In March, as most of the world shut down, AT&T's (T 1.34%) stock got crushed. Since then, the company's significant dividend yield seems to have helped the shares from collapsing further. Unfortunately, AT&T's declining DirecTV business is a drag on the company's results. If the company sells DirecTV, investors shouldn't forget that the telecommunications giant will lose that business's cash flow. Though AT&T generates significant profits from its wireless business, anytime a stock with a significant dividend is thinking of selling a cash generating unit, it pays to look at the potential impact. To trust AT&T's yield, shareholders will need to figure how much much of it depends on DirecTV's cash-flow contributions.
A silver bullet or a fire sale?
AT&T's CEO, John Stankey, seemed to drive the final nail into DirecTV's coffin on AT&T's Q3 2020 earnings call. He said the company's over-the-top streaming package, known as AT&T TV, is a more natural fit for customers than satellite. When a company's CEO talks down a service, sale rumors start to run wild, and investors get a signal that the service might not stick around.
Image source: Getty Images.
There are two likely options when it comes to the potential sale of DirecTV:
- AT&T gets a decent value for the business and receives cash to shore up the balance sheet.
- AT&T sells all or a part of the business, confirming that it destroyed a massive amount of shareholder value.
Why did AT&T buy DirecTV in the first place? AT&T's CEO at the time, Randall Stephenson, said the transaction would allow the telecommunications company to expand its high-speed Internet customer base and its television and mobile coverage. AT&T spent approximately $48.5 billion in shares and cash to acquire DirecTV, as well as assuming over $18 billion in debt.
Once the deal was completed, AT&T had 26 million total video customers. The company seems to have overestimated its ability to retain video customers since then; its subscriber count shows the cord cutting trend very clearly.
Data source: AT&T. Chart by author.
The more than 7 million video subscribers AT&T has shed since the DirecTV deal in 2015 help explain why the company is looking to sell the business. In fact, the New York Post described bids for the unit as "fire sale" pricing.
According to Bloomberg's Scott Moritz, final bids are expected to be valued at about $15 billion. Even if we ignore the over $18 billion in debt that DirecTV added to AT&T's balance sheet, a $15 billion valuation suggests a loss of $33.5 billion in a roughly five-year time frame. There's no way to gloss over a loss of this significance. However, trying to squeeze cash out of a business that's in a nosedive isn't a great option, either.
There's good news and bad news
First, the bad news. The video portion of AT&T's revenue represented about 17% of AT&T's total revenue last quarter. In addition, video makes up about 70% of the entertainment group's revenue. When it comes to other adjustments, AT&T doesn't provide details of how much operating income or cash flow DirecTV provides. However, according to Walt Piecyk analyst at LightShed Partners, DirecTV generates about $4.5 billion in annual free cash flow. This would suggest DirecTV is generating an average of $1.1 billion in free cash flow per quarter.
If we adjust AT&T's most recent quarterly results and subtract what DirecTV potentially generates, AT&T investors should be encouraged. It seems even without the satellite video business, the company could still easily cover its dividend.
|
Line Item |
Reported results, Q3 2020 |
Results Without DirecTV |
|---|---|---|
|
Entertainment Group Revenue |
$10.05 billion |
$3.07 billion |
|
Free Cash Flow |
$8.27 billion |
$7.17 billion |
|
Dividend Payout Ratio |
45.2% |
52.2% |
(Data source: AT&T. Results without DirecTV from author's calculations.)
Now for the good news. Even if AT&T lost all the video revenue from its entertainment division (an aggressive assumption), the company's payout ratio would increase by just 7 percentage points. Without DirecTV, the telecommunications company's total revenue would have declined by 3.5% annually last quarter, compared to the 5% reported decline. If AT&T received around $15 billion for DirecTV, the company would likely use the funds to pay down debt. Paying down debt would potentially reduce AT&T's interest expense and improve the company's dividend coverage even further.
Though AT&T obviously made a bad deal buying DirecTV, getting out now isn't as devastating as it first might seem. AT&T should more than cover its dividend, and its revenue growth rate would theoretically improve. Investors looking for an income stock, with a significant yield, should have AT&T on their potential investment list.
