Friday, February 26, 2021

The Counter-Intuitive Take on Wisdom of DirecTV Purchase

With the spin-off of AT&T’s linear video assets into a separate entity called DirecTV, owned 30 percent by TPG, there will be much commentary about the mistake AT&T made in buying DirecTV in the first place.  


That is a legitimate observation. An asset that depreciates from about $67 billion enterprise value (equity and debt) to perhaps $16 billion, in about five years, is hard to justify with the word “success.” 


In fact, you'd be hard pressed to find a single commentator arguing that the acquisition had any value at all.


But free cash flow is really important to AT&T, and the firm could not--for antitrust reasons--have done something more "sensible," such as buying additional mobile and fixed network assets. Facing a number of not-so-good alternatives, AT&T made a choice that almost certainly boosted free cash flow more than any other investment or acquisition antitrust authorities would have permitted.


On the other hand, nobody ever is able to demonstrate there was any other investment of $67 billion that AT&T could have made, in 2015, that would have generated $4.5 billion in annual free cash flow, immediately. The only possible alternative that would have done possibly done so, and passed antitrust review, was a series of smaller purchases of video content assets, had they been available. 


Content assets (studios or networks) tend to sell for enterprise value ratios ranging from 13 times to 23 times revenue. 


In other words, to buy $1 billion in free cash flow (using EBITDA) might require buying an asset costing somewhere between $13 billion and $23 billion. To acquire an asset generating $4.5 billion might have required purchasing assets costing between $58.5 billion and $103.5 billion.


The point is that generating an incremental $4.5 billion in free cash flow is an expensive proposition, even ignoring the time it can take to create and build a free cash flow stream of such size. 


Free cash flow matters for AT&T because it requires huge amounts of free cash flow to support its dividend and fund capital investments. 


To be sure, perhaps nobody actually expected free cash flow to be so threatened by attrition of the gross revenue stream. Some might argue that AT&T “should have” invested that same amount in its mobile or fixed networks businesses. 


Precisely what a mobile investment might have entailed is not so clear, as AT&T could not simply have purchased another mobile company, for antitrust reasons. The same argument holds for purchase of additional fixed network companies. Antitrust concerns made either of those choices impossible. 


If acquisitions were off the table, what about investments in the core networks? To be sure, AT&T might have invested in smaller cells, or more cells, to boost coverage or capacity. The problem is that I have seen no analysis that suggests how such investments--though increasing customer satisfaction or reducing churn--would generate $4.5 billion in additional free cash flow.


It might be argued that AT&T could have put all that cash ($67 billion) into fiber-to-home upgrades, for example. Even a cursory analysis would show that this could not have generated $4.5 billion immediately. It is doubtful if even at the end of five years, free cash flow would be significantly close to $4.5 billion. 


AT&T passes perhaps 62 million housing units. In 2015, it was able to deliver video to perhaps 33 million of those locations, mostly using a fiber to neighborhood approach. 


Upgrading just those 33 million locations to FTTH would take many years. A general rule of thumb is that a complete rebuild of a metro network takes at least three years, assuming capital is available to do so. 


Even if AT&T was to attempt a rebuild of those 33 million locations, and assuming it could build three million units every year, it would still take a decade to finish the nationwide upgrade. The point is that incremental free cash flow would not approach anything like $4.5 billion after a decade. 


Of those 33 million locations, perhaps 20 percent were already customers. Since AT&T competes against a cable operator at virtually all those locations, the issue is how much video market share AT&T could wrest away from the incumbent cable operator, which typically has about 60 percent share (a telco might get 20 percent, while satellite gets about 20 percent). 


So the realistic upside from new video subscribers is between a few percent to possibly 10 percent. Assume AT&T could build FTTH for a cost of about $2000 per location, and can build three million locations a year. At the end of one year, AT&T would have spent $6 billion. Assume subscription lift was 10 percent. That would add 300,000 video subscribers.


Assume annual revenue per account is about $80. That generates about $24 million in new revenue. Assume free cash flow is about 20 percent of gross revenue. That suggests incremental free cash flow of perhaps $4.8 million. 


Of course, FTTH also would allow At&T to compete with cable for internet access accounts more effectively. Assume the local cable operator has 70 percent share, while AT&T has 30 percent or less. 


Assume average annual revenue is $540 per account. Assume AT&T could gain five percent market share within a year. The FTTH upgrade then adds 150,000 additional internet access accounts, or about $81 million in incremental gross revenue. Assume margins are about 40 percent, and that all that is free cash flow (generous, but this is an exercise). 


Incremental broadband cash flow grows $32 million or so in incremental free cash flow. Add that to the video uplife and AT&T gains $37 million in incremental free cash flow from the FTTH upgrades. 


Assume the results are consistent across the homes AT&T could continue to upgrade (33 million total). After five years, AT&T might be able to grow free cash flow by $185 million annually, after investing $30 billion. Hopefully I have done the math correctly. 


In buying DirecTV, AT&T spent $67 billion. But it began earning $4.5 billion in free cash flow immediately. 


In other words, diverting $30 billion of capital to FTTH upgrades produces a fraction of the free cash flow that DirecTV did. True, the asset declined much faster than expected. But if the point is free cash flow generation, avoiding the DirecTV purchase and investing in FTTH would have produced far-worse returns. 


Sure, losing so much equity valuation is painful and unwanted. But investing in FTTH as an alternative might have been far worse, as a generator of free cash flow, even if asset values would arguably have been higher. 


Sometimes a firm has no good choices. This might have been one of those instances. Keep in mind that DirecTV is still spinning off $4 billion in annual free cash flow.


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