On Sunday afternoon, AT&T (NYSE:T) announced it had reached a deal to acquire DirecTV (DTV) for $48.5 billion, $65 billion including assumed debt (press release available here). This deal was widely expected, and I had been negative on it in the past. After reviewing the announced terms, I continue to believe DTV got the better deal, as AT&T is overpaying for assets with minimal strategic value. Every transaction has a buyer and seller, and in this case, the seller did better than the buyer. As a consequence, investors should sell AT&T and consider rotating into arch-rival Verizon (NYSE:VZ).
First, let's explore the terms of the deal. AT&T is paying $95 per share for DirecTV. Of this amount, it will pay $28.50 in cash and $66.50 in stock. If shares trade between $34.90 and $39.58 at closing time, DTV shareholders receive the number of shares that would equal $66.50. Below $34.90, they simply receive 1.905, and above $38.58, they receive 1.724. This collar system protects DTV shareholders from volatility in AT&T's stock during the next twelve months, and will leave them with a roughly 15% stake in the new company. AT&T will fund the cash portion of the deal with debt issuance and the sale of non-core assets, like its $6 billion stake in America Movil (NYSE:AMX). Depending on other asset sales, I expect AT&T to add another $5-$8 billion in debt. This comes on top of its $76 billion in net debt (AT&T's financial and operating data available here). DirecTV also carries about $16.5 billion in net debt (DTV's financial and operating data available here). All told, AT&T will be left with nearly $100 billion in debt, which is still less than Verizon's $108 billion. It also will generate around $15 billion in free cash flow, meaning this debt is sustainable.
Now, AT&T says this deal is accretive, but that is because the company is using low-cost debt and underperforming asset sales to buy DTV shares, while increasing leverage. T is trading at 14x earnings and 17x free cash flow, while the deal values DTV at 17x earnings and 20x free cash flow. AT&T is trading its cheap stock for relatively expensive stock and using leverage to make the deal seem accretive in the near term. If it has to roll over maturing debt at a higher interest rate in coming years, rising interest expense will slow earnings growth and change the mathematics of the deal.
Now, AT&T does anticipate $1.6 billion in annual synergies, to be realized within 3 years. Calculating synergies is a tricky endeavor, and it is difficult to tell whether these are real synergies. According to the press release, "The expected synergies are primarily driven by increased scale in video." In other words, because the company is bigger, costs will fall. In particular, a larger company may be able to negotiate better rates with content providers like CBS Corp. (NYSE:CBS). It will be impossible to tell whether these synergies materialize, as we will not know what DTV and T would have paid in fees to content providers had they remained separate. Combined, the company will have 25 million subscribers, about 20% more than DTV currently has. DirecTV already has tremendous scale, and I am unconvinced that additional content savings will be meaningful. Synergies will likely fall short of this goal.
Now, I was happy see that AT&T can get out of this deal if DTV is unable to renew NFL Sunday Ticket, as this sports package has been critical to DirecTV's growing subscriber base over the past decade. Should DTV lose this package, subscriber numbers could fall dramatically, and AT&T would be dramatically overpaying. This is an important caveat, but a deal will now likely be reached. Still, DTV will probably have to pay a bit more to the NFL, which could pinch margins if the cost is not fully passed on to customers.
In a nod to regulators, AT&T preemptively pledged to maintain DirecTV's pricing model, and will roll out high-speed broadband to 15 million rural consumers. The federal government has wanted to expand the high-speed internet access, and AT&T is pitching this deal as a way to make this goal achievable. Between this and the fact that DirecTV will still be smaller than the new Comcast (NASDAQ:CMCSA), regulatory approval is more likely than not. However, this expansion will consume all of the merger synergies. AT&T is spending the $1.6 billion in synergies to provide internet to high-cost rural customers. In other words, T shareholders will not realize the benefit of these synergies, and will be losers if they do not materialize.
Finally, the fatal flaw of this merger continues to be the lack of a strategic purpose. This deal will 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, 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.
Therefore, AT&T is making a very costly strategic mistake in buying DTV. I would rather see AT&T focus in its core wireless business and build out U-verse in densely populated areas. This deal adds debt and increases the share count to enter the pay TV market, which is seeing competition from online streaming services. It is also at an expensive valuation that ignores the threat of rising NFL costs, an economic slowdown in South America, and secular challenges to the pay TV model. On this news, investors should be sellers of AT&T, as the deal will be dilutive within 3-5 years, and consider rotating into VZ, which pays a solid dividend and is focusing on wireless.
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.