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Summary

  • AT&T may announce a deal for DirecTV in the next two weeks.
  • At $95-$100, AT&T is paying too much, as DirecTV would be trading 20x free cash flow, not including the assumption of $16 billion in DirecTV's debt.
  • Latin America and Sunday Ticket will also pressure DirecTV's earnings growth.
  • Using stock to fund the deal will be dilutive, and AT&T shareholders should rotate into Verizon on this news.

Various media outlets are now reporting that AT&T (NYSE:T) will almost certainly acquire DirecTV (NASDAQ:DTV), and the company will be paying quite a bit for the satellite TV behemoth. The two companies are putting the finishing touches on the deal, and a final agreement could be reached within two weeks, according to Bloomberg. The major remaining issues are the termination fee and breakdown of stock and cash AT&T uses to pay for DirecTV. Assuming an unexpected roadblock doesn't come up, it looks like AT&T is preparing to significantly overpay for an asset of limited strategic value.

The major question mark remaining is the breakup fee, if the deal is blocked by regulators. This issue is important to AT&T after it paid billions to T-Mobile (NYSE:TMUS) when that deal was blocked. There is already another major TV merger in the workings, with Comcast (NASDAQ:CMCSA) working to convince regulators to let it buy Time Warner Cable (NYSE:TWC). Timing this deal now minimizes the likelihood that regulators thwart AT&T yet again. Regulators would struggle to explain why they approved Comcast's deal but blocked AT&T. Regulators will need to either approve both deals or nix both, and at this point, regulatory approval is more likely than not. Once combined, AT&T and DirecTV will have roughly 25 million video subscribers, which is only 25% bigger than Comcast currently is today. It also would be smaller than the merged Comcast-Time Warner. While bigger, AT&T-DirecTV would not be a monopoly; it would not even be the biggest pay TV service, nor would it control a monopoly in any major market. After all, the new AT&T will still face competition from traditional cable providers. This proposed merger, while likely to draw scrutiny, is unlikely to be blocked.

However, I continue to believe AT&T shareholders would probably be better off if regulators blocked the deal. In January of this year, DirecTV was trading below $70, and AT&T's bid is likely to be in the $95-$100 range, according to reports. This represents a roughly 40% premium. Simply put, AT&T is paying far too much on a standalone basis. In this price range, DirecTV will be worth around $50 billion, and AT&T will assume its $16 billion of net debt (DirecTV's financial and operating data are available here). That makes the enterprise value of this deal $66 billion.

While strong, DirecTV's operating results simply do not justify this price tag. In 2013, DTV generated around $2.6 billion in free cash flow. At $100, DTV is trading 20x free cash flow, and the company is being valued at 33x free cash flow when including its debt. At $100, DTV is also being valued at over 17x 2014 earnings. To make this deal accretive, DirecTV will need to grow dramatically. Unfortunately, I think growth expectations are far too high.

First, DirecTV has a significant business in Latin America; however, much of the Latin American economy is facing problems amid emerging market turmoil. We are also seeing devaluations in various countries like Argentina and Venezuela, and currency will continue to be a headwind. While Latin America has solid long-term fundamentals, it will likely be a rough 24 months. Also, in the United States, DirecTV has expanded its customer base by offering exclusive content, namely the NFL Sunday Ticket. The NFL has seen consistently strong ratings and is arguably more popular than ever. The current contract expires at the end of this year, and negotiations are still ongoing. At the very least, a new deal will be more costly, which will pressure margins. At the worst, another provider could win NFL Sunday Ticket, which would seriously pressure revenue and profitability. This renewal could mildly cut earnings, while a failure to renew could seriously weaken results.

At the same time, it is important to note that AT&T will pay for a portion of this deal in stock. In essence, AT&T is trading its shares for DirecTV shares, which is an unfavorable trade. While DTV is 20x free cash flow and 17x earnings, AT&T is less than 15x earnings and 17x free cash flow. AT&T is paying up for DTV, while offering its stock at a comparatively cheap price. Using stock will make this deal even more dilutive and will drag on EPS in the coming two years. AT&T currently carries $76 billion in net debt, so it will need to fund some of the $50 billion with stock (AT&T's financial and operating data available here). Issuing equity will only worsen the fact that AT&T is overpaying for DirecTV's operations.

This deal will also focus the business away from wireless, where AT&T's growth is. It also provides a strategic headache in markets where AT&T offers U-verse TV. AT&T has spent billions building U-verse into a viable business, and it is finally succeeding on this front, with U-verse growing revenue 29% to an annual rate of $14 billion last quarter. Once this deal is completed, though, AT&T will be competing with itself in some markets, offering both U-verse and DirecTV. Competing with itself makes little sense, so this deal will effectively force the company to cease offering U-verse TV, wasting the billions spent to build the service. Buying DirecTV now that its own TV service is gaining traction causes more problems than it solves. On the positive side, AT&T could bundle DirecTV with its wireless offerings to combat competitive pressures from Sprint (NYSE:S), Verizon (NYSE:VZ), and T-Mobile. However, it would be far cheaper to simply enter strategic partnerships with cable providers and agree to a revenue sharing scheme. This would make far more financial sense than paying 20x free cash flow for DirecTV.

On the whole, AT&T is overpaying for DirecTV. At $95-$100, DTV is trading at a significant premium to AT&T, and there are risks to its growth story. This deal also makes minimal strategic sense, and a partnership would make more sense than an outright acquisition. AT&T should focus on growing its wireless unit and returning cash to shareholders. DirecTV will not contribute to these efforts, and at the current price, is unlikely to be accretive. DirecTV shareholders are definitely getting the better end of this deal, and I would be a seller of AT&T on this news. After this deal, investors would be better off owning VZ.

Source: AT&T Is Paying Too Much For DirecTV