AT&T: DirecTV Sale's Most Valuable Component Might Not Be The Cash

Summary

• Despite recent reports, I cannot believe that AT&T management would walk away from an offer to sell DIRECTV for $15 billion.
• Assuming the sale goes forward, it is likely that AT&T will report a write-down of as much as $32.6 billion in connection with DIRECTV.
• That massive write-down will generate deferred tax assets worth as much as $1 per share on their own.
• This is beneficial to AT&T, as the write-down itself is non-cash and largely already priced in. However, AT&T will probably simultaneously report a massive debt issuance to fund its C-Band spectrum auction purchase.
• Altogether, I expect that the latter will outweigh the former, so AT&T may not get much of a bounce despite a very fortuitous overpayment by the acquirer of DIRECTV.

After writing an AT&T (NYSE:T) article just last week, I hadn't intended to write another so soon, but AT&T is currently rather fascinating to me. It is a company whose bullish and bearish trends can be encapsulated almost perfectly in a tale of two trends, each involving an auction of a multi-billion-dollar asset.

A Completely Abstract Way To Begin

Among the many, many ridiculous deals and decisions to come out of the 2008 financial crash, one of the more absurd ones, at least to those like us who follow market developments closely, was the Merrill Lynch/Lone Star transaction. For those who don’t recall, back in 2008 Merrill Lynch was desperately seeking a way to offload its toxic CDO/MBS portfolio, and after a lot of “are you nuts?” Merrill Lynch found a buyer, eventually: Lone Star Funds, a private equity shop which agreed to pay 22 cents on the dollar for the assets, with the usual 3:1 debt/equity ratio for private equity. The funny thing was, no one would lend Lone Star money either, not against assets so toxic, so Merrill Lynch itself lent Lone Star the 75% debt portion of the money to complete the deal.

I know, I know, this is an AT&T article, not a Merrill article. Let’s get to AT&T now, but just keep that little anecdote in the back of your mind; it is relevant to AT&T, or at least it potentially could be. For one thing, Merrill only seemed to make such a lopsided deal because it expected the market would reward it for getting an under-performing asset off the balance sheet, no matter how ridiculous the terms it was offered. AT&T is now trying to do something very similar with DIRECTV, though hopefully while obtaining better terms to do so.

Hopefully, that's the only parallel between the two, though as I will show there is a scenario where the deals become a little too similar for comfort.

One other thing before we get started: there are enough AT&T articles on Seeking Alpha to practically launch a second website with. I don’t want to just add to the jumble, so the only topics covered here will be new questions and answers that I haven’t seen covered already by other Contributors. For this article, I will be assuming that the reader already has at least some familiarity with AT&T and has covered the other articles already on this site. I do not plan to repeat all of that, so if you need some additional references here is my most recent article as well as several others within the last few days that may be useful to you.

Some Overlooked Aspects Of The Sale

The topic of this article is, once again as it was in my last AT&T article, the pending (we think) sale of DIRECTV to an unknown buyer, although it may be Churchill Capital IV (CCIV) since Apollo (APO) appears to have taken a pass. While some of the implications of this have been explored already, by me and by others, there are a few that I haven’t seen anyone talking about yet, so I want to cover three things today: the write-down/tax implications, the financing implications, and whether the combination of these with the spectrum auction should produce a net positive or negative reaction, enough to produce a short-term bounce in the stock?

And yes, I am aware that AT&T is reportedly considering walking away from the auction and not selling at all. But I simply cannot believe that any management - even AT&T’s management - would be that foolish. This is a chance to take an asset whose long-term value is probably zero and get at least something back for it. Yes, AT&T paid $50 billion more for DIRECTV than what it is now being offered for it, but that is simply water under the bridge. Refusing to sell only makes sense if you believe a rebound is in DIRECTV’s future. And even AT&T’s bulls don’t believe that anymore.

So, I just have to believe that AT&T will indeed be selling soon; by all accounts it has a willing buyer. Now, how does that sale affect the stock? Can it produce a bounce?

Reframing The Question

The potential to produce such a bounce probably lies not in the sale itself, which will entail a massive mea culpa from management and produce a relatively small amount of cash, but in the accompanying write-down and its tax implications. In order to assess that, we first need to know just how large the write-down will be.

Obviously, we could just wait for AT&T to tell us when it announces the sale, but we’ll never get ahead of the market that way, so I’m going to make my own estimate now. To construct that estimate, I’m going to use the breakdown of the merger that AT&T included in its 2016 Annual Financial Review, released in early 2017, which showed a total of $34.6 billion in goodwill from the purchase.

I am aware that AT&T initially reported $35.4 billion in goodwill for the DIRECTV purchase, but it later revised this down to $34.6 billion. I haven’t seen a more recent estimate than this, and this was a 2017 document, so I think it’s safe to call that number final.

The Minimum Write-Down

Of course, we all remember that the actual purchase total was $67 billion and change. The rest of the assets were recorded in the Intangibles and Property, Plant, Equipment categories, as well as a smattering of cash and accounts receivables assets. At least $12 billion of those intangibles were due to be amortized along with, obviously, all the PPE eventually being depreciated.

The one complicating qualifier here that I can’t answer with 100% certainty is whether that $34.6 billion of goodwill has been written down at all since then. I am almost certain the answer to this is no, as I have been following AT&T for several years and don’t remember ever hearing anything about a goodwill write-down. However, not all goodwill adjustments are as simple as “big announcement, we’re writing this down” and I can’t vouchsafe that it never happened. However, I have reviewed the 10-Qs, 10-Ks and Annual Financial Reports for the last three years for AT&T and I did not find anything about a write down.

So, I’m 99% sure there has been no change to the goodwill number yet. That means that AT&T will take a minimum $20 billion write-down when it finalizes the sale, as even crumbs of leftover assets will be enough to take the sales price that far below the goodwill level.

Now, What's The Real Number?

But that’s the minimum. More likely, the remaining $15 billion of value will reflect a considerable portion of intangibles and PPE, so I think the write-down will be even larger.

In the merger five years ago, AT&T reported DIRECTV at $12 billion in orbital slot FCC licenses and also reported that just the DIRECTV brand name was worth $1.4 billion. These two kind of go hand in hand, because presumably the name’s worth will expire with the last satellite, which is also when the orbital slots will become worthless.

If we assume these assets have lost half their value, then $6.7 billion of the sale price will be reflected in these two categories, leaving a goodwill write-down correspondingly larger. And that’s assuming they’ve lost half their value. In the final merger tabulation (the 2017 document) AT&T specifically broke the Trade Name value into two components; the $1.4 billion is the “indefinite lived” portion, while another $2.9 billion was already scheduled to be amortized. So AT&T might have anticipated the end of the satellites' life and the full $1.4 billion will be transferred. But let’s leave this here for now; there’s another, bigger number to consider.

DIRECTV owned $9.3 billion of Property, Plants and Equipment five years ago, as well as $2.4 billion of “Investments and other Assets.” AT&T made clear years ago that it wasn’t launching any new satellites, so presumably this PPE number has gone down as satellites have been retired, but with its ground transmission and operation facilities still intact, DIRECTV will presumably transfer another batch of several billion in this category with the sale as well.

In fact, it's theoretically possible some existing PPE from pre-merger AT&T will be going as well, since it is also transferring U-Verse customers in the deal, at least according to the reports.

If we cut the existing number in half to $5.85 billion, we’re at $12.55 billion. Let’s round that up to $13 billion to account for maybe some small U-Verse and permanent Trade Name value. At that point, only $2 billion of the transaction would be considered goodwill.

"Something With A Three-Handle"

This means that AT&T, assuming we’re right about it taking no write-downs so far, would be looking at a staggering $32.6 billion write-down, or thereabouts, following the closing of the deal. At a 21% tax rate, this write-down will generate roughly $6.9 billion of Deferred Tax Assets.

As horrendously humiliating as this announcement will be for AT&T management, however, it might be the best thing for AT&T shareholders. Presumably the market has already priced that horrendous loss into the stock price, which has fallen 40% since I initially recommended a short in February 2017. This means that the sale itself will add $6.9 billion in assets that weren’t there before, and these will be actual assets, not the dead hulk that DIRECTV goodwill had become.

The market may not have priced that in yet, making the sale a net positive for the market’s perception of AT&T’s assets. With AT&T currently sporting a float of 7 billion shares, more or less, those DTAs are worth roughly $1 per share in value on their own.

Will It Be Shades Of 2008?

The other interesting question mark here is the source of the debt. Does Churchill already have funding for this $7.5 billion lined up? Or is it potentially going to be lent from AT&T itself, circa Merrill Lynch/Lone Star in 2008? This is why I wanted you to remember that old story.

It’s not immediately relevant to Churchill IV shareholders where the money comes from, as long as it gets lent, but it is significant for AT&T. Assuming someone else is lending the money, AT&T can look forward to an over $11 billion cash infusion and can truly put the DIRECTV debacle behind it, aside from a stake for a couple billion in the new DIRECTV.

But if AT&T has to lend the money itself, it will only net $3.75 billion or so. The other $7.5 billion could potentially be put back onto its own balance sheet if Churchill IV’s bet on a DIRECTV turnaround doesn’t work out. Churchill IV could simply file the new company into bankruptcy in a year or two, turn over the asset to the creditor (that’d be AT&T, in this scenario) and walk away. And AT&T would find DIRECTV and all its old problems right back on its balance sheet again, though at least it’d have a couple billion in cash to show for its trouble.

Indeed, as was remarked about ML/Lone Star all those years ago, in this scenario, AT&T hasn’t so much sold DIRECTV as sold a call option on DIRECTV. The purchase price is almost like the option premium - Churchill IV takes the asset and keeps it if it does well, if it does poorly, the option “expires” and the asset goes right back to AT&T.

Spectrum's Long Shadow

Even assuming good answers to all of the above questions - will AT&T be smart enough to sell, will the market treat the DTAs as “new money” for AT&T, and will AT&T be able to dump the task of financing the deal on some other creditor - the last question is whether all this good news will be enough to outweigh the bad news that AT&T will probably be announcing around the same time.

Presumably the reason AT&T is choosing now to throw in the towel and take a $40-50 billion haircut on its disastrous merger is because prices in the C-Band spectrum auction are spiraling out of control, and if AT&T wants to get all the C-Band spectrum that it needs for its 5G network, it requires more capital to bid to the FCC. Even assuming that AT&T nets $11.25 billion in cash, not $3.75 billion - that would be a relative pittance when bidding has surged past $80 billion and is only going to go higher when the next round that started January 4th finally finishes - AT&T is probably still about to spend somewhere between $20 and $30 billion on C-Band spectrum. With the market originally anticipating that the total gross would only be about $25 billion, a lot of that is probably “new costs” in the market’s eyes, no less than the DTAs are - hopefully - “new money.”

Investment Summary

Obviously, we can’t know for sure until the official announcements, both with regards to the sale and the auction. But my best guess is this: AT&T will sell, will get someone else to finance, and the market will consider the DTAs new money. All good things, the best AT&T investors could possibly hope for. I included the "self-financing" analysis only because no one has explicitly said yet, so far as I am aware that AT&T won't be financing the deal, and until it does, investors need to be aware it is a (however remote) risk factor. But I honestly don't think AT&T would do this deal if it had to self-finance it, so the news will probably be all good here.

And yet, it probably won’t produce any kind of bounce. My best guess is the spectrum issue swamps all that good news. We already know, of course, that spectrum bidding is out of control. But because the FCC isn’t releasing the identities of the winning bidders and their dollar amounts, my guess is the market may not yet be fully incorporating those costs into its assessment of AT&T. I don’t believe AT&T can really afford to sit back and be boxed out of the market for 5G spectrum, so it probably hasn’t pulled back as prices climbed - it’s just going to end up spending a lot more money.

For this reason, even though I think the DIRECTV sale itself should go smoothly, I don’t think it will produce a bounce, and I am planning on continuing to avoid AT&T stock.

Disclosure: I/we 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.