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26 November 2015

AT&T numbers hide the potential disaster of the DirecTV deal

Some of us think all sorts of clever thoughts about mergers and acquisitions, how the larger company can combine products to create a new class of product, at discounted prices, using new technology, but the AT&T DirecTV merger is more about simple size creation, or at least that’s what the senior AT&T management think, and at Faultline we think they are wrong, or at least only partly right.

Simply imbuing the relatively dubious DirecTV brand with the solidity that is associated with the AT&T brand, should make the deal work out fine. Satellite TV has long been considered poor man’s cable, and despite great content and a well-run marketing machine, DirecTV still hasn’t quite gotten away from that tarnished branding. It should finally complete that under AT&T.

But ask yourself what you expected when the two merged? At Faultline we thought its content buying potential, when compared to AT&T’s content purchasing deals (rather than DirecTVs) would mean that all AT&T would have to do is sell the same amount of customers, and the profitability would increase dramatically, through discounted content.

At this year’s result AT&T made that point loud and clear as it signed with Viacom, one of the most “difficult” and strongly positioned programmers, at the old DirecTV rates – “best content pricing going forward” AT&T said of the deal. And more was promised. “I encourage them (content providers) to look at our wireless and broadband assets to widen their distributions,” is in effect code for “every renewal will be cheaper and make us some savings.”

That’s a tick on the plus box on this deal, but the big X in the negative box has to be the number of subscribers the survivor inherited. At the results not a single financial analyst asked AT&T what happened to the TV subscriber base, and that’s because it stated that it had, “26,000 satellite net adds post deal close.”

But the figure it gave was 19,570,000 for the number of subscribers it had on September 30, claiming that since then it had added 26,000. But it failed to put up the numbers prior to that, with DirecTV in June having 20,300,000 customers. It quite simply lost 730,000 pay TV customers in that quarter. Now how was that?

The landscape is a complex one right now – US pay TV is saturated, but more than that, it is being savaged by cord cutting and cord shaving. DirecTV itself has OTT services, but this is about the high value of the core service. It has its DirecTV Phone and Tablet apps, which give around 120 TV channels plus some VoD assets, some available on the road, some only in your home. It has a DirecTV Sunday Ticket sports App, as well as a 4K movie service and its own Hispanic and Kids services.

These are, for the most part, TV Everywhere apps, and if you are paying the average revenue per user of $110 a month, which has gone up $7 during the past year alone, then perhaps you are thinking, I can get a paid OTT app for $20 a month from a rival, and cancel my service. If it is this causing cancellations, then these losses will not be recovered.

The market for pay TV in the US is, as we have said, mature. That means that some rivals like Dish have aggressive new offers out which accept the condition of the market. The Sling TV OTT service is one such service, but also the DTH service itself will have been made more compelling, because Dish is losing subscribers net of Sling TV additions, which some have estimated this at around 155,000 to 195,000 a quarter. So at a time when everyone is pulling out every marketing and discount and quad play trick in the book, we can say at the very least that DirecTV was busy consulting with AT&T management on future strategy and took its eye off the ball.

Judging from the earnings discussion the new strategy is simple. Put the existing DirecTV offerings into AT&T shops (there are 2,200 of them in the US) and keep the prices where they are – i.e. high. AT&T also said that it has stopped its “value” offerings in U-Verse, which is why it also lost 91,000 U-Verse video customers. The plan is just to sell harder, with a better, more  appreciated brand, and don’t discount so much, or offer incentives to buy the service. Perhaps this loss of 730,000 subscribers is an example of what that kind of strategy will lead to. Perhaps it was just uncertainty in the interregnum.

Let’s not beat about the bush here. When TCI sold its cable business to AT&T in 1999, it lost customers and failed to manage its integration. It thought all it had to do was use its existing approach and lend its brand to TCI and cable customers would emerge from everywhere. It then bought other cable assets, spending in total some $105 billion. When these mergers clearly failed for AT&T, 3 years later it sold the business off with a loss of over 50% of the value, around $57 billion – which is more than it paid for DirecTV.

John Malone sold old AT&T the TCI cable operation, and it was John Malone that sold DirecTV to the new AT&T in 2015. He also bid to try to buy TCI back, but lost out to Comcast. If the same thing happens again, there may be anti-trust issues preventing anyone but Malone from buying it back.

We say the new AT&T, because essentially this company is SBC Communications, which was more successful at growing a subscription business than AT&T. But it acquired AT&T in 2005 and changed its name, to AT&T, again because of the value the brand has with the US public. Isn’t it funny that Americans trust a brand that is totally focused on making as much money out of them as possible?

Even if, under new management, the situation turns around, how long will it take AT&T to recover from its 91,000 U-Verse video loses and its 730,000 DirecTV pay TV losses?

It is difficult to establish a run rate for future gains, but clearly that 26,000 gain in what amounts to less than a month is not a guideline, since U-Verse is losing more than that(3 x 26k versus 91k). AT&T says that it is now selling DirecTV and broadband together, that it will sell them in combined packages, where both are available. Where it has ADSL customers (2.7 million of these are left) it can offer DirecTV with an upgrade to AT&T U-Verse broadband – not price based, you understand, but somewhat value led.

AT&T says it will certify dealers and online sources, as well as ramping up sales in its call centers. All traditional marketing steps. But if it does all that, how will we know if anything is happening in the next two or three quarters, other than those 730,000 lost customers being called up and offered a deal to come back, resulting in a zero sum game.

AT&T says it has lots more cross selling ideas up its sleeve. As it trains service reps and technicians for a premium single-service experience, so we will see the benefit of those strategies impact future quarters. There are also technical issue here. It needs to integrate IT systems and that will likely take more than a year, so that a single service management platform can be built to create new combo products rapidly, including U-Verse Broadband, fixed and cellular voice and TV – presumably under one brand. It will also have to merge its U-Verse App with its DirecTV app, and re-align all of its content licenses. It will take time.

But broadband is another issue. AT&T said it added 192,000 IP broadband customers, but it lost 222,000 ADSL customers, so it converted 192,000 to IP Broadband (U-Verse broadband) and lost 30,000. This is another point that it is hard to place a likely growth line on. U-Verse is offering 50 Mbps. It will shortly offer vectoring, but is taking longer than any other leading global telco to get this organized. Vectored broadband is not enough, and it is likely that AT&T is waiting for a combined vectoring and strategy. It agreed to a mandate from the FCC to upgrade 12.5 million broadband lines to 45 Mbps or greater. It can do this without actually spending very much – it just has to make vectoring and available to most of its U-Verse DLSAMs as an option and hey presto, that’s done.

If it does the very least that it can in broadband, it might continue to lose broadband lines over the coming two years. At its height in 2014 it had 16.5 million broadband lines. Today AT&T has only 15.8 million, a loss of some 700,000, a similar fall in broadband lines over 18 months, to the number of lost DirecTV customers in a single quarter. To get those all back in a single year (1.43 million) would count as success, but it would need a run rate of some 120,000 a month or 360,000 a quarter, split half for broadband (180,000) and half for pay TV (180,000).

But AT&T says that it wants to be measured not on volumes, but on profit, and by maintaining its margins, and even improving ARPU, it might achieve profit parity, on lower volumes.

If anyone asked our advice at Faultline we would say that during the cord cutting era it’s not important to make excessive profits from OTT or any form of pay TV, instead it is most important to maintain market share, for when ARPUs rise again later. AT&T seems to be set on the opposite course. That’s what you get when you listen only to shareholders – you have a less successful business.

Even the Latin American numbers at DirecTV appear to be slowing. The June quarter was the same as the September quarter and you have to go back to March to see an 800,000 gain across Pan Americana (7.2m, up 400k), DirecTV Brasil (5.6m, up 100k) and Sky Mexico (6.9m, up 300k).

Can it get back to that March to June growth? We don’t know. You cannot drop value propositions in poor countries, so it depends on how AT&T proceeds. Right now the issue is that currency exchanges are making this look worse than it really is.

AT&T says it plans to save some $2.5 billion and this will mostly come from its content and supplier relationships. It will pay DirecTV prices, across AT&T, and end up disrupting the content and technology supplier markets.

Surely the biggest excitement of the merger is that AT&T offers its wireless customers a paid OTT play using all that cheaper content that the DirecTV purchase brings. This would put it on a par, or ahead of Go90 from Verizon, and it might turn the tables in Mobile First TV. However T-Mobile has gone the opposite route, acting as a conduit for existing OTT services with its Binge On deal, offering free data to carry them. That could mean that there is little room for AT&T to steal the OTT show with wireless customers and it is forced back on these more conventional marketing plans.

It has introduced one such step that it calls “walk out watching,” where if you buy DirecTV from an AT&T store, it can be added to your phone with an App download, before DirecTV has even been installed at home. Let’s welcome AT&T to the instant world of OTT.

Looking at the ultimate downside, if DirecTV content offers continue to be offered in preference to U-Verse, and if broadband and pay TV do not hit those 180,000 a quarter targets each, then in just one year the sum of the parts will be less than the two halves and AT&T will be in trouble. Its management have never received the full wrath from the investor market for trying to buy T-Mobile when it was obvious (at least we predicted it) that it would never be allowed, and now the same management team will have to be blamed for successfully negotiating a merger which then fails.

Whatever happens, unravelling this merger would be a disaster. U-Verse would have to be revived or AT&T would be out of the video business and it would become purely a cellular player, and if it gets its mobile video strategy wrong, it will be a cellular player which is losing customers.