AT&T: Dropping A Loser

Summary

• Video sub losses have weighed on the company for several years.
• DirecTV was just a bad investment at a high price.
• Cutting some fat is good because spectrum bids are weighing.
• Streaming and WarnerMedia are bright spots and the future.
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We continue to be of the opinion that AT&T (NYSE:T) stock will mostly move sideways this year. This comes despite some recent buzz surrounding a renewed investment from Elliott Management.

The bottom line here is that there is ongoing pressure on revenue streams, earnings power, and the balance sheet. As we now know, following speculation for weeks and weeks, the bid amounts from AT&T on spectrum costs are in. More on this in a moment. We have covered many earnings reports for the company, and often document the ongoing decline in video subscribers. Our opinion is DirecTV was overpaid for, and underperformed. But there are bright spots in WarnerMedia, and in the future with streaming. We think you can hold for the dividend, which still yields over 7%, and as we have documented, remains well covered. Perhaps the best news we have seen in some time, AT&T is finally cutting the fat and dropping a loser.

Dropping a loser

It is kind of sad to know that AT&T spent $49 billion to acquire what ended up being somewhat of a dud. Sure, revenues came in, but they continued to wither year after year. The company and the stock largely suffered. But now AT&T has finally seen the light and is spinning off DirecTV to private-equity firm TPG Capital. There are opinions on all side of this, but we love the fact that the company is going to take $8 billion in proceeds from the deal and direct it toward debt relief. It will need it, after lots and lots of effort to cut debt, it is still sizable. As we will see, the spectrum access costs will be high. Something had to be done. Just like in trading stocks, sometimes, when you make a bad investment, you have to cut losses.

Folding hands in poker is one of your greatest weapons. The same is true in investing. Comparisons can often be drawn, and we like to make those comparisons. Consistent good decisions lead to wins. This is true for management of a company. DirecTV, while at the time seemed like a good branch out, was too expensive. And now, management is cutting its losses. The terms of the deal mean AT&T is taking a loss. What is going to happen in all this will be that TPG along with AT&T will setup a company under the DirecTV name that will AT&T's video business units of DirecTV, AT&T TV and U-verse. However, the key here is that the winning lines of business, WarnerMedia and the new streaming service HBO Max will remain under AT&T's purview.

But why is it a loss? Well if you look at the deal, the value of the newly set up company calling itself DirecTV will be worth just over $16 billion. AT&T will own 70% of the new company. AT&T is also taking near $8 billion in proceeds and putting it toward debt. This matters because spectrum bid amounts have been revealed.

Spectrum bids are in, and they are key to being competitive

The data is in from some of the spectrum bids and while exact costs remain to be seen, we have a sense of what AT&T was willing to spend here. AT&T bid about $23.4 billion. This was about half of competitor (VZ). It simply did not have the financial ability to bid too much more because of the existing debt. The airwaves auction is important to future expansion and bringing high speed and modern access to customers. AT&T's competitors have the same goal, so seeing what the companies are willing to spend may be correlated to a degree with future access. We will know more details in a few weeks, but the biggest companies took in over 90% of the available licenses in this auction. For more on the technical reasons behind why this spectrum auction matters, this recent piece from our colleague Steven Fiorillo summarizes the science nicely.

Looking ahead

We saw no word from management that the spinoff would impact free cash flow, though the accounting will change for DirecTV now of course. The focus however, in our opinion, needs to be on continuing debt reduction, while protecting the dividend. The dividend is all this stock has. It should be owned for income. Growth just is not there. But at a 7% dividend yield with a dividend that is well covered, we are comfortable holding the stock. We would not buy it, and we would not sell it. We think on share price increases toward $30, investors should implement a covered call strategy for more income. In coming weeks and months we will be closely watching to see what steps are taken to reduce and already leveraged balance sheet. Dropping the loser that is DirecTV off the direct in house revenue sources (ok it is keeping a chunk of the company for a payoff now) in our opinion was wise, while the company can focus on expanding HBO Max subscriptions, and bringing new and interesting content through its WarnerMedia division. The latter will be growing like wildfire in our opinion as the world opens up, movies can be safely filmed, and theaters reopen. In the meantime, we continue to expect about a 60% dividend payout ratio, in free cash flow of $25-$26 billion in 2021. The news is bullish overall, but the stock is still a hold.

Analyst’s Disclosure: I am/we are long T. 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.