On the surface, AT&T's (NYSE:T) pending acquisition of DirecTV (NYSE:DTV.DL) 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.
Chad Henage owns shares of Verizon Communications. The Motley Fool recommends DirecTV. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.