Over the past week, rumors have been circulating that AT&T (NYSE:T) is talking with DirecTV (DTV) about a potential acquisition (details available here). As these rumors intensified, DTV shares rallied from the mid $70s to the mid $80s as speculators attempt to front-run AT&T. After all, to acquire a company, the bidder typically has to offer a sizable premium that is often greater than 20% to convince everyone to accept the terms of the deal. Currently, DTV has a $43 billion market capitalization. The company also has $18.3 billion in long-term debt against $2.2 billion in cash (DirecTV's financial and operating data can be found here). When we factor in the premium AT&T would have to pay (a deal will probably require a bid of $95-$100 per share), the value of the transaction would be around $62-65 billion. This type of mega-merger simply does not make sense for AT&T.
First, it is important to note that AT&T can afford to buy DirecTV as it has a relatively strong balance sheet. At the end of last quarter, it carried $80 billion in debt with $3.6 billion in cash (all financial and operating for AT&T can be found here). AT&T also had $90 billion in shareholder's equity for a debt to equity ratio of 0.88. For a telecommunications firm, this is not that much leverage. For comparison, Verizon (NYSE:VZ) carries $108 billion in debt. The company will also generate free cash flow in excess of $11 billion and operating cash flow in excess of $32 billion. It has the cash generation to easily carry this much debt and could borrow more to make a major acquisition. In all likelihood, a deal for DTV would have a cash component (funded by debt) and a share exchange, which would leave AT&T's balance sheet intact.
Just because a company can afford to do a deal does not mean it should do the deal. In this case, DirecTV makes little strategic sense. First, it is important to note that unlike Dish (NASDAQ:DISH), DirecTV does not have any wireless spectrum. Control of spectrum is critical for the wireless companies like AT&T, Verizon, T-Mobile (NASDAQ:TMUS), and Sprint (NYSE:S) to improve the quality of their networks. With T-Mobile becoming increasingly competitive on pricing and Sprint having the backing of Softbank (OTCPK:SFTBY), the wireless industry is more competitive than it has been in years. Owning enough spectrum to offer better coverage than competitors will be a critical way to compete in coming years.
AT&T is primarily a wireless company, and wireless is generating the majority of its growth as consumers move away from legacy landlines. All potential deals must be viewed from the perspective of whether they will benefit this core business. In the first quarter, wireless generated $5.1 billion in operating income, which accounted for 81% of AT&T's operating income. Protecting and growing the wireless business should be management's number one priority as it is the main driver of results. An acquisition of DirecTV does nothing to help AT&T's core wireless business. Unlike an acquisition of Dish, it would not provide the company with valuable spectrum to improve the quality of its network. If AT&T was determined to move aggressively into TV, I would rather see it acquire Dish than DirecTV because it would provide some benefit to the wireless benefit.
Even then, there is no need for the company to acquire another TV provider. AT&T has spent billions rolling out its high-quality TV and internet service, U-verse. After billions invested in the service, U-verse is starting to gain a lot traction. AT&T added 201,000 TV subscribers and a robust 634,000 broadband subscribers last quarter. U-verse continues to gain share from traditional cable providers, and AT&T now has a combined 11.3 million TV and broadband subscribers. As a consequence of strong subscriber growth, U-verse revenue was up 29% year over year, and it generated an annualized $14 billion in revenue. U-verse is actually accelerating its gains and will fully offset the weakness being felt elsewhere in AT&T's wireline business due to unfavorable secular trends.
U-verse is winning share against cable and satellite providers in markets it has entered. Of course, it is still smaller than DirecTV, which generated over $31.7 billion in revenue last year. AT&T can generate growth by focusing on its U-verse product rather than buying another TV provider. While DirecTV does bring national reach, it begs the question of how AT&T would handle markets where DirecTV and U-verse overlap. It either would be forced to compete with itself or not offer U-verse TV anymore, wasting billions it spent building out the service. If AT&T wanted to acquire a TV provider, it should have done so six or seven years ago before it spent billions building its own. Now that AT&T has built U-verse into a sustainable and growing entity, buying DirecTV makes little sense.
A deal for DirecTV would extremely expensive. It would likely cost 17x earnings and 20x free cash flow with the assumption of $18 billion in debt. AT&T is trading at less than 15x earnings and 17x free cash flow. To do this deal, AT&T will be paying up for a business that makes little, if any, strategic sense. DirecTV does not help the core wireless business because it doesn't have wireless spectrum, which Dish does have. Similarly while DirecTV does add national scale, U-verse has proven to be a strong product that gives AT&T enough expose to TV. AT&T should focus on growing wireless and U-verse rather than acquiring DirecTV. At current prices, AT&T is reasonable and offers a solid dividend, but if it makes a formal bid, I would be a seller of T.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.