Shares of AT&T (NYSE:T) rallied 20% this year, thanks to robust demand for dividend stalwarts in a low interest rate environment, optimism regarding its DirecTV takeover, and the belief that its proposed merger with Time Warner (NYSE:TWX.DL) will usher in a new era of growth. But looking ahead, AT&T faces three tough challenges -- ensuring that the Time Warner deal closes, defending its controversial zero-rating strategies, and keeping its debt levels under control.
1. Defending the Time Warner merger
AT&T's biggest challenge is to convince regulators that its proposed $85 billion takeover of Time Warner isn't an anti-competitive move. Regulators believe that the merger could encourage AT&T to block pay TV competitors' access to Time Warner shows and movies, while favoring its own media portfolio over independent content.
AT&T CEO Randall Stephenson told lawmakers that bundling wireless, pay TV, and media assets together would offer "better-priced options" to consumers who are upset by high cable bills, and that the merger would let them "pay for their content once and watch it anywhere, anytime." Billionaire Mark Cuban also defended the deal, stating that the merger would create a stronger competitor against digital ecosystem giants like Apple, Alphabet's Google, and Facebook.
If the merger is approved, AT&T will have to convince investors that it didn't sacrifice too many potential benefits -- like "zero-rated" Time Warner content and more competitive pay TV bundles -- to appease lawmakers. If the merger is rejected, AT&T must find other ways to integrate media and advertising content into its wireless, wireline, and pay TV platforms.
2. Defending its zero-rating strategies
AT&T's zero-rating strategies, which offer data-free consumption of DirecTV streaming content on mobile and home devices, have been panned by net neutrality advocates. AT&T does this to strengthen its bundles and counter cord cutters, but critics claim that it's an unfair strategy to use against streaming companies like Netflix (NASDAQ:NFLX), which can't zero-rate their content unless they sign special deals with AT&T and other telecoms companies.
The FCC recently reached a preliminary conclusion stating that AT&T's zero-rating strategy violated net neutrality rules. AT&T defended its strategy, claiming that letting other companies pay to stream data-free video leveled the playing field. However, the FCC believes that AT&T still has a cost advantage against companies like Netflix, since it controls both the internet infrastructure and the video platforms.
If the FCC forces AT&T to drop its zero-rating strategy, the idea of building its own massive digital ecosystem with zero-rated content across multiple platforms could fall apart. It would also make the Time Warner deal less attractive, since AT&T customers wouldn't get data-free episodes of their favorite shows, such as Game of Thrones on HBO Now anytime soon.
3. Keeping debt levels under control
AT&T's growth strategies have caused its debt levels to surge over the past few years. Its $18.2 billion purchase of AWS-3 spectrum licenses and its $49 billion purchase of DirecTV already prompted Moody's to downgrade its senior unsecured notes rating to Baa1 last year. Its total long-term debt currently stands at over $117.2 billion, with $7.98 billion maturing within the next year.
Moody's also warned of another potential downgrade after AT&T agreed to buy Time Warner, noting that the deal would increase its adjusted gross leverage from 2.8x to 3.5x -- a threshold which may impact its dividend growth.
However, AT&T still has several ways to keep meeting its short-term debt obligations without reducing its dividends. It can divest DirecTV's Latin American pay TV business, which Spanish telco Telefonica was once eyeing for $10 billion. It can sell additional wireline assets, as it previously did in a $2 billion deal with Frontier Communications. It could also negotiate new paid peering deals with companies like Netflix to guarantee streamlined access to its networks.
The key takeaway
I previously highlighted AT&T as a core holding which I don't plan to sell anytime soon. Concerns about Time Warner, net neutrality, and debt will likely dominate headlines about AT&T in the near term, but investors should note that the telco giant trades at just 17 times earnings -- which is much lower than its industry average of 25.
Its forward yield of 4.9% is also easily supported by a payout ratio of 81%, and AT&T has hiked that payout annually for over three decades. Based on those numbers, AT&T is still an undervalued stock with a big dividend -- making it an ideal long-term play for conservative investors.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun owns shares of AT&T. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Facebook, and Netflix. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Moody's and Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.