AT&T (NYSE:T) and Verizon (NYSE:VZ) have both made huge corporate changes in recent years. The logic behind the shifts makes complete sense, since both are facing a future where the domestic cell market will be more about market share than growth. However, the biggest asset they have, their cell networks, could soon turn into a big headache if the FCC can't get comfortable with so-called zero-rating.
No more growth
The problem that Verizon and AT&T face is pretty simple. They astutely pivoted toward cell phones when their historical position in landline access was being threatened by the new technology. And they were able to grow their businesses smartly along with the growth in cell penetration.
But the U.S. cell phone market is largely mature. At this point cell providers are fighting for market share. Which means that growth for AT&T and Verizon has to come from somewhere else. That's a tough question that both have been trying to answer in their own ways.
Verizon has been shifting toward content creation by buying web-based providers like AOL and its agreement to buy key parts of Yahoo! (YHOO). The Yahoo! Deal, it's worth noting, may not take place because of a years old hacking incident that has only recently come to light. But the overall goal at Verizon looks to be cobbling together a content company from the ashes of once proud web companies that have fallen on hard times.
Until recently, it looked like AT&T was going a completely different route. It expanded into Mexico and bought DirecTV, a satellite company. Both are largely businesses in which AT&T would own the pipes into people's homes, a business it was familiar with, even though DirecTV's primary product is media content.
However, AT&T's recent deal to buy Time Warner (NYSE:TWX) represents a huge shift. Now AT&T wants to own the pipes and the content. Only it isn't going after struggling web companies, it is trying to buy a premier media name. That changes the game in a big way.
The FCC cares
One of the issues that is increasingly coming to the fore is zero-rating. That's when a cell phone company lets customers use company-specific services without having to pay for the data they are using. In other words, an AT&T cell customer watching an AT&T video service would get a free ride while the same customer would have to pay for the data used to watch Hulu or Netflix (NASDAQ:NFLX).
This is a big issue to watch, particularly since the FCC just sent off letters to AT&T and Verizon on the topic. Why? Because zero-rating has the potential to kill businesses not affiliated with a cell provider, effectively turning AT&T and Verizon into a duopoly in the wireless media business. Or it could force streaming services into a position of paying the carriers for the right to receive favorable treatment, too. One view of that is that it's good business, the other is to consider it akin to extortion...
Clearly, however, either of those outcomes would be good for AT&T and Verizon and pretty bad for the tech companies looking to change the way consumers access video. It would basically replace the current cable model with a new model that's almost exactly the same… just in the wireless world.
You can see why companies like Disney (NYSE:DIS) and Netflix would be upset at the prospect of being beholden to cell phone companies. Disney is a part owner of Hulu, but also has its own aspirations in the media space. Zero-rating would make it much harder for Disney on both fronts. Netflix, meanwhile, would suddenly face a notable headwind to subscriber growth--a key metric for the streaming service.
With Disney owning so much valuable content it is sure to find a way to change with the times. But it has a vested interest in killing zero-rating just the same. Netflix has a similar interest, but with a smaller benefit from demand for the content it creates since it's only just starting down that path. Others without any of their own content would be at an even larger disadvantage.
There's going to be a big fight over this and it's hard to tell how it will fall out. That's especially true since a new set of leaders are set to take control of the U.S. government early next year. Simply put, the Trump presidency could materially alter the dynamics here.
It could happen
Zero-rating could, in the end, be the fly in the ointment that kills AT&T's Time Warner deal. And it could be the issue that turns its growth plans, along with the plans of Verizon, into a much smaller opportunity. AT&T yields around 5% today and Verizon about 4.6%. Those are enticing yields in a low yield world, but they come with risks that are very different from what either has faced in the recent past.
Although on a PE basis AT&T looks relatively cheap compared to its five year average PE, it looks, at best, fairly prices based on price to book, price to sales, and price to cash flow The yield, meanwhile, is a little lower than the five year average, hinting that it's expensive. Verizon, meanwhile, looks expensive on all of the same metrics. That said its yield is in-line with its recent average. The takeaway is that neither appears cheap here despite the lofty yields relative to the broader market. At best you might say the pair are fairly priced.
That means bad news, which might include a protracted and ugly fight with the FCC over zero-rating, could have a larger negative impact than investors expect. That's not to say either company is good or bad, just that investors should note that risk is elevated right now. Both AT&T and Verizon are transitioning to new business models and the changes have raised the eyebrows of Uncle Sam. That's usually not a positive…
Disclosure: I am/we are long DIS.
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.