AT&T (T) reports its first quarterly results including DirecTV this week. We think the cost synergies management expects to generate from the deal over the next three years are reasonable – greater negotiating power to buy content at cheaper rates, marketing synergies, more concentrated truck-rolls to service customers, supply chain benefits from set-top boxes, less SG&A redundancies, and more.
With wireless and pay-TV markets looking saturated, buying more subscribers via acquisition and taking out costs is a logical strategy to further enhance market share and free cash flow generation. However, we believe T’s large move into pay-TV trades near-term synergies for greater long-term strategic uncertainty.
Dividend investors only concerned with the safety of T’s 5.6% dividend yield do not need to worry, but we believe the DirecTV acquisition creates an extra layer of uncertainty with regards to T’s long-term total return potential. With that said, the business is still very stable and T’s status as one of the 52 S&P Dividend Aristocrats remains very secure.
Business Overview
Prior to its acquisition of DirecTV, T’s business was fairly balanced between wireless and wireline operations. In fiscal year 2014, wireless accounted for 56% of its sales and 75% of its income (low-to-mid 20% operating margin). Wireline made up the remainder of the business. Following its $49 billion purchase of DirecTV, which gained approval earlier this year, T became the largest pay-TV company in the United States. Altogether, T has close to 75 million wireless voice/data subscribers, around 28 million pay-TV subscribers, and over 15 million broadband internet subscribers.
No company has ever had as many subscribers across each service line as T now does, which the company hopes will give it advantages in negotiating costs for TV content, selling its various services via price-effective bundles (internet, TV, and mobile on one bill), realizing cost synergies (e.g. advertising, consolidated headquarters), and more. Essentially, T hopes that its ability to provide customers with their video, data, and information needs anytime, anywhere, and on any device will be enough differentiation to drive its next leg of growth.
Unlike T, VZ is maintaining its focus on its wireless network assets, which generate almost all of its profits. However, both companies are looking to capitalize on the rapid growth of video services. Rather than make a large acquisition, VZ has instead invested several hundred million dollars and acquired AOL for $4.4 billion to build its own over-the-top mobile video services, called go90. Despite the heightened competition rippling through the saturated wireless industry, VZ remains one of our favorite income stocks in our Top 20 Dividend Stocks list.
While the telecom industry will continue to generate stable cash flows for years to come, increasingly saturated markets and emerging competition from non-traditional competitors like Netflix, Amazon, Google, and Apple are slowly changing the way T and VZ must play the game. Let’s take a look at the industry.
Business Analysis
With T’s acquisition of DirecTV, analyzing T now requires an understanding of the wireless, pay-TV, and broadband markets. Each of these markets carries substantial barriers to entry and is generally more concentrated than most other industries as a result. From spectrum licenses to network infrastructure, billions of dollars are required before a single subscriber can be secured.
Today’s entrenched players maintain massive subscriber bases which they can spread their substantial depreciation, marketing, and interest expenses across. A sizable base of customers also provides cost synergies in the form of TV content deals, handset rates (wireless voice / data), equipment purchases, and more. Some players also offer a range of services, covering voice, data, internet, and TV. This is what T is trying to capitalize on with DirecTV because it allows them to bundle services together to undercut pure wireless companies and raise switching costs for consumers. T notes that 15 million DirecTV customers don’t buy its wireless products, and over 20 million of its wireless customers do not have DirecTV service.
New entrants to the market lack the large customer base necessary to cover the substantial costs needed to build out a cable, wireless, or satellite network. With most markets looking very saturated today, it is practically impossible for a new entrant to take share and survive. Simply put, in a saturated market dominated by a small handful of incumbents, it is much easier to defend a subscriber base than to grow one from scratch. Therefore, we view technological change as the real long-term risk to the industry’s players and expect intensified competition between incumbents as they battle for a stagnating number of total subscribers. However, T is pursuing some areas that could drive organic revenue higher over coming years.
Unlike VZ, T is pursuing international growth. The company opened up a new wireless market opportunity in Mexico through its acquisitions of Nextel and Iusacell, providing a near nationwide foothold in the country. T also plans to invest $3 billion in capex to develop its network in Mexico. While EBITDA is expected to remain negative through 2017, the company is optimistic that its Mexican operations could grow to become at least 25% the size of its United States wireless business over time. Unlike some markets, Mexico appears to be underserved and its incumbents offer services with inferior quality levels. DirecTV’s presence across Latin America could provide additional opportunities for international growth.
Regardless, these are still very mature industries and T is working from an annual sales base of more than $130 billion. T’s 5-year annual sales growth rate of 1.6% reflects this fact:
Source: Simply Safe Dividends
However, the industry’s substantial barriers to entry and the lack of alternative choices in the market for consumers create very predictable free cash flow for T and make it a favorite stock for investors seeking safe current income:
Source: Simply Safe Dividends
Very few businesses last forever without needing to reinvent themselves, and T’s industry, especially within pay-TV, is no exception. Let’s look at the challenges facing the company.
Key Risks
From our perspective, market saturation is creating most of the risk faced by T. Within the wireless market, we are already seeing greater price competition between the four major players in the US as smartphone penetration approaches its limits. However, the wireless market appears to face less potential disruption from new competitors that are challenging pay-TV providers.
Of the major service buckets (pay-TV, internet, wireless voice/data), we view pay-TV as the one most ripe for disruption and major change. Improvements in the internet’s speed, a number of new connected devices to consume content on (e.g. tablets, smartphones, smart TVs), and falling technology costs have resulted in the rise of online streaming companies entering the TV market.
Netflix released its first original TV show more than three years ago, completely bypassing cable operators to reach consumers. The company has since made deals with DreamWorks and Disney to bolster its content. Netflix isn’t alone. Amazon, Hulu, and Google (YouTube) are all actively developing content services to rival traditional cable and satellite TV, and Sony, HBO, and CBS have launched their own streaming service, too. As a result, consumers are slowly canceling their pay-TV subscriptions, resulting in the industry’s first negative growth rate in subscribers earlier this year, according to Pacific Crest.
In our opinion, the consumer trend is toward more flexibility, freedom, and paying only for what content is actually wanted (not 130+ channels). Most of the over-the-top streaming options available today cost a fraction of a traditional monthly cable bill. These preferences stand in stark contrast to T’s strategy to become the number one pay-TV provider with DirecTV and offer restrictive service bundles. We have some concern that management pursued the acquisition solely for the enticing near-term cost synergies with less regard to what the pay-TV industry might look like in five years.
Fortunately, T still has a very sizable base of internet and wireless subscribers to diversify away some of the risk of pay-TV industry developments. We believe the toll-takers (i.e. the high-speed internet service providers) will ultimately have to move to a pricing model that charges internet users by the amount of bandwidth they consume but stand to possibly benefit from this trend. Without moving to a bandwidth-usage pricing model, it will be challenging for them to keep their infrastructure ready to handle the needs of rapidly-growing demand for video consumption and more over the internet. As a result of strong demand for faster internet services and the gradual decay of traditional TV subscribers, Comcast now has more internet subscribers than TV subscribers, perhaps a sign of the times.
As online streaming companies increasingly enter the field and content costs simultaneously rise, we believe pay-TV revenues and profits will gradually come under pressure. DirecTV and other traditional providers offer their own streaming content to subscribers, but the service’s relatively high price point and overstuffed channel structure will continue to turn away many consumers, in our view. While we have no idea if VZ’s mobile streaming initiative will be successful in what is a very crowded field, we prefer them risking less capital to pursue this theme rather than investing billions into the increasingly challenged area of traditional pay-TV services.
Dividend Analysis
T’s dividend is safe but has low growth prospects. The company’s dividend has consumed about 80% of its free cash flow over the last twelve months, slightly higher than its 10-year range (see below). Given the stability of T’s business, we are not concerned by its higher payout ratio.
Source: Simply Safe Dividends
The balance sheet is what gives us greater pause, especially in light of the increased leverage that will result from T’s DirecTV acquisition. Should industry trends surprise to the downside over the next several years, we would need to re-evaluate the safety of T’s dividend. Prior to the DirecTV deal closing, we can see that T has more than $110 billion in debt on its balance sheet and about $21 billion in cash. Most of its debt metrics are on the upper end of what we like to see, but the company has stated it will be paying down debt and continues to log very stable business trends for now.
Source: Simply Safe Dividends
From a growth perspective, T’s dividend ranks poorly. As seen below, the company has increased its dividend at a 2% compound annual growth rate over most historical periods. Its relatively high payout ratio and weak revenue growth (1% 5-year CAGR) limit the dividend’s growth potential.
Source: Simply Safe Dividends
Essentially, dividend investors looking for long-term capital appreciation should probably look elsewhere for yield. For retirees, however, T is an attractive source of safe income with low price volatility.
Valuation
T trades at about 13x forward earnings and has a dividend yield of 5.6%. According to our database, T has a dividend Yield Score of 83, meaning that its dividend yield is higher than 83% of all other dividend stocks. Stocks with such high dividend yields are typically either facing adverse business conditions that could result in a dividend cut, expectations for falling earnings, minimal growth prospects, and/or complicated tax effects (e.g. MLP’s).
In T’s case, the current dividend payment looks pretty safe based on what we know today. Future earnings growth is a bigger uncertainty. The company’s balance sheet is pretty maxed out with debt now that the DirecTV deal has closed. T’s interest costs will eventually rise, but the bigger issue is how the pay-TV and wireless services industries play out in coming years. Should competitive forces reduce prices or take share from incumbents, the company’s balance sheet might not look so great relative to T’s increasing cash flow volatility. All factors considered, the current valuation looks reasonable, but we would be more interested if the price fell to $30.
Conclusion
T and VZ are two giants operating in markets with extremely high barriers to entry. Market saturation, evolving media consumption habits, and the rise of non-traditional competitors like Netflix and Google are all working together to pressure incumbent wireless, pay-TV, and internet providers. T has made a big bet on pay-TV and service bundling, two areas that we believe have fairly uncertain futures. VZ has remained focused on its wireless network while placing a relatively smaller bet on mobile video services, a crowded space but one that seems more likely to see substantially higher growth rates than traditional pay-TV going forward.
While both companies’ strategies will take years to play out, we are more in favor of VZ’s approach given what we know today. However, retired investors seeking safe current income would do well holding either stock.
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