Why AT&T might not get up to $20 billion for DirectTV

(Seeking Alpha) – News reports are suggesting that AT&T (T) might sell its DirecTV unit for up to $20 billion. The wireless and media company paid $49 billion for the company back in 2015, but investors shouldn’t be assured that a private equity buyer will pay such a large sum for a declining business.

My investment thesis is that AT&T continues to lose relevance, and any ability to focus the business is a positive, but the price tag for DirecTV isn’t necessarily value-creating.

DirecTV Business In Decline
One really has to ask why private equity or any other business would want to pay billions for a business in major decline. Consumers are cutting the cord at record rates, and the pace isn’t expected to slow down, as the move to streaming services only escalated during the COVID-19 crisis.

In addition, new SVOD services continue providing more content at cheaper costs. Video distributors such as AT&T via DirecTV have less and less value in this scenario, where Disney+ (DIS) and Apple (AAPL) TV+ charge far less than $10 per month for content. In both cases, subscribers can get these services for free with subscriptions to other services, such as wireless plans or other SVOD services via a bundle.

Since 2010, only the 65+ crowd has spent more time watching pay TV. Key demographics under 49 have all cut viewing times by over 50%. The sad part for AT&T shareholders is that this trend was obvious back when the DirecTV deal was made in 2014.

MoffettNathanson analyst Craig Moffett agrees that the dynamics in the industry question whether a private equity firm such as Apollo Global Management (APO) or Platinum Equity will fork over $20 billion for the division. The business has to be valued based on declining cash flows, which makes for a very tough sell.

A private equity group is highly unlikely to spend $20 billion to take on the DirecTV risk. At a substantially lower price, private equity might take some risk with flipping the business to DISH Networks (DISH), which could ultimately cross-sell pay-TV subs with new wireless service.

Weak Financials
The real key is what is included in the DirecTV business up for sale. The Entertainment group now includes high-speed internet customers accounting for $2.1 billion in quarterly revenues. Just the video entertainment business includes revenues of $7.0 billion, but this amount still includes U-verse customers, not just satellite pay-TV customers.

The video connections includes AT&T TV Now customers of 720K. One would assume AT&T would want to keep these streaming customers in a combined service with the HBO Max division of WarnerMedia.

In total, the entertainment division has operating income of only $1.0 billion for Q2. Naturally, the business was hurt by COVID-19, with the Q1 number at $2.2 billion. The 1H’20 operating income was down over $600 million from 2019 levels.

Assuming the DirecTV sale only includes the satellite subs as part of the video connections, the business is probably about 60% of the Entertainment Group revenues of $6.0 billion for Q2. Even giving the division credit for the 1H’20 operating income margin of 11.5%, DirecTV would have operating income of $690 million.

Investors should assume a range of quarterly operating income of $600-750 million depending on a more normalized economy after the COVID-19 shakeout. The annualized operating income would be in a range of $2.4-3.0 billion. After taxes, the division generates around $2.0-2.5 billion in net income, with the potential for a substantial amount of depreciation expenses providing a boost to cash flows.

The ultimate troubling part is the rate of customer losses in premium TV. Over the last year, the customer count dipped 18% to 17.7 million subscribers. Any buyer has to factor in substantial declines in annual cash flows, questioning the desire to spend so much money on a declining cash flow stream.

AT&T shareholders would have to handle a substantial loss of cash flows. Selling a business for only $20 billion while losing operating cash flows of up to $5.0 billion would cut existing free cash flows substantially, considering less capital investments are going into the satellite TV network.

The key investor takeaway is that a $20 billion price tag for a business with a transaction value of $67 billion due to net debt of over $18 billion doesn’t appear shareholder-friendly. AT&T could throw off a declining asset, but the DirecTV business still generates solid free cash flows included in the $23-24 billion target the wireless and media giant uses to pay the large 7% dividend yield requiring a $15 billion annual payout.

Clearly, the devil is in the financial details. Investors will need to scrutinize the actual details of any deal, but AT&T is unlikely to find a buyer or actually profit off a deal at the listed value.