On the surface, AT&T's (NYSE: T ) pending acquisition of DirecTV (NASDAQ: DTV ) sounds like good news for both companies. With Verizon (NYSE: VZ ) presenting a strong competitor in the wireless business, and the possibility of a merger between Comcast and Time Warner Cable in the cable business, AT&T has its work cut out for it. While this deal for AT&T sounds like progress, it should leave investors asking a few questions. The most pressing question is, does this deal threaten AT&T's dividend?
The irony of this "growth" plan
The first question investors need to ask about the DirecTV-AT&T merger is what type of growth can the combined company really expect? It has been suggested that AT&T will benefit from DirecTV's large video subscriber base and nationwide coverage.
DirecTV generates about $100 in revenue per user every month, whereas AT&T's U-Verse triple-play customers generate about $170 per month. In theory, this merger is designed to drive wireline growth for AT&T.
AT&T currently offers high-speed Internet and TV for $79 a month for the first 12 months. After that, the price goes up to $148. At this price, the customer is effectively paying $74 a month for each service. When you add in $10 a month for HD service, the video service alone runs about $84. As you can see, there isn't a huge price difference between AT&T U-Verse video service and what DirecTV gets per customer.
While it's true DirecTV has the ability to market nationwide, whereas AT&T only can market U-Verse in 22 states, this isn't the revolutionary change for AT&T that some would think. DirecTV is already free-cash-flow positive and has been heavily marketing its service.
Given that DirecTV's domestic business grew by only 0.2% year over year, if AT&T is looking for growth, it won't find it here. DirecTV's international operations are growing by between 2% and 4%, yet each of these businesses generate average revenue of at least 40% less than the company's domestic division.
The point is, both AT&T and Verizon should be concentrating on their wireless businesses. Both companies generated 7% annual revenue growth last quarter, compared to 4% growth at DirecTV. With DirecTV's operating margin at 15%, compared to 28% at AT&T Wireless and 35% at Verizon, respectively, it seems crazy to think that DirecTV can be a huge growth driver for AT&T.
How do these two technologies talk to each other?
The second question investors need to ask: Can AT&T and DirecTV find enough common ground to develop synergies that will make this merger cost effective? The issue is pretty straightforward, but with no clear answers.
Both AT&T and Verizon run their best high-speed Internet and video services through fiber-optic systems. Given that DirecTV uses satellite delivery, investors should ask how these two technologies co-exist. In theory, AT&T will have to continue maintaining both delivery services, which directly calls into question potential cost savings.
A much bigger problem
Given that AT&T has a debt-to-equity ratio of less than 1, and the company has been retiring shares, the structure of the DirecTV deal seems questionable. First, AT&T will issue between 1.7 and 1.9 shares of stock for each share of DirecTV. Given that AT&T has worked hard to retire about 5% of its diluted shares in the last year, this reverses that course completely. Arguing that shares are attractive enough to retire but still using them as currency sends a mixed message, to say the least.
Second, with $28.50 per share being paid in cash and DirecTV sitting at about 500 million outstanding shares, AT&T will need to use about $14 billion for the cash portion. The company last reported about $3.6 billion in cash, and said it will sell non-core assets and use debt.
This leads us to our third question: How could this merger affect AT&T's dividend? It's true that AT&T generates billions in free cash flow -- $2.6 billion in the last quarter. But the company's dividend is less safe than some investors may believe. In the last three months, AT&T's core free-cash-flow payout ratio was 92%.
Verizon generated about $6 billion in core free cash flow, yet paid $1.5 billion in dividends. The company's 25% payout ratio is far lower than AT&T. With AT&T assuming DirecTV's nearly $18 billion in net long-term debt, and adding more debt for the purchase, the company's interest costs will rise.
The bottom line
Long-term investors should worry about AT&T's dividend if this merger goes through. With a dividend payout ratio over 90% -- and potentially higher interest costs in the future -- this seemingly safe stock could get less safe very quickly. If DirecTV doesn't bring growth and serious cost savings to the merged company, this $48.5 billion merger could be a huge mistake.
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