market will continue to focus on trends in AT&T and Verizon Communications’ wireless subscriptions, setting the stage for further volatility when the companies report quarterly results.

AT&T’s biggest challenge this summer has nothing to do with its operations: Closing its proposed acquisition of Time Warner (NYSE: TWX) still requires the US Dept of Justice’s approval. During AT&T’s second-quarter earnings call, CFO John Stephens indicated that the deal is still expected to close by the end of the year. That said, the growing chaos at the top of the Dept of Justice could push back this timeline.

But the company still offers exposure to a number of underappreciated growth drivers, including the rollout of its 5-G wireless network and push into “edge” computing to support self-driving cars, robotic manufacturing, and virtual-reality applications.

Many of the questions on AT&T’s second-quarter earnings call focused on trends in wireless subscriptions and, to a lesser extent, customer counts for its wireline network and DirecTV. This focus makes sense, as the company generates the bulk of its revenue from these businesses. Holding its own in these markets and continuing to expand its footprint in Mexico will provide the cash needed to invest in future opportunities.

However, where AT&T and Verizon Communications’ shares trade at the end of this decade will depend on how they capitalize on the next-generation of communication services. These telecom behemoths have already built a sizable lead on their peers when it comes to 5-G networks and machine-to-machine communications, which bodes well for the long term.

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