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Analysis: Will An AT&T-DirecTV Merger Fly?

(An earlier version of this story appears in the May 19 edition of Multichannel News.)

AT&T finally pulled the trigger Sunday on its week-long awaited acquisition of DirecTV, a deal that values the satellite giant at $48.5 billion, or $95 per share.

The deal, a countermeasure to the pending $69 billion cable merger between Comcast and Time Warner Cable, creates a 26-million subscriber rival for the television business. But as AT&T and DirecTV tout the benefits of the merger , analysts and observers are split as to the deal’s benefits. On the plus side, it could allow AT&T to free up bandwidth for its U-verse broadband service — it currently allocates 15 Megabits per second for video and 10 Mbps for high-speed Internet service in about 25% of the country, and could give the telephone giant the incentive to upgrade its digital subscriber line plant (which maxes out at around 1.5 Mbps) to fiber.

Critics of the deal point to the merger as a temporary fix — DirecTV’s video business is basically flat, adding just 12,000 net new customers in the first quarter — and though the business is well run, operating DirecTV as a separate entity would require AT&T to support two cost structures in 25% of the country with just a one-product offering in the other 75%.

Regulations will be another hurdle. While a DirecTV/AT&T merger would be easier for regulators to swallow than a Dish Network-DirecTV merger, it is by no means a slam dunk. The union would eliminate one video service provider in 25% of the country, something that the Federal Communications Commission typically frowns upon.

AT&T has been trying hard to convert digital subscriber line customers to its U-verse broadband product, but has been losing customers of the lower-speed service to cable operators by the bucketful. According to Leichtman Research Group president and principal anlayst Bruce Leichtman, AT&T has lost broadband customers in every quarter except Q1 for more than two years. In the first quarter of 2014, overall broadband customers were essentially flat, but AT&T had about 5.5 million DSL customers, down from 8.1 million in the prior year.

 Here’s a look at some of the reasons for DirecTV to sit this one out.

1. The price could be too “frothy.” Charlie Ergen, chairman of satellite-TV rival Dish Network, said it first, back on a conference call with analysts to discuss his own fi rstquarter results, in describing what was then rumored to be a $40 billion deal for DirecTV as too “frothy,” or too pricey for what is at best a stable business. At $48.5 billion, or $95 per share, the deal works out to be a 22% premium to DirecTV’s May 8 closing stock price of $77.60 per share, just prior to the news of talks leaking out. (In contrast, Comcast’s $158.82 per share valuation for Time Warner Cable represented an 18% premium to its price before the deal was announced.)

What’s more, at $48.5 billion, the deal would represent a multiple of about 7.7 times DirecTV’s 2013 operating profit before depreciation and amortization, the high range of recent deals. (In contrast, Comcast is proposing to acquire TWC for a multiple of about 6.7 times operating cash flow.)

2. The merger will solve AT&T’s cash problem, but only temporarily. AT&T is hungry for cash to help it fund its dividend — estimated to be about 90% of free cash flow — and DirecTV’s cash reserves could go a long way toward solving that dilemma. But a lot will depend on how the deal is structured. Some reports have said AT&T is in favor of using as much stock as possible for the deal, keeping its leverage low and its investment-grade rating intact. But more stock also means a larger dividend commitment. And even at a 50/50 cash-and-stock deal, the union doesn’t move the needle that far for AT&T.

According to MoffettNathanson principal and senior analyst Craig Moffett, the addition of DirecTV would better AT&T’s dividend coverage from a dismal 87% to an almost-as-dismal 83%.

3. On the surface, it doesn’t look much better from a DirecTV perspective. While there may be some hidden synergistic reasons to do the deal outside of programming-cost savings (estimated at about $400 million), even proponents of the union are hard pressed to justify the pact from a DirecTV perspective, other than the hefty premium in cash and stock they will receive. Some analysts have said the prime motivation for DirecTV could be that it is running out of time and potential merger candidates.

“From a long-term perspective, this is about partnerships,” Telsey Group media analyst Tom Eagan said in an interview. “For DirecTV, if they are ever going to partner with anyone, it’s got to be now.”

On the AT&T side, Eagan said the telco may have more wireless license synergies with Dish Network — which owns about 50 Megahertz of spectrum. But those synergies are what would make an AT&T-Dish combination less likely to pass regulatory muster.

4. The broadband benefit to the deal is questionable. DirecTV is on record saying it needs a broadband product, and has tried to create one in the past with a satellite-delivered service — the failed, costly and unreliable DirecWay — and via co-marketing partnerships with telcos like AT&T and Verizon that have been moderately more successful. With AT&T, DirecTV would get access to a robust, broadband service (U-verse), at least in the markets where it is already available.

For AT&T, being able to convert its 6 million U-verse TV subscribers to DirecTV homes would free up a tremendous amount of bandwidth — it currently allocates 15 Mbps to video and 10 Mbps to high-speed Internet. Being able to offer a 25 Mbps service would help, but it still falls far short of cable competitors that regularly offer speeds of 50 Mbps and 100 Mbps and are striving to boost those rates exponentially. “With DOCSIS 3.1 coming in 2016, cable operators will be rolling out 5 [gigabits per second] to 10 Gbps service,” Eagan said. “U-verse has to find a way to cope with that.”

5. AT&T gets a national video footprint in a slow-to-nogrowth business. DirecTV has about 20 million subscribers, and the addition of U-verse’s 5.7 million video customers will boost that figure to about 26 million, closer to the 30 million that will be created after the Comcast-TWC merger. And though unlike cable, DirecTV is growing subscribers — 169,000 in 2013 — that growth is slowing.

DirecTV added 199,000 net new subscribers in 2012 and 662,000 in 2011. Analysts estimate that DirecTV will add between 40,000 and 85,000 net new customers in 2014.