Looking over the details of the AT&T (NYSE:T) and DirecTV (DTV) acquisition, I'm a serious fan. The overwhelming consensus is that AT&T will overcome the regulatory hurdles to buyout the company. However, the debate falls on whether or not AT&T's rumored move to acquire DirecTV will lead to accretion, and further acceleration of growth due to front-end product efficiencies, along with back-end efficiencies from overlapping back office functions.
Usually, management teams at major companies will justify a major acquisition by mentioning the growth prospects of the combined business. Usually, the math works out to massive net income growth with topline revenue becoming consolidated, and a modest sales ramp on "potential synergies."
The acquisition will boost revenue significantly
Before flying off the handle, with tons of input, I want to get into the nuts and bolts of what the two combined entities will generate in terms of revenue and net income.
Admittedly, following AT&T's acquisition of DirecTV, the accounting may change a little on inventory timing, sales recognition, and other GAAP accounting vagaries. The point behind this exercise is to get a basic idea behind what the two companies would actually generate both in terms of sales and net income regardless of the marginal adjustments post acquisition.
The rumored buy-out value of $50 billion indicates AT&T will pay a .62 P/S ratio, which is a good price, assuming AT&T is able to generate back-end savings on administrative costs.
What about cost efficiencies?
At the present moment MoffettNathanson estimates that cost savings will amount to only $400 million, quoted from the New York Times. This is unlikely to be the case, and I think the analyst that was covering the potential cost savings over generalized, as DirecTV spent $548 million in advertising in its 2013 fiscal year. The advertising spend figure is way too close to MoffettNathanson's assumed cost savings.
Looking closely at the accounting notes, there are various categories that the company can generate savings on. However the category offering significant synergies is subscriber acquisition costs:
Subscriber acquisition costs consist of costs we incur to acquire new subscribers. We include the cost of set-top receivers and other equipment, commissions we pay to national retailers, independent satellite television retailers, dealers and regional telephone companies, which we refer to as telcos, and the cost of installation, advertising, marketing, and consumer call center expenses associated with the acquisition of new subscribers in subscriber acquisition costs. We expenses these costs as incurred, or when subscribers activate the DirecTV services, as appropriate, except for the cost of set-top receivers lease to new subscribers, which we capitalize in "Property and equipment, net" in the consolidated balance sheets and depreciate over the estimated useful lives.
In laymen terms, DirecTV charges all costs related to acquisitions in the cost of acquisitions line item on the income statement, the costs range from installation, retail square footage, sales representatives, call center support, advertising, and equipment. The company outsources some of its sales functions, and at the present moment, the company may be overspending in this specific category. By consolidating this under a larger entity like AT&T, the cost savings realized through efficiencies alone may be significantly higher than what analysts on a consensus basis are estimating at the present time.
Currently, the company spends $873 on average subscriber acquisitions costs, ie. cost of acquiring per person. Most of this cost is composed of labor related costs, as set-top boxes really aren't that expensive to produce, procure, or manage. In 2010 the average selling price on set top boxes were $103, and the bill of materials for building a set-top box is expected to decline by 10% or more by 2015. This indicates that of the $873 in subscriber acquisition costs, about 12% cannot be mitigated or reduced by much if in the event AT&T acquires DirecTV.
Click to enlargeHowever, the remaining 88% can be reduced significantly, as AT&T can bundle advertising costs into its current advertising program for smartphones. Furthermore, DirecTV can manage all service related issues from AT&T stores. This would significantly lower costs, and would require AT&T's pre-existing fleet of employee's to be multi-faceted, which would probably require additional training, with some integration with DirecTV employees. Also, back-end administrative costs, such as accounting, legal, and the like can be simplified to be managed by AT&T's in-house team. Since the industry falls under the category of communications accounting, legal, human resources, and other administrative functions are similar enough to allow for adjustment in current business practices that can produce lower labor hours per business function.
Therefore, I believe that profit margins can improve significantly from current levels. Currently, DirecTV's profit margin is 8.6%, whereas AT&T's profit margin is 14.26%. Assuming, some overlapping function can be removed, DirecTVs net profitability may reach 15%. To do this would require significant cost savings. To do this successfully would require SG&A costs as a percentage of revenues to decline from 31.8% to 24%. This is certainly attainable assuming administrative costs, and subscriber acquisition costs can be reduced by $1.7 billion (basically 40% over previous year). This will in turn generate a 14.7% net profit margin.
When doing the math, and including the added cost efficiencies in two areas where it's easy to generate them, the potential consolidated net income of DirecTV and AT&T is $22.83 billion. However, interest related costs on a $50 billion loan, may reduce AT&T's net income by $2.5 billion. I expect, AT&T to issue debt, and its maturity to be in 2045 (30-year term), with 5% cost of interest. However, other analyts, think that AT&T could buy-out DirecTV with a stock and cash deal. This could lower the interest costs significantly. Courtesy of Seeking Alpha's breaking news feed:
Oppenheimer thinks a 50/50 cash/stock deal at $100/share would lead AT&T to pay out only 55% of its 2016 free cash flow through dividends vs. 65% otherwise.
Assuming, AT&T buys out DirecTV with some stock, the cost of interest on $25 billion in debt, would be closer to $1.25 billion, making the barrier of buying out the company significantly lower than my more conservative estimate of $2.5 billion in interest related costs. Furthermore, interest costs on a $25 billion or $50 billion bond offering would have to be offset by additional subscriber growth, which I will go into more detail in the next section.
Product bundling the final ingredient
After estimating the company can generate $1.7 billion in cost savings, I'm also willing to estimate that AT&T can generate additional revenue and net income from bundled subscriptions. The way this would work would involve bundling internet, mobile plans, and television together. Assuming AT&T is able to squeeze enough efficiency, to generate a 15% profit margin on new subscribers, the company may be able to generate both top-line, and bottom-line growth well ahead of historical trends.
27% of the United States uses AT&T. Therefore, at the present moment, approximately 27% of DirecTV's subscriber's base also has an AT&T postpaid plan. Well, if we exclude the benefit from pre-existing people who both have DirecTV, and AT&T, that leaves us with the remaining 73% that have DirecTV, but don't have an AT&T post-paid subscription.
Well, those 73% can be converted into a combined AT&T and DirecTV subscription package. However, by having more services under one package, the total cost savings for consumers is something that none of the other carriers will be able to match. This in turn, would result in a massive shift in postpaid subscribers from other carriers onto the AT&T network. The average revenue per user figure may be lower on these mega bundles, but I'm assuming that if price elasticity matters enough, perhaps a 20% decrease in average revenue per user, to capture the added users will still balance to a significant boost in revenue and net income. The 20% price decrease may have some impact on profits, but because telecoms have high fixed costs, and tend to operate better at greater economies of scale, the negative impact from lower pricing on larger bundles can be offset. Furthermore, 90% of post-paid subscribers are already on a family plan, or some bundle, according to AT&T, so the average revenue per user figure only needs to be diminished marginally, to generate added subscribers gains from an even larger bundle.
Based on current estimates, the average household size in the United States is 2.55. This means that the average DirecTV subscription for internet and television covers approximately 2.55 people. DirecTV's U.S. subscriber base is composed of around 20.3 million subscribers. Of those 20.3 million subscribers, I estimate that the number of people with a mobile plan is 51.76 million, and of that amount 37.78 million don't have an AT&T postpaid subscription.
Currently, AT&T generates $66.33 in average revenue per user on its postpaid plans. A 20% price reduction, in some way or form, whether through an up-front rebate, lower costs over the course of the plan, and etc. will push prices low enough so that other competitors won't be able to compete as easily, and will result in net-adds. In this case, AT&T could price itself at $50 a month, putting it well ahead of other pre-paid plans, and in turn generate significant upside assuming it converts 37.78 million additional people onto its network.
$50 per month is equivalent to $600 in revenue per year, and when multiplied by 37.78 million people, additional revenue will equate into $22.66 billion. Assuming the company can generate 15% net profit margins (maybe less) the company will generate $3.39 billion in additional profit on new lines of business.
This can be summarized with the table below.
However, that net income figure would come with interest costs of around $2.5 to $1.25 billion. Just to be conservative, I'm going to assume AT&T, will pay $2.5 billion in interest related expenses per year. Therefore AT&T will be left with $23.725 billion in net income. Assuming that's the case, AT&T's net income will grow from $18.249 billion to $23.725 billion in this pretty realistic scenario, representing 30% earnings growth. The earning per share, assuming the share outstanding remains at 5.2 billion is $4.56. I'm willing to give AT&T a price target of $48.79 assuming the company's price-earnings- multiple remains constant. However if it trades at a P/E multiple similar to peers, the stock would trade at $62.06. Therefore, assuming mid-point my finalized target is $55.43.
The stock has 50.85% upside from current levels assuming AT&T is able to successfully acquire DirecTV at $50 billion, finances the deal for 5%, and generates a consolidated profit margin of 15%. I expect the pricing of this type of event to happen over two to three years, as it will take time to transition post-paid subscribers to a larger bundled plan.
There will be a lot of factors outside of the changes that I anticipate. This will dampen the visibility that shareholders have of the long-term growth trajectory, which may result in P/E multiples stagnating or worsening over the short-term.
As an added side bonus AT&T pays a 5% dividend yield. When including dividends, the total upside may be closer to 65%, giving investors a solid return assuming AT&T has great execution.
Also, AT&T doesn't have an actual network in Latin America, so there's not going to be any synergies between DirecTV's LatAm segment. However, AT&T can use DirecTV's LatAm exposure, as a means to open a telecom network, and offer a super-bundle of all communication services under one-house. If that were to occur, the long-term growth rate of AT&T may be even higher than what I had already calculated.
From the way I see it, AT&T is a buy.
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.