Hoping AT&T Hangs Up on Its European Strategy

 | Nov 08, 2013 | 12:00 PM EST  | Comments
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We have liked AT&T (T) as a conservative, dividend-oriented investment, discussing it twice in the past year. It has been an okay investment, up 4.2% year-to-date, and has paid a healthy 5% dividend yield while investors wait. We were comfortable with the business progress as reported in the past quarter and have looked for the stock to continue as a slow and steady performer going forward.

However, there is one negative to the investment case that has started to gain a lot of traction in the past week. After months of market rumors and hints by the company, AT&T more formally put the investment community on notice that it has a serious interest to expand in Europe. The most likely path would be to try to buy Vodafone's (VOD) remaining assets after that company sells its Verizon Wireless stake to Verizon (VZ).  From AT&T's perspective, this deal would make it a global player and enhance its long-term growth prospects.

For reasons discussed below, we are very wary about this move, and believe it could significantly detract from the company's investment appeal. While we are not recommending selling, we suggest investors monitor the situation carefully as the structure and cost of any such deal becomes clearer. 

While the deal might be accretive on paper, we have significant concerns about the business realities of expanding in Europe. We would look to sell if the stock rallies on any excitement over possible earnings accretion.

There are a number of key issues to consider when assessing this potential deal. Most importantly, the regulatory hurdles to the deal are large and unfavorable. The EU has shown it's not particularly friendly toward American companies buying European ones, especially when the subject assets are considered as strategic or national champions. 

If the EU does allow the deal, then the separate regulators in each of the countries where Vodafone operates will weigh in on rate and service offerings, making it cumbersome for AT&T to do business in a coordinated way throughout the region.  Thus, the national service plans in the United States will be hard to replicate on a pan-European basis.  Additionally, individual country telecom regulators appear to favor their "home team", to the detriment of foreign-owned competitors, as Vodafone has already experienced.

In Western Europe especially, the "quad play" (wireless in addition to telephone/data/video in a single bundled offering) has gained traction. The result has been to even further commoditize wireless phone service, placing the Vodafone assets under new, more severe price pressure. In fact, this was a factor driving Vodafone to monetize its U.S. investment, so that it could redeploy the proceeds to defensively invest in wireline infrastructure and wireless pricing.

In the end, a foray into Europe by AT&T would be costly, and would require significant management attention, resulting in a company less focused on its critical U.S. business. Since the U.S. business is facing its own challenges, a European foray would result in fewer resources available for shareholders. 

Valuation of the stock is not a stretch at all, at 13.2 times next year's EPS and a dividend yield of just over 5.1%; on both metrics, the stock is markedly cheaper than Verizon, its closest comparable. 

At the current price near $35.10, we believe AT&T is modestly under-valued. At a few dollars cheaper, we would suggest the risk/reward is favorable. At a few dollars higher, we would be concerned that the market was overlooking the substantial risk from such a deal, including the difficulty of executing on the big potential sure to be promised by management. 

Priced where it is now, we'd suggest holding the stock for the dividend income and for some potential price appreciation from its reasonable valuation, especially in comparison to the market. But investors should be watchful as AT&T's strategy becomes clearer, and should be prepared to hang up if the company won't.

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