AT&T is Still in the Content Business, Just in a Different Way

One key question some might have had about the spin out of DirecTV assets was the impact on AT&T cash flow. That was the reason DirecTV was purchased in the first place, and cash flow generation matters mightily to AT&T.  Also, there were few other major transactions AT&T could have made without regulatory opposition. 

The acquisition, in other words, was the fastest way to add free cash flow, of the alternatives available to AT&T at the time. So what else could AT&T have done with $67 billion--what it spent on DirecTV--assuming a 4.6 percent cost of capital? 

Cost of capital is the annualized return a borrower or equity issuer (paying a dividend) incurs simply to cover the cost of borrowing.

In AT&T’s case, the breakeven rate is 4.6 percent, which is the cost of borrowing itself. To earn an actual return, AT&T has to generate new revenue above 4.6 percent.

First of all, AT&T would not have borrowed $67 billion if it needed to add about three million new fiber to home locations per year. Assume that was all incremental capital, above and beyond what AT&T normally spends for new and rehab access facilities.

Assume that for logistical reasons, AT&T really can only build about three million locations each year, gets a 25-percent initial take rate, spends $700 to pass a location and then $500 to activate a customer location. Assume account revenue is $80 a month.

AT&T would spend about $2.1 billion to build three million new FTTH locations. At a 25-percent initial take rate, AT&T spends about $525 million to provide service to new accounts. So annual cost is about $2.65 billion, to earn about $720 million in new revenue (not all of which is incremental, as some of the new FTTH customers are upgrading from DSL).

The simple point is that building three million new FTTH locations per year, and selling $80 in services to a quarter of those locations, immediately,  does not recover the cost of capital.

The DirecTV acquisition, on the other hand, boosted AT&T cash flow about 40 percent.

 

To be sure, the linear video business deteriorated faster than AT&T expected. Still, to the extent that triple play still made strategic sense at the time, the deal allowed AT&T to claim a major position there without the time and expense of upgrading its copper fixed network to achieve such a position. 

AT&T said as part of its second quarter 2021 results that the company expected lower revenues by $9 billion; cash flow (EBITDA) lower by $1 billion and free cash flow lower by about $1 billion. AT&T also received about $7 billion in cash as part of the transaction. 

The now separated asset still means AT&T gets a 70 percent share of DirecTV cash flow and revenue, plus equity value upside. That answers the question. 

Assuming the primary use of free cash is payouts to the owners, rather than heavy reinvestment in the business, AT&T continues to receive the great bulk of cash flow value. Widely viewed now as a “mistake,” in large part because of the debt burden, the DirecTV acquisition still was a reasonable bet on boosting free cash flow immediately. 

Even now, after spinning out the asset, DirecTV offers AT&T most of the cash flow, though de-consolidating the asset, raising cash to pay down debt, and freeing up management time for other work.