AT&T (T 0.99%) and DirecTV have finally tied the knot, and they are racing to get their plans together to run one of the largest mergers in recent memory. Can AT&T leverage its now comprehensive suite of service offerings to jump start its stock price?
And while Netflix (NFLX 0.68%) does not seem fazed by the sharing of streams, Amazon.com (AMZN 1.22%) has made some adjustments to its terms and conditions to prevent freebie usage of its great Prime services.
A full transcript follows the video.
Sean O'Reilly: The FCC says that Ma Bell can get even big, on this consumer-goods edition of Industry Focus.
Greetings, Fools! I am Sean O'Reilly, joining you here from in beautiful Alexandria, VA, just south of the nation's capital, at Fool headquarters. I am joined today by the incomparable, the incredibly handsome, Vincent Shen. How you doing, man?
Vincent Shen: Thanks for laying on the adjectives there.
O'Reilly: You bet.
Shen: I'm doing well, Sean.
O'Reilly: I'll come up with new ones next week.
Shen: New ones next week?
O'Reilly: New ones. I just look at you and I think, "Incomparable, incredible, handsome," all that good stuff.
Shen: Thank you.
O'Reilly: It's been a long time coming, but the FCC finally gave AT&T and DirecTV clearance to merge. It's not nearly as big as AT&T used to be 30 years ago, but still pretty big. First and foremost, what are the final terms of the deal?
Shen: This is a pretty long, one year-plus process.
O'Reilly: It's been about year.
Shen: A lot of these big deals, like the Comcast process -- even though that was unsuccessful -- one year or more for the regulatory overview and review. The final terms of the deal: This ultimately amounts to about a $49 billion purchase price for DirecTV. In order to get that through, the FCC had quite a few stipulations.
A lot of that focused on AT&T, the combined entity, expanding Internet access for certain low-income households, schools, libraries that are lacking good Internet access. That was a big focus for some of the concessions that the company has to make in order for the deal to go through.
O'Reilly: Was that all they required? Did they require any other hoops? Did the government say, "Do this and this, and you can do this thing"?
Shen: Here are the main ones. AT&T agreed to expand its high-speed, fiber gigabit broadband access to 12.5 million customers. That's quite a big boost from its current base. That's about a 10 times lift. Also, they have to be able to offer discounted, standalone broadband to low-income households. Again, they want to be able to better serve ...
O'Reilly: Sorry to interrupt -- that was one of the things the government would have wanted with Comcast, if I recall. They wanted them to do a low-income type.
Shen: I'm not sure. That seems to be the focus. Obviously, some people had concerns about these two companies coming together, but they thought the competitive landscape can handle it, and we are going to allow the deal to go through if we had the added benefit of expanding.
O'Reilly: As long as you don't have to be a billionaire to afford high-speed Internet.
Shen: Exactly. Another big thing is, AT&T was a very vocal opponent to the net neutrality rules that were passed earlier this year. Now they're saying, "OK, we're in; we'll abide by them; let this deal go through." Sales and other concessions. No discrimination against online video competition; no favorable treatment for its own streaming services. Those were basically the main concessions.
O'Reilly: Got it. What does the new combined entity look like? DirecTV has 10 or 12 satellites orbiting planet Earth giving satellite TV to subscribers, and AT&T has cell phone lines and cable.
Shen: I look at it like each company is bringing their strength to the table. They're ultimately bringing those together to offer this very diversified portfolio of service offerings. AT&T has about 130 million wireless subscribers in U.S. and Mexico; they're bringing that to the table. It also has about 6 million paid TV subscribers; they're bringing that to the table. On the other hand, DirecTV has about 20 million. Together they're a 26 million paid TV subscriber base, and that makes it the biggest in the country. For context, Comcast has about 22 million. So they're the big dogs now.
O'Reilly: Right.
Shen: That number grows to 45 million if you factor in DirecTV's very significant presence in Latin America, where they have another 18 to 19 million paid TV subscribers. That's a huge base.
O'Reilly: One of the benefits of when Comcast wanted to buy Time Warner Cable, there was talk of huge cost savings because you've got two cable companies and there are a bunch of costs there like accounting and stuff you could probably save hundreds of millions of dollars a year on.
That doesn't happen with this deal, because you've got people dealing with satellites that are orbiting planet Earth, and then you've got people that are handling cell-phone towers and cable. There's not tons of level out there. What can they do for growth? What's the deal?
Shen: Actually, you'd be surprised, because initially AT&T management said if the two companies could come together, we can expect about $1.6 billion in cost synergies.
O'Reilly: Per year?
Shen: Annual.
O'Reilly: Hold on. Is this accounting? That's a lot of accounting.
Shen: Before the deal was approved, they actually upped that number. They're showing that management is very confident, and they're putting themselves on the line to meet these estimates that they use to push the deals through. Now they're saying within three years of the deal closing they're expecting $2.5 billion of cost synergies annually.
O'Reilly: I hope they're not just firing people. That would make me sad.
Shen: The main company is going to be based in Dallas now. Otherwise, there's a lot of overlap overall in terms of overhead, operational, the fact that they both have these paid TV offerings, in terms of the fleets that they need to service households and things along those lines.
O'Reilly: I wonder how call centers, customer service -- I'm trying to think of what else both companies do. Marketing?
Shen: That's a huge thing. Something else that will help in reducing those costs is the fact that now you have those two companies combined. They can offer this comprehensive connectivity package for the few wired phones there still are; that's offered. Wireless service, AT&T has you covered. Paid TV; it goes on both sides. Also now, you have broadband access. That is the quadruple play -- incredible optionality there and diversification for their offerings.
O'Reilly: In those cost savings -- that just sounds incredible. Incredible claims need incredible evidence. Are they including leveraging content negotiations in that $2.5 billion? I could see that.
Shen: That's one of the huge perks for this deal. We talked about how they have 26 million paid TV subscribers and as the gatekeepers to the consumers, they're going to have a lot more leverage in negotiations.
O'Reilly: It's like negotiating with Wal-Mart or something.
Shen: They're going to have a lot more leverage with the content producers, and the thing is, content costs have been steadily rising over the past several years. It's one of the biggest items. Being able to trim that is a really big benefit for them.
O'Reilly: That's a really big deal, yeah.
Shen: Just think about the fact that, if you're signed up through AT&T for all your connectivity needs you're much less likely to switch to a new provider. That saves them money on acquisition costs for new customers, less churn, and again that all adds to their bottom line. It can help them expand their margins a little bit. Again, that's a big sell.
O'Reilly: You're making me wonder if Comcast is going to try to buy a cell phone provider now.
Shen: Recently, a couple days ago, the first example of what AT&T envisions with this new company is, they made an offering. It's the first mobile, cellular, TV package where it's $200, you get four TV-DVR receivers ...
O'Reilly: This sounds amazing to me.
Shen: Four wireless phones, 10 GB of shared data, and it's all just $200 a month.
O'Reilly: You figure the basic cable package is $100 to $130. Cell phones are $100 to $150.
Shen: For four lines.
O'Reilly: For four lines, yeah.
Shen: That's going to be ...
O'Reilly: This saves the average house around $50 to $100 a month.
Shen: They're estimating close to $600 in annual savings for new customers.
O'Reilly: That's pretty rocking.
Shen: Again, we touched on the ability to negotiate with the content providers, offering these crazy packages; ultimately, I think, a big opportunity for AT&T -- because DirecTV has that exposure in Latin America ...
O'Reilly: I'm not sure our listeners are aware, but Warren Buffett's Berkshire Hathaway is actually a shareholder of DirecTV. One of the bull cases for it, aside from it being a free cash flow machine that mints money, was, here in the United States DirecTV has to compete with cable companies. In most urban areas, there is that competition there.
It's trickier in Latin America to install trillions of dollars' worth of cable lines. That was one of DirecTV's major growth avenues; people could just put the satellite dish up, and they were good to go.
Shen: They've done very well in that region. The big thing is, especially for paid TV, the U.S. is a pretty saturated market. I think the penetration for Latin America is only about 40%. It's a huge opportunity.
O'Reilly: Especially in the next couple of decades as it continues to grow.
Shen: A lot of people there, DirecTV is a leading provider in that region. Now all those customers can be targeted for AT&T's other offerings. It's not like AT&T hasn't been moving into that region itself. They've recently had a few deals in Mexico of $4 billion taking over Nextel Mexico.
O'Reilly: OK. This is The Motley Fool; we are investors; we think Foolishly and long term. What does this company look like? Is it a buy? We're throwing around very aggressive cost savings and growth opportunities in Latin America and all this stuff. What does the company look like? Do you like it? What do you think?
Shen: AT&T, the stock isn't a high-growth stock. Ultimately a lot of people are in it for the very rich dividend, which is currently at 5.5%. That's a very nice yield.
O'Reilly: With the Treasury yielding 3%?
Shen: Something along those lines. The stock's traded in a pretty tight range over the past two or three years, between $32 and $37 per share. It's currently at $35. Some people don't think a lot of the benefits of this deal have priced into the stock yet. At the same time there's some concern. With that rich dividend yield they were paying out about 80% of their free cash flow just for dividends.
The big benefit is DirecTV generating quite a bit of cash, so that will help bring that number down, not only making the dividend payouts safer -- AT&T is a dividend aristocrat; they want to keep doing that. They've been doing it for 30 years. Also, they want to potentially grow those payouts at a higher rate.
With that said, you also have to caveat all these benefits assuming that management will execute well on the new offerings, investing aggressively in these new offerings and opportunities, but also try to expand into new markets at the same time. It's a lot of balls in the air.
O'Reilly: It's a lot of balls in the air. This is not a small company. They have a balance sheet with hundreds of billions on there. When this deal was announced, I loved that AT&T was doing it, because DirecTV was such a good business. What was its return on capital? It had a negative return on equity because they kept buying back shares and they don't need any equity on the balance sheet.
The returns on capital were 26%. If you have a balance sheet with $100 billion in assets you're making $26 billion. It's nuts. That was just a huge number, but as I recall DirecTV had free cash flow every year over $3 billion and they're minting money; they don't know what to do with it. I noticed over the last three or four years, AT&T is still generating around $10 billion in free cash flow.
Shen: Yeah, somewhere around there.
O'Reilly: That's down from $20 three or four years ago. Even if they own DirecTV, which is a great business with its growth capabilities; three is smaller than 10.
Shen: Yeah, but it shores up the position. At the same time there is some concern with the debt on the balance sheet for AT&T. The same applies, because they're going to take over DirecTV's debt, and their debt balance goes up to $100 billion.
O'Reilly: What's their total assets? What will the ratios be?
Shen: I think for debt to equity it will be 1:1.
O'Reilly: OK. 50/50.
Shen: I think AT&T will be able to bring better average revenue per user; it will be able to lower the costs, hopefully expand ...
O'Reilly: That value offering for $200; oh my gosh.
Shen: That's all hinged on management execution and also being able to rein in that debt. That's definitely a risk. Overall I don't think the market has properly priced in the opportunities there. AT&T will be able to focus and get this done, and I think there's some upside. I'm pretty bullish on this deal.
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We're talking now about Amazon Prime and its new policy regarding the number of people that are allowed to use the Prime membership.
Shen: I'm glad we can have a quick discussion about this. The change happened over the weekend somewhat subtly for a company that generally loves ...
O'Reilly: Very vocal.
Shen: Exactly. In the past, with an Amazon Prime account you could link up to four other accounts. It was supposed to be other people in your household, but there was no real way to enforce that, because both the payment and the shipping information was independent for these accounts.
O'Reilly: It sounds crazy.
Shen: It could be co-workers, maybe some roommates, friends, all sharing this account, splitting the cost of the yearly membership. Now they're trying to bring that down a bit. You can only have two people sharing the account linked, and at the same time they want to limit that to be people actually in the same household by saying both people on the account can use the credit and debit cards that are linked to it. Are you comfortable sharing that information with a friend, or roommate, or co-worker? Potentially, no.
O'Reilly: If I buy something with my credit card with my Prime account -- and I am a happy Prime user -- can I still mail it to my parents or something?
Shen: Yes, you can.
O'Reilly: OK. So that's fine.
Shen: It's just having the actual linked accounts that were independent that had the benefits of the shipping, for example. Now the linked accounts get Prime Instant Video, they get access to the Kindle Lending Library, and they call it the Amazon Household program. True to that name, they're also allowing four kids to be linked to the account as well. They can't make purchases, but they could get access to shared books like a library, the video content; things like that. That is the change.
A lot of people are wondering why.
O'Reilly: That was my question. I was like, "Jeff Bezos is now worth $50 billion, they're rocking it ... it's minting money. Why are they doing this? Why do they care?"
Shen: At first I looked at this thinking that they're naturally cracking down because the one thing I think really pushed the outperformance for earnings recently for Amazon was the bump up they had in their Prime memberships. The thing is, by limiting the number of joint accounts, you potentially force some people to sign up for their own, and they're really aggressive in building out their Amazon Prime membership because of some of the numbers that research has shown.
They think there are 45 million Prime members now, but the big thing is for U.S. shoppers, Prime members make up 47% of their shopping for Amazon. When you're getting $1,200 of purchases from Amazon Prime members per year and only $700 from non-members, they really want people to aggressively join.
O'Reilly: That's the difference in what the total value of what people are ordering.
Shen: Exactly. That's why you also see with Prime Day, they've always had these 30-day free trials.
O'Reilly: I loved how they contrasted it with Black Friday. They want Prime Day to be the new Black Friday, or something.
Shen: People signed up to try Prime Day for the 30-day free trial, and they're seeing research estimating that there's a 70% conversion from those free trial memberships into actually paying full memberships. They're very aggressively pushing on that. This is probably part of those efforts.
O'Reilly: Making sure they get their cut. Is sharing becoming a big problem with a lot these online streaming services? I don't know if anybody's noticed, but we're becoming a streaming planet, or country. You hear these rumors about how technically it's a felony to use someone else's Netflix when you're in another state.
Shen: Really?
O'Reilly: I don't know. You hear these things floating around.
Shen: I'm glad you brought up Netflix, because they are in a similar situation. People are sharing their Amazon Prime memberships; a lot of people are sharing their Netflix accounts.
O'Reilly: There's nothing I love more than my friend's Netflix password.
Shen: Exactly.
O'Reilly: That's a joke. I'm a happy subscriber, and I pay money.
Shen: While Netflix does allow sharing within the household, there's probably been a lot more of that outside of your household. There's a recent survey that said U.S. and U.K. Netflix users indicate that as many as 65% of them share their account with other people.
O'Reilly: Wow!
Shen: Right now there's supposed to be about 65 billion worldwide Netflix accounts. The number of actual people who are consuming content through the service could be as high as 100 million or more, because a lot of people aren't accounted for.
O'Reilly: I get it, because it's like, "Oh, sure. You could use my Netflix." It's not like you're asking someone to help you out with something that's ridiculously expensive. Like you're in college and you say, "Can I borrow your car?" This is something that costs $8 a month. It's not Draconian to pay $8 a month.
Shen: Yeah, but are you surprised by the amount of people?
O'Reilly: No, I'm not. I'm just saying it's not like, "Hey, can I use your cable/Internet/Wi-Fi password?"
Shen: The concern is that Netflix and other companies with these online services are leaving a lot of money on the table. Potentially hundreds of millions of dollars or more. Overall, the industry has seemed to shrug their shoulders and say, "We're aware of this, but this is not material for us." In the end, is it really that bad that you're getting more and more people tied and more loyal to your service?
O'Reilly: I'm sure they're thinking, "They might be getting us now, but in five to 10 years, once they're addicted to Netflix; then we'll get them."
Shen: Yeah. Some of the research indicates that a lot of the sharing happens among younger consumers. So maybe as they get older they're like, "I should probably get my own account." Then right there you have more and more people adding to your user base.
O'Reilly: Very good. Thank you for your thoughts, Vince.
Shen: Thank you, Sean.
O'Reilly: We'll see you next week. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!
