DirecTV May Yet Cost AT&T Another Dividend Cut

Summary:

• The market may be gravely underestimating how much damage Sunday Ticket’s move to streaming will do to DIRECTV.
• DIRECTV is no longer publicly traded but is owned by TPG and AT&T, with a 70% share for Ma Bell.
• AT&T’s profit and FCF could fall by as much as $1 billion; TPG’s will be proportionally identical.

After days of unofficial leaks and months of rampant speculation, it is now confirmed that the NFL Sunday Ticket package will be leaving DIRECTV and going to Google’s (GOOG) (GOOGL) YouTube TV. While the implications for Google certainly could be substantial, it seems to be far more substantial for the ones losing it: AT&T (NYSE:T) and its new satellite-TV partner.

Those who follow my work will know that I’ve been consistently bearish on DIRECTV pretty much ever since it sealed its original merger deal with AT&T seven years ago. That view has certainly been vindicated. Last year, AT&T sealed a deal to spinoff DIRECTV – along with U-Verse TV, AT&T’s original in-house TV service – to a new joint venture with TPG (NASDAQ:TPG) for $7.8 billion in cash, including debt. It was actually less than that, but we won’t go into that now.

That was roughly $60 billion less than it bought DIRECTV for. AT&T, however, retains 70% of the New DIRECTV. So it still cares a great deal about what happens to the satellite company going forward. As does TPG for that matter.

This is a real hit. And perhaps a far bigger one than some think.

Satellite Has No Ticket To Ride

To be sure, while YouTube’s winning bid was a major development, DIRECTV’s lack of one wasn’t exactly news. The CEO of the New DIRECTV has been clear almost from the moment he was named that he wasn’t interested in extending the deal, at least in its current form. DIRECTV charges $300 for a year’s subscription to Sunday Ticket, plus more to bars and restaurants. But even so, Sunday Ticket losses for DIRECTV have been estimated at no less than $500 million per year. They could conceivably be considerably more. Personally, I think they’re a lot more.

The reason is, like anything, how revenues relate to costs. DIRECTV was already showing signs of strain when it paid $1.5 billion to renew its Sunday Ticket deal in 2014. That was only a $100 million increase over the previous deal, much less than other companies paid in NFL rate hikes.

It was estimated that even in its heyday, only about two million of DIRECTV’s 20 million peak subscribers paid the fee to become Sunday Ticket subscribers. That pencils out to $600 million in annual revenue.

At one time, it was still worth it to DIRECTV because it also profited from attracting subscribers who would otherwise select a different provider for their TV service if they could get Sunday Ticket elsewhere. DIRECTV could attribute the entire TV service profit stream of those subscribers to Sunday Ticket. If that profit stream came to at least $800 million, there is at least a chance DIRECTV was breaking even as recently as just a few years ago. If it comes to over $1 billion it was definitely turning a profit even now.

But with the acceleration of cord-cutting in the last few years, this math is getting scrambled. Unlike some regions, the US has consistently shown a pronounced tendency for satellite losses to exceed cable’s, sometimes as much as doubling them. That means that while overall pay-TV penetration is only down about 25%, DIRECTV’s fell a lot more.

Extrapolating DIRECTV’s Subscriber Trend

DIRECTV no longer reports its subscriber figure, but outside analysts put it at 13.3 million. However, that is for both the DIRECTV satellite platform as well as AT&T’s old U-Verse IPTV service and the streaming service DIRECTV Stream (formerly AT&T TV Now, formerly DIRECTV Now.) Assuming that DIRECTV Stream is now negligible – it was absolutely collapsing when DIRECTV went private – and assuming U-Verse is still one-third of DIRECTV’s size like it was when AT&T merged with the original DIRECTV in 2015, then the satellite, Sunday Ticket-eligible side now accounts for roughly 10 million subscribers.

The general expectation is that this will deal a blow to DIRECTV’s subscriber totals, but not to its profits since the package is now a money-loser anyway. This thinking generally tends to follow something along the lines of a proportionality exercise: when DIRECTV had more subscribers to amortize the Ticket over it was a good deal, now it’s not.

This sort of thinking generally assumes that DIRECTV was bleeding Ticket subs and non-Ticket subs at about the same rate. And of course, DIRECTV has lost a lot of subscribers. Sunday Ticket subscribers, however, are probably more loyal than the typical DIRECTV member – after all, they can’t get Sunday Ticket anywhere else.

Consumer Ticket Surveys

There’s evidence of this in the consumer surveys of Sunday Ticket penetration among DIRECTV customers. For a long time, when DIRECTV had close to 20 million subscribers, surveys would consistently return that 10-15% of them were Ticket subscribers as well.

Lately, however, the number has been creeping up, with some surveys showing as much as 23% of total subscribers being Ticket members. However, considering that the platform is half the size it was six years ago, that penetration may actually simply represent a consistent two million Ticket subs or so standing by their provider as others leave, representing a larger slice of a smaller pie.

So there seems to be a lot of Ticket loyalty … which will go from being a DIRECTV asset to a liability as soon as the product they’re loyal to leaves the DIRECTV umbrella.

DIRECTV’s Potential Exposure

I’m not at all convinced that the damage stops at two million.

First, DIRECTV regularly made a point of advertising a one-year free Sunday Ticket offer to its subscribers when they signed two-year contracts. Often, this pertained to renewals as well. This means that potentially as much as another two million subscribers who are not currently paying customers of Sunday Ticket may nevertheless be equally motivated to follow it to a new home, if they were receiving it for free at the time.

Secondly, however, is that because DIRECTV has been the home of Sunday Ticket for three decades, it is not just home to current subscribers of Sunday Ticket – paying or not – but also many former subscribers. Obviously, once someone stops subscribing to Sunday Ticket they are back to presumably being more or less indifferent as to which TV provider they use – or, at the very least, they are no less indifferent than the general customer base.

But unlike streaming services which pride themselves on being cancellable with a single click – not out of charity, but because they hope easy cancellations will encourage people to return and give them another try later – cancelling traditional cable/satellite pay-TV has always been a royal pain. Switching even more so, since it involves a cancellation and a new installation. For quite separate reasons of their own, cable executives have been regularly reminding us lately that change in address is their best chance to steal customers from satellite, since installation is necessary at that point anyway.

For myself, I’ve expressed before that I’m not so sure that is the primary cause of the decline in cable broadband growth. But regardless, the point still has some bearing on DIRECTV, I think. It’s not hard to imagine that even if a customer ultimately decides to leave Sunday Ticket behind, any customer who wants to even try Sunday Ticket has to move to DIRECTV … and perhaps would be less inclined to move again to another provider afterwards, since a second change would presumably be less urgent, but no less annoying and inconvenient.

Former Subscribers

Unlike current Sunday Ticket subscribers, former subscribers presumably have been affected by cord-cutting to at least some degree, but I still think it’s likely that there are a considerable number of them. Sports is what holds the linear bundle together today, such as it is; 83% of sports watchers are still bundle subscribers while the overall pay-TV penetration is down by a third or more. Even former Sunday Ticket subscribers are, by definition, sports fans, and therefore probably less inclined to cut the cord than some.

If these last customers have left Sunday Ticket behind forever and have no intention of going back perhaps they won’t care as much, but it seems logical to assume that like many customer groups they cycle in and out of the product. Some of them probably represent customers who take the free year of Sunday Ticket when they renew their contract but don’t pay the $300. Such customers might well follow the ticket to its new home and do the same thing. Others might have been turned off by the high cost altogether; if Google finds a way to offer an effective price cut – not by cutting the headline price, which is prohibited by the contract, but perhaps by offering to bundle some other desirable product in with a sale – they might be tempted as well.

To be sure, not everyone will follow the Ticket to its new home; some may be so far out in rural areas that effective high-speed broadband internet can’t reach them. But the continuing expansion of wireless internet by Verizon (VZ) and T-Mobile (TMUS) might solve that problem as well.

DIRECTV’s Financial Impact

Altogether, it seems possible that as many as five million subscribers or even more could be impacted by DIRECTV’s loss of the Sunday Ticket. That is a very significant number when DIRECTV’s once mighty 25 million subscriber base has already been cut in half.

It’s even more significant for AT&T and TPG because DIRECTV has considerable debts to pay off on a relatively tight schedule, ensuring that cash flow to the equity owners drops off even faster than operating income does. While DIRECTV’s $6 billion debt load at sale doesn’t seem so high compared to AT&T’s twelve-figure sum, it has far less cash flow to service it with.

In the first nine months of the year, AT&T’s 70% share of DIRECTV profits came to $1.4 billion, suggesting that DIRECTV is on somewhere around a $2.7 billion run rate of profit. My (very rough) estimate based on certain comparative exercises is that DIRECTV’s operating income hits zero somewhere around 3.3 million satellite subscribers, which would correspond to somewhere around 4.4 million total subscribers assuming that U-Verse really is 1/3 the satellite division’s size and that subscriber drop-off is otherwise proportional.

If this is right – and I acknowledge the math is rough – the Sunday Ticket departure, far from being a minor matter, could see DIRECTV lose as much as half its profit, chopping roughly $1 billion per year off of AT&T’s net income and FCF.

Impacts For Wireless

A quick aside: emphasizing the impact on YouTube TV and Google probably also overlooks a smaller, but still significant impact on T-Mobile and Verizon. They are both investing in constructing large-scale wireless home broadband networks, and T-Mobile has indicated that fixed-wireless penetration significantly over indexes in rural areas which have never had access to high-speed broadband before.

Sunday Ticket on YouTube TV might give rural inhabitants one more reason to sign onto fixed-wireless and bring in some extra customers these companies wouldn’t otherwise get. With T-Mobile, in particular, reaffirming its commitment to the excess-capacity business model, revenues from fixed-wireless basically go straight to the bottom line, meaning even relatively small revenue boosts can substantially boost profit.

AT&T could benefit from the same thing … if management wasn’t deliberately shunning the fixed-wireless market.

Investment Summary

AT&T and TPG are co-owners of a platform which we already knew was in trouble, but this could be the final straw. Rampant cord-cutting means that DIRECTV’s profits were already shrinking; these losses among the one customer segment of DIRECTV that wasn’t subject to cord-cutting are all additional losses on top of the ones DIRECTV was already taking every year.

Obviously, AT&T is more than just its DIRECTV stake, and so is TPG. But for AT&T, in particular, concerns that another dividend cut may be coming will only get louder if another billion dollars a year disappears from its cash flows.

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Disclosure: I/we have a beneficial long position in the shares of TMUS either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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