AT&T Inherits Long-Term Strategic Issues With DirecTV

 AT&T (T) has reached an agreement to acquire  DirecTV  for $95 per share in stock and cash. As we've previously stated, we don't believe this move makes strategic or financial sense for AT&T. Using our stand-alone fair value estimates for the two firms and assuming no merger-related cost synergies, our fair value estimate for AT&T would drop to $32 per share from $35 while our fair value estimate for DirecTV would increase to $86 from $51 if the deal goes through. We believe there are meaningful cost synergies to be had. We previously estimated these synergies would total around $1 billion annually, though AT&T pegs the savings at $1.6 billion annually, three years after closing. If we assume cost savings have a net present value of $10 billion, which we view as reasonable, our AT&T fair value estimate falls to $33 and our DirecTV fair value estimate increases to $89. As of now, we peg the odds that this deal wins regulatory approval at 50/50. As a result, we are likely to move our AT&T and DirecTV fair value estimates to $34 and $70, respectively. The firms are holding a conference call with investors before the market opens Monday. We plan to finalize any changes after the call.

We still believe AT&T's primary aim in striking a deal with DirecTV is to focus regulatory attention on the importance of scale in the pay television business as  Comcast (CMCSA) attempts to acquire  Time Warner Cable . The biggest benefit to AT&T from this deal would be increased leverage in negotiating with content owners like Disney. By highlighting the fact that other pay television providers need to keep pace with Comcast and putting its own deal forward, AT&T is forcing regulators to consider a world with significantly increased concentration in media distribution. 

While saving on programming costs and other expense savings may be attractive, we don't believe a satellite acquisition makes long-term strategic sense for AT&T. Owning DirecTV only enhances AT&T's service capabilities in those markets where it doesn't plan to offer U-verse television service (ultimately about a third of its fixed-line service territory). AT&T already partners with DirecTV to offer bundled services to these customers. In many of these markets, AT&T has invested to improve Internet access capacity and speed, and the firm has said in the past that it is positioned to provide television service to these areas if the television model changes (that is, if over-the-top television services take off). In other more rural markets, we expect wireless service will play an increasingly important role in AT&T's service offering. In exchange for the modest strategic benefit of adding television capability in a portion of its territory, AT&T has to take on a business that operates, in our view, at an increasing competitive disadvantage across the rest of the country.

The acquisition of DirecTV would reduce the number of competitors in most markets where AT&T provides U-verse television service to three from four. We expect this reduction in competition in markets serving around one fourth of the U.S. population will receive significant regulatory scrutiny. AT&T has promised to maintain stand-alone nationwide package pricing for DirecTV service for at least three years after closing. We believe regulators will view this commitment as weak, and we would note that  DISH and Directv made a similar argument when trying to merge a decade ago.

From a balance sheet perspective, the acquisition won't change net leverage much. The cash portion of the deal totals about $14.5 billion, but AT&T plans to sell its stake in America Movil, currently worth about $6 billion, to finance part of this amount. Absent any cost savings, we estimate the deal will increase AT&T's net leverage to about 2.0 times from 1.8 times currently.  AT&T's annual dividend payout will increase about $1.7 billion to $11.3 billion. Absent synergies, we estimate the dividend would have consumed about 75% of free cash flow over the past year on a combined basis, the same percentage AT&T has paid out on its own. With synergies, we estimate the payout ratio would have been about 70%, but our outlook for free cash flow growth in the medium term and our view on long-term cash flow sustainability are diminished.

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