Coming a few days after a mixed earnings report from rival Verizon Communications , AT&T 's (NYSE: T) second-quarter report suffered from a similar problem. Wireless customers have been slow to upgrade their smartphones, leading to lower equipment revenue for the wireless leaders.
AT&T saw equipment revenue drop 5.8% year over year in the second quarter, enough to cause the company to miss analyst expectations. But unlike Verizon , which saw its stock drop in the wake of its earnings report, AT&T stock had one of its best days in months on Wednesday.
Low churn and continued subscriber gains
The sluggishness of customers upgrading their phones does reduce AT&T's revenue, but it doesn't turn a profit on equipment sales. Discounted and subsidized smartphones are a component of the company's customer acquisition strategy.
What's clear from AT&T's second-quarter report is that this slower upgrade cadence has some upsides. Postpaid phone churn , a measure of how many customers switch providers, was just 0.7%. The company expects this to be the lowest churn rate in the industry.
A phone upgrade is a natural time for customers to reconsider their wireless provider and perhaps take advantage of a deal to switch providers. With customers holding off on upgrades, AT&T is losing fewer subscribers as customers stick with their current phones.
This lengthening upgrade cycle doesn't seem to be hurting AT&T's ability to win new subscribers. It reported 419,000 postpaid net adds in the second quarter, an acceleration compared to the same quarter last year. These new subscribers helped push mobility service revenue up 3.4% year over year.
A hidden benefit of fiber internet
The fiber internet business also performed well for the company, gaining 239,000 net subscribers during the quarter. Fiber helped push consumer broadband revenue up 7% year over year, although it wasn't enough to offset declining legacy wireline revenue on the business side.
Beyond providing another growth business beyond wireless, AT&T is seeing fiber internet customers increasingly choose its wireless service over the competition. Nearly 40% of AT&T fiber households also subscribe to AT&T's wireless service. The company offers discounts for bundling fiber and wireless, a strategy that appears to be working.
Once a customer chooses both fiber and wireless from AT&T, switching providers becomes even more unlikely because the bundle discount will vanish. Even if an alternative wireless plan is a better deal, the pain of switching plus the loss of discounts will likely lead to extremely low churn for customers taking advantage of the bundle.
Free cash flow galore
AT&T generated $4.6 billion in free cash flow during the second quarter, up about $400 million from the prior-year period. The company remains on track to generate between $17 billion and $18 billion in free cash flow this year, and it reiterated that outlook in its earnings report.
Based on the midpoint of that guidance, the stock trades for less than 8 times free cash flow. Modest growth is the most investors should expect on average, but even so, that valuation looks extremely pessimistic.
AT&T is gaining subscribers at a healthy pace despite an industrywide unwillingness among customers to upgrade smartphones, and it's losing few customers to churn. The spread of its fiber network can help boost growth in the wireless business, and there's still plenty of room to convert existing fiber customers into wireless customers as well. With AT&T sticking with its free-cash-flow outlook, the stock looks like a compelling buy.
Timothy Green has positions in AT&T. The Motley Fool recommends Verizon Communications. The Motley Fool has a disclosure policy .
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