AT&T's Next Plan Could Crimp Its Cash
Short-Term Boost to Earnings Could Carry Hidden Cost for Shareholders
AT&T T +0.03% may have found the next big thing, but it could come with hidden costs.
Shares of the No. 2 U.S. wireless carrier by subscribers have risen more than 11% over the past month. For a mature company with a market capitalization of $186 billion, that is no small pop, especially as rival Verizon Communications VZ -0.10% ' stock has risen less than 1%.
The rally also seems anomalous against the backdrop of intensifying competition, which should be hurting margins. Yet forecasts of AT&T's earnings have risen.
AT&T owes much of this apparent margin magic to a wireless plan called Next. This separates the cost of the phone from that of the service, letting subscribers pay off the device in installments.
AT&T accounts for those device revenues differently from those collected under its traditional plan, booking a significantly larger chunk upfront. The accounting shift adds up to a lot of extra profit, boosting earnings before interest, taxes, depreciation and amortization, or Ebitda, by $2.9 billion in 2014, equal to 80% of projected Ebitda growth in the wireless business, according to UBS.
The problem is that additional profit may actually result in lower cash flows.
Under a traditional plan, a subscriber pays perhaps $200 upfront for a top-of-the-line device like Apple's iPhone. AT&T books that as revenue. If the actual cost of the device is $650, AT&T takes a one-time hit to Ebitda of $450, which it makes back over time through the overall cost of the plan.
With Next, a subscriber puts no money down, trades in an old device, and then pays down the cost of the new one over 20 or 26 months. But now, UBS estimates, AT&T books $531 of that $650 as net revenue as soon as the customer takes the phone. That figure comes from backing out $65 for loss on the trade-in value of the device and roughly $54 for finance charges. So the hit to Ebitda is just $119 in the first year, much better than a $450 loss. Next subscribers can upgrade after 12 or 18 months, so AT&T could take another $119 hit the following year, but that is still better versus the traditional plan.
AT&T also discounts the service portion of the Next plan to account for the piece that would have gone to subsidizing devices. In that sense, the new accounting moves revenue from one box to another, and the long-term economic outcome for the two plans is roughly the same. But timing differences in when costs are accounted boost near-term earnings.
AT&T has boosted marketing efforts to push subscribers toward Next. But the income statement's gain could be cash flow's loss. Under a traditional plan, the device cuts AT&T's cash flow by $450 in the first year. With the 26-month Next plan, the cash outflow in the first year is $330 after accounting for installments paid, the trade-in value of the old device and the discount to the wireless service plan, UBS estimates. So far, Next is still winning.
If a Next subscriber upgrades after 18 months, though, AT&T could see another $330 of cash flow out in the second year, against zero for the traditional plan. So over two years, the negative cash flow impact of the device under Next could be $660. And cash matters for a company forecast to pay out roughly 86% of free cash flow in dividends this year.
Granted, all the other major carriers have adopted similar programs. But so far they seem to be having less of an effect on earnings. During Verizon's last quarterly earnings call, for example, the company said its comparable Edge program was generating less than 1% of profits.
Those focused on AT&T's upfront profit gains should ask themselves what comes after Next.
