DirecTV Offers Compelling Value For Income Investors

Aug.25.14 | About: AT&T Inc. (T)

Summary

The yield on cost of AT&T obtained by purchasing DirecTV at current price levels is very favorable.

AT&T has not participated in the broad-based market rise over the past few years and can be considered undervalued.

DirecTV and AT&T have made positive strides including a major negotiating point in the buyout terms.

DirecTV (DTV) offers superb value at current price levels for income investors, as well as those who hope to realize a significant capital gain. Based on its buyout terms with AT&T (NYSE:T), shareholders of DirecTV stand to receive an excellent package of value. AT&T has not participated in the market rally over the past few years, and can be considered undervalued based on current price levels. The two companies have made major strides so far in moving toward completion of the merger, which makes the risk/reward ratio for a new or current investor in DirecTV favorable.

Under terms of the buyout, if approved by regulatory agencies, DirecTV shareholders stand to receive $95 per share in the form of cash and stock. This is comprised of $28.50 in cash and $66.50 in AT&T stock. In general, those are the buyout terms but they may vary slightly based on the closing share price of AT&T upon completion of the deal. If AT&T's share price is below $34.90 or above $38.58, shareholders of DirecTV may end up receiving less than $95 of value. That is limited though, and no matter how the share price ends up, shareholders stand to receive significantly more than the $84.55 per share that DirecTV closed at on August 22. For the sake of simplicity in addition to forecasting the most likely outcome, let's assume that DirecTV shareholders will receive $95 in value.

Based on $95 per share, $66.50 of that would be in the form of AT&T stock. So if an investor purchased DirecTV stock at $84.55 per share, we would immediately subtract out the cash payment of $28.50 to arrive at a cost for the AT&T shares received through DirecTV ownership of $56.05 ($84.55-$28.50). To keep things straight forward, we are not factoring in the brokerage commission for buying DirecTV shares, which would most likely be immaterial. Furthermore, let's now assume that a shareholder of DirecTV receives $66.50 in AT&T stock at a cost of $56.05 based on this example. With AT&T's current dividend yield of 5.2% as of 8/22/2014, let's multiply 5.2% by $66.50 to determine the yearly cash received on those shares based on the current yield. That gives us $3.458 per share. The yield of that payout based on the $56.05 current cost jumps to 6.17% ($3.458/$56.05). This means that if the merger goes through based on the most likely closing share price of AT&T, a new investor in DirecTV would obtain an astounding 6.17% dividend yield through AT&T after the merger.

Currently, the market is implying a heavy discount to the $95 buyout price for DirecTV. I believe that this is due to the fact that the market thinks there is significant risk to the deal being approved. Additionally, the share price of AT&T has fallen below $34.90 per share, which would lower the value received by DirecTV shareholders if the share price of AT&T stays where it is. As it stands now, it would give shareholders 1.905 shares (based on the $34.50 closing price of AT&T on 8/22/2014) for $94.22 of current value. Before the recent decrease in share price of AT&T, DirecTV shares were trading at a slightly higher level. I believe that the market is erring to the side of extreme caution of this deal receiving the regulatory approval that it needs.

In order for this to be compelling to an investor, one has to be willing to own AT&T shares as a replacement to their DirecTV shares. With a long history of increasing dividends annually, the yield on cost is poised to get better and better every year. You would have a difficult time finding a low risk bond that would pay this high of a yield, even in AT&T bonds themselves.

A major question that potential investors in AT&T should ask themselves is if the share price is overvalued at current levels, particularly given the recent rise in the Dow Jones Industrial average over the past few years. AT&T's share price consistently had a range of between $38-$42 in 2007. This clearly shows that the stock has not participated in the large market rally over the recent years. A renewal of excitement for the telecom industry could bring large increases in the share price long-term. The airline industry is a perfect example of this as over the past couple of years it has risen sharply after many years of underperformance.

AT&T has a long history of higher profits and rich rewards to shareholders, and has proven to be able to create shareholder value organically. For example, AT&T started U-Verse from scratch and it now boasts over 5.7 million subscribers.

One of the major negotiation points of the merger was that DirecTV had to successfully renew its contract with the NFL to provide NFL Sunday Ticket. That has transpired, and that in itself is a major stride in improving the risk/reward ratio for potential and current shareholders of DirecTV and AT&T.

In recent news, AT&T and DirecTV also have formed a partnership to acquire a Houston sports television station. The two companies are in an excellent position to obtain favorable distribution for this channel through DirecTV and AT&T's U-Verse. This partnership shows that the two companies working together will form a formidable company that can generate excellent returns on investment for shareholders over the long-term.

In conclusion, based on the fact that the companies operate in separate industries as it stands now, regulatory opposition to the merger should not be sufficient to block the deal from going through. The NFL Sunday Ticket deal going through in 2014, along with AT&T and DirecTV creating an additional business relationship through ownership of the sports television station, further support the financial rationale for the merger. Based on these factors, the risk/reward ratio for buying DirecTV stock at current price levels is looking very good. The yield on cost offers a rare opportunity for income investors. I recommend buying the stock of DirecTV at current price levels but as always, please do your own due diligence and research before buying any stock.

Disclosure: The author is long DTV, T.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.