AT&T’s decision to sell a minority interest in DirecTV to TPG Capital didn’t come as a surprise, it had been expected for months as the phone company let small details around the deal trickle out beginning last year. But the deal, where TPG Capital will get a 30% interest in DirecTV, virtual MVPD AT&T TV Now and IPTV service U-verse for $7.8 billion, had analysts searching for meaning behind selling what was once the premier pay TV asset for about a quarter of what it paid for it seven years ago.
The TPG deal values DirecTV, once the scourge of every cable operator and the largest multichannel video programming distributor in the country, at $16.25 billion (after it paid, including assumed debt, $66 billion for the asset in 2015). Enough has been said about how since AT&T bought DirecTV, it has nearly sucked the life out of the satellite giant, how it has lost nearly 10 million customers, its relevance as a brand and its heart as the gold standard for customer service and quality. Put those thoughts on the shelf for a minute. What the deal shows, according to some analysts, is that AT&T, seeking a way, any way, to pay down the debt it has accumulated over the past six years through the DirecTV buy and its $100-plus billion purchase of Time Warner Inc. -- has again been taken advantage of in the TV space.
Granted, DirecTV is a declining asset -- it has lost bucketsful of subscribers over the years and in the broadband era, its product can’t really compete with cable operators with two revenue streams and the streaming services that appear to have taken over the TV business. But, c’mon, did it really have to end like this?
In an email to clients, MoffettNathanson principal and senior analyst Craig Moffett, long a critic of AT&T’s purchase of DirecTV in the first place, wrote that the TPG deal serves the purpose of removing the satellite company’s dismal financials from the phone company’s books. But that’s essentially where the benefit ends.
“In short, what they’ve really done is buy the right to lock DirecTV in the basement in the hope that no one remembers it’s down there,” Moffett wrote. “It will surely no longer be mentioned when AT&T reports earnings.”
The “bewilderingly complex transaction,” according to Moffett, will basically give AT&T some extra cash ($1.8 billion from TPG), a vehicle in the spun-off entity to raise debt ($5.8 billion) and control of an asset it doesn’t care for.
And the ultimate irony is that the deal doesn’t actually reduce AT&T’s leverage, it increases it. According to Moffett, the $7.8 billion used to pay down debt is offset by the loss of $3 billion in cash flow from DirecTV. So in real numbers, AT&T leverage ratio climbs from 4.1 times cash flow to 4.2 times when the deal closes in the second half of this year.
The deal may be complicated, but Moffett said one thing is glaringly obvious.
“This much is clear,” he wrote. “ AT&T’s DirecTV is inarguably one of the worst acquisitions of all time.”
In a research note, Barclays Group media analyst Kannan Venkateshwar noted that AT&T has said that it expects about $1 billion in annual free cash flow starting next year from the spin-off. While the structure is complicated -- he added that it isn’t clear how AT&T will split the $4 billion in DirecTV free cash flow (70/30 or 50/50) -- if TPG gets in the neighborhood of the $1 billion AT&T expects, the returns on its $1.8 billion cash investment will be rather large in a very short period of time. Remember, that according to the deal terms, TPG is contributing $1.8 billion in cash and assuming about $6 billion in debt as part of the deal. Curiously, that amount is pretty close to the $8.1 billion TPG received in its sale of Astound Broadband, the 1-million subscriber cable operator (RCN, Grade Communications, Wave Broadband and enTouch) it sold to Stonepeak Infrastructure Partners last year.
Venkateshwar was one of many analysts who pointed out that the deal appears to favor TPG more -- in another research note, Evercore ISI Group analyst Vijay Jayant wrote that determining whether the sale was good for AT&T is “Complicated”. But the Barclays analyst deal hinted that the TPG deal is so bad for AT&T that it just has to have an angle that maybe others are missing.
In his note, Venkateshwar said that the deal is interesting because it hits almost none of the metrics usually associated with such deals -- it’s free cash flow dilutive, it doesn’t really reduce AT&T’s debt that much (about $200 million) and allows AT&T to “lose strategic control” over one of its biggest cash cows. To make matters worse, he wrote that the leverage on the new company is a lot lower than what investors would normally expect from a private equity deal.
“A skeptical read could be that the decision to sell despite the low valuation, the inability to hit financial deal objectives, and the unusually low leverage are all likely due to more structural risk than investors may have anticipated in AT&T,” Venkateshwar wrote. “However, in our opinion, the unusual structure could imply that the transaction is potentially just the first phase of a more comprehensive transaction. It is also possible that it is a combination of both.”
Venkateshwar suggested that TPG might be able to work better behind the scenes toward a Dish merger, adding that the synergies of such a deal could boost AT&T’s economics at some point in the future.
“This would also explain the decision to put a low leverage on the asset as the combined company could have significant synergies which can then be levered up more efficiently to drive much higher returns for all counterparties,” Venkateshwar wrote. “Therefore, while the initial read for AT&T from the announcement seems to be negative, we think there could be more to the deal than meets the eye.”
On a conference call with analysts to discuss the deal on Feb. 25, AT&T CEO John Stankey didn’t want to comment on the merger potential of the deal.
“There are a lot of different terms and conditions in it [the TPG deal] and a lot of different scenarios that might be out there that I’m not going to talk about or fill in the public on,” Stankey said on the call. “Generally speaking, we remain a participant in any future value that gets created as a 70% owner of this entity. If something else occurs, we get 70% of the value and our partner gets 30% of the value as a general rule. Both parties are incented to try to create more value because it’s good for our investment and our structure moving forward. That’s the simplest way to think about it. ”
The concept of the combination of DirecTV and Dish is nothing new. But even though the climate has changed, and the fact that the only two satellite TV companies in existence are both struggling, regulators are apparently no more open to a combination now than before. As recently as October, under a Republican administration mind you, the Dept. of Justice was reportedly sending messages that they would not allow a merger to take place. With a current Democratic administration not necessarily keen on making even struggling rich guys richer, chances of a deal happening can’t be much better.
Dish chairman Charlie Ergen has said the merger of Dish and DirecTV is “inevitable,” adding that the satellite business is a declining asset and that putting the two together would ensure their health.
“Make no mistake, whether it’s a year from now or 10 years from now, I believe it’s inevitable those companies go together,” Ergen said during Dish’s Q3 conference call in November.
To me, putting together two companies in an industry that has passed them by isn’t a solution, it’s procrastination. Together the two may have some cost synergies and additional scale, but the satellite TV business is still going to die. A Dish/DirecTV merger would only prolong the inevitable demise of both companies.
In an August research report, Moffett estimated that merging with Dish would only improve the combined company’s subscriber erosion to 15% per year. And Moffett added that with Charter and others planning to increase rural broadband buildouts, the picture is even gloomier.
“If we see a huge post-COVID stimulus/infrastructure bill next year targeting broadband expansion, as seems likely, then the defensible rural segment will all but disappear,” Moffett wrote in the August note.
So, perhaps the reasoning behind the deal is really as simple as a company that realized it got into a bad business at an even worse time and just wanted out. In opening up the conference call on the deal Feb. 25, Stankey said " We didn't expect this outcome when we closed the DirecTV transaction in 2015, but it’s the right thing to do."
Or maybe, as a slightly older, wiser sage once put it, there is no why.
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