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Will AT&T's Deal Pass Regulatory Muster?

Jeremy Glaser

Jeremy Glaser: For Morningstar, I am Jeremy Glaser.

AT&T announced this weekend that it intends to buy T-Mobile from Deutsche Telekom for $39 billion.

I am here today with associate director of equity research Mike Hodel to take a closer look at the deal, see what the chances of it going through are, and what the impacts could be on the broader wireless industry.

Mike, thanks for joining me today.

Michael Hodel: Thanks for having me.

Glaser: So, can you give us a little bit of background: Were people surprised that AT&T completed this deal? I know there was some talk that Sprint was thinking of purchasing T-Mobile from Deutsche Telekom.

Hodel: I don't know if people in general were surprised, but we certainly were. If you would have asked us a week ago whether a deal like this could get down or whether AT&T or Verizon Wireless would have attempted to do a deal like this, we would have said "no."

Our view has been that AT&T and Verizon Wireless are so much larger than the rest of the players in the industry that the regulatory hurdles that any further acquisitions would have to clear are so large that neither firm would try to do anything certainly of this scale.

So we were certainly shocked that AT&T made this announcement that they are going after T-Mobile.

Glaser: So, what about the price that AT&T is paying? Does this seem like a rich deal, or are they getting a bargain here?

Hodel: I think they are getting a very good price for T-Mobile. They are paying about seven times EBITDA, which is little bit on the high side maybe for a wireless company, probably right about in the right range. Again, may be little bit on the high side. But the cost-cutting opportunities available to AT&T with this deal are simply too big to ignore.

Both firms operate on the same network technology. They serve, obviously, overlapping markets. So, the opportunity to cut out marketing expenses, network expenses, etc., are huge. So there's plenty of opportunity for AT&T to create a lot of value for shareholders with this deal.

Glaser: So from the AT&T shareholders' perspective, this seems like a win?

Hodel: I think it is a win. It's a little bit more complicated than just to say it is a win. There's a breakup fee involved here. If regulators kill this deal or if the deal doesn't get done for any reason, AT&T is on the hook to pay T-Mobile $3 billion and give it some spectrum assets. So that does create a risk for AT&T, but we think that that risk is so small relative to the upside potential if the deal goes through that it's well worth the risk for AT&T shareholders. And the total value of the breakup fee is less than $1 per share to AT&T, and the amount of value that they create if the deal goes through is large.

Glaser: Let's talk about the regulators then. Certainly, that seems to be the biggest question mark over the deal right now. What do you think is going to happen? Do you think that this is going to see any sort of speedy approval, or do you think it's going to take a long time?

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Hodel: Well, it's certainly going to take a while, and we'd expect the FCC and the Department of Justice to go market-by-market and look at the impact of the deal on competition in each individual market and make some determination of how many markets AT&T needs to divest to get the deal approved. And it'd really come down to, I think, how many markets have to be sold off. But we expect this to be a really tough approval process.

Again, if you would have asked us a week ago, whether AT&T would have even attempted something like this, we would have said "no," simply because regulators have shown an increasing discomfort with the level of power that AT&T and Verizon Wireless have in the industry. You can look at a company called LightSquared. It's a startup wireless business that's trying to build out a new network. The FCC put conditions on some of their spectrum that limits how closely they can work with AT&T and Verizon Wireless. So these sort of things that are singling out these two companies as being dominant in the industry give us some reservation about how much more power [regulators] are willing to let these two companies, AT&T and Verizon Wireless, really have.

Glaser: This, obviously, is going to have a huge impact on the wireless industry in general. I guess there are two big questions. The first is Sprint and the second will be Verizon.

So for Sprint, how do they react to this? They are going to be very distant third if this deal were to go through.

Hodel: Sprint is the one company that we think is most at risk here. We think that they have lost some control over their own destiny as a result of this. Part of that is because AT&T/T-Mobile frees up Verizon Wireless to think about doing deals of its own and possibly in short order.

I think Verizon Wireless has an incentive to get a deal on the table fairly quickly to force the FCC to evaluate any deal that it might want to do in conjunction with AT&T and T-Mobile, simply because once the AT&T/T-Mobile deal is done, the level of concentration in the industry might be such that any deal Verizon would want to do would then be off the table. So I think, again, it's in Verizon Wireless' best interest to force the FCC to evaluate any merger proposal that it might have in conjunction with the AT&T/T-Mobile deal.

Glaser: So, it'd be less surprising to hear more merger talk coming from either of those players sooner rather than later to make sure that their views are being heard at the table?

Hodel: Right, and why that's a risk for Sprint is that Verizon Wireless could well make a run at Sprint, but that would be, again, yet another degree larger consolidation than what you have with AT&T and T-Mobile.

More likely is that Verizon might go after some of the larger players that Sprint might have wanted to acquire to beef up its position. So, having T-Mobile off the table removes a merger partner potentially for Sprint. It also could potentially remove additional merger partners if Verizon Wireless goes after some of the smaller players, guys like Leap Wireless and MetroPCS.

Glaser: Then for consumers, it's too early to say what the impact could be on wireless pricing or on handset availability? Is all of that still up for negotiation?

Hodel: Well, that will all be determined by the level of competition in the industry, and there is no doubt that AT&T combining with T-Mobile will reduce the amount of competition that you see in the wireless marketplace. T-Mobile and Sprint in particular have been fairly aggressive on pricing at the lower end, and that serves to keep AT&T and Verizon Wireless honest on pricing. Taking out T-Mobile, you eliminate one of those players from the market, and so that will certainly have an impact on consumers.

AT&T will sell this deal as benefiting consumers in that it will enhance network coverage, it enhances their ability to get the types of speedy data services to consumers that consumers are increasingly demanding, but again, what you pay for that service will be determined by the level of competition in the industry.

Glaser: Finally, looking at stock valuations across the sector, do any stocks look attractively priced right now to kind of ride this wave of consolidation, or is it better to watch from the sidelines?

Hodel: Well, we've thought that Sprint is attractive for some time now. Just given the assets that they controls, we think that it's very attractively priced. As I said earlier, this deal increases uncertainty for Sprint shareholders, and we've increased our uncertainty rating on the stock to reflect that, but given how hard the stock has sold off today, I still think it's relatively attractively priced.

AT&T is up on the news, and again this is clearly positive for shareholders if it goes through, but there is still this uncertainty that it doesn't go through. We think the stock is close to fairly valued here. Verizon Wireless is also up today on the news, and we think it's close to fairly valued as well.

Glaser: Mike, thanks so much for sharing your thoughts. I'm sure we'll be talking about this a lot in the coming year.

Hodel: Sure. Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.