The Curse Of The Smartphone

You've probably seen or read an article in last few years about how wireless carriers both love and hate smartphones. On one hand, companies like AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) benefit when a customer chooses a smartphone, because they are required to pay for a data plan for their device. However, the high subsidy that these devices normally require can take many months to recoup. Although AT&T looks like a good buy based on the company's yield of more than 5%, there may not be a clearer picture of the curse of the smartphone.

Ahh, the good old days
Prior to the advent of cell phones, telecommunications companies essentially had one main business. These companies just had to make sure that their voice lines were up and working and each region essentially had one carrier with a monopoly over its customers.

With AT&T, Verizon, and Windstream (NASDAQ: WIN  ) all reporting landline losses of at least 6% in their current quarters, it's obvious that each company must make up for the loss of this revenue and cash flow. While AT&T and Verizon have their wireless divisions to fall back on, Windstream must turn to high-speed Internet, video, and enterprise offerings to try and make up these losses.

Low and slow
In a recurring theme, AT&T seems to constantly play second fiddle to Verizon when it comes to their respective wireless operations. For instance, AT&T reported wireless revenue growth of over 5%, whereas Verizon grew its wireless revenue by more than 7%. What is slightly more troubling, is AT&T also reported a lower operating margin of just over 26% in its wireless operations compared to a nearly 34% margin at Verizon.

Based on the above numbers, it's not surprising that Verizon is also growing revenue per user faster than the old Ma Bell. AT&T reported average revenue per user increased by 1.5%, while Verizon reported an increase of more than 7%. Whether it's AT&T's low wireless margin or slow revenue growth, AT&T investors should be seeing red.

3 warning signs
The first issue facing AT&T is, over the last nine months, the company's core operating cash flow (net income + depreciation) increased by just 1.7%. By comparison, Windstream was able to increase this same measure by roughly half of a percent. Given that Windstream doesn't have the growth engine of AT&T Wireless, AT&T's results are worrisome. When you consider that Verizon increased its core operating cash flow by 13%, this worry becomes a big red flag.

The second concern facing AT&T investors is, their company is generating free cash flow at a lower rate than they might expect. Both Windstream and AT&T generated $0.10 of free cash flow per dollar of sales in the last nine months. Verizon, on the other hand, nearly doubled this production with $0.18 of free cash flow from each dollar of sales.

Third, AT&T's free cash flow payout ratio could be an issue. For point of reference, Windstream's core free cash flow (net income + depreciation-capital expenditures) payout ratio came in at 97% in the last nine months. AT&T reported stronger revenue growth, but posted a payout ratio of more than 75% in the same timeframe. Once again, Verizon topped both of its peers with a core free cash flow payout ratio of just over 27%.

Final thoughts
Of the three companies we've looked at, only AT&T and Verizon have to worry about smartphone penetration. The difference is, while Verizon's total smartphone penetration is still less than 70%, AT&T sits at 75%.

AT&T has to pay higher subsidies than Verizon since more of its customers are smartphone users. These higher subsidies eat into margins, lower margins lead to lower cash flow, and in the end, AT&T's higher payout ratio.

Investors can also see AT&T's challenges based on the fact that analysts expect the company to grow earnings by just over 6% annually in the next five years, as compared to the better than 10% growth expected from Verizon.

In fact, it seems like AT&T and Windstream have a lot more in common than some investors would like to admit. Both companies have slow operating cash flow growth, relatively high payout ratios, and challenges keeping up with their competitors. While Windstream at least offers investors a double digit yield to compensate for its other weaknesses, AT&T pays a yield that is just slightly more than Verizon.

Almost no matter how you look at it, AT&T is suffering from a curse that can't easily be cured. It might be wise for investors to exorcise this stock from their portfolio before their returns are cursed as well.

More compelling ideas from Motley Fool
Want to get in on the smartphone phenomenon? Truth be told, one company sits at the crossroads of smartphone technology as we know it. It's not your typical household name, either. In fact, you've probably never even heard of it! But it stands to reap massive profits NO MATTER WHO ultimately wins the smartphone war. To find out what it is, click here to access the "One Stock You Must Buy Before the iPhone-Android War Escalates Any Further..."


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