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AT&T's $49 Billion Direct TV Bust

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- By John Kinsellagh

It wasn't supposed to end up like this. The purchase of DirecTV was going to be a surefire springboard for AT&T Inc.'s (NYSE:T) ambitions to be a prominent player in the entertainment and media business. AT&T executives viewed the DirecTV medium, which, at the time, controlled one-fifth of the pay-TV market, as a cost-effective and viable launching pad for the company to enter the entertainment distribution business.

The acquisition was fraught with risk from the start. At the time of purchase in 2014, the company knew a significant share of the 18 to 29-year-old demographic was dropping the service or had no plans to subscribe. In a rather odd corporate obituary, AT&T also disclosed to the Federal Trade Commission it expected consumers in other age groups to follow suit in the coming years. It is clear the company thought it could extract enough value from the DirecTV purchase by staying ahead of the rate of consumer cost-cutting. As is apparent, the company badly misjudged the market and the rate of cable departures.

The strategy AT&T has employed for entry into the entertainment and media business seems like a patchwork solution, with far too many unrelated moving parts and erroneous assumptions about the streaming TV market. The disjointed business plan seems evident as AT&T hasn't been able to entice those customers who dropped the service toward its new DirecTV Now streaming service. Although the company touts its nearly new 2 million subscribers, that total includes customers who signed up for a free trial and cellphone subscribers who added low-cost channel packages. Its existing new customer base for its streaming offerings seem rather shaky, a thin reed on which to build a viable streaming service.

The strategic initiative to break into the streaming market is even more confusing because AT&T is offering another streaming video service to respond to Google's (GOOG)(GOOGL) YouTube TV, Netflix (NFLX) and Hulu as well as Amazon Prime (AMZN). Is there any doubt the multifarious, multi-tiered and vastly different packages available are going to create customer confusion? Compare AT&T's launch into the digital streaming market with the position of leader Netflix. AT&T presents its potential customer base with a diverse array of services with different video and channel offerings at different prices. Netflix is one company,with a simple pricing structure. For consumers, Netflix offers convenient, one-stop shopping.

Although AT&T claims its packages will take time to yield a profit, given a market that will soon include Disney (DIS) and Comcast (CMCSA), it may be running out of time. The company is also constrained somewhat by its $14 billion annual dividend cost. The same shareholders who would balk at a reduction in the dividend are also concerned about the company's staggering debt. AT&T's $185 billion debt liability makes it the most leveraged nonfinancial corporation in the world.

In 2019, AT&T says approximately 2 million two-year DirecTV contracts are expiring, an opportunity it plans to use to discontinue discounts.

"As those customers come due, we'll get closer to market pricing," John Donovan, chief of the telecom business, said at a November investor conference. "We'll be respectful of our customers, but that will move up."

This projection is rather sanguine. Given the entry of multiple players in the streaming market, the company may not have the pricing flexibility to maintain existing customers should the monthly subscription increase. At present, AT&T simply doesn't have the depth of programming that will draw in sufficient new subscribers while retaining existing DirecTV viewers.

As the customer exodus continued unabated, why the company believed it could help defray the loss of revenue from the departures by offering combined cell phone services with a DirecTV connection is mystifying and indicative of the haphazard strategy for growing its entertainment business so that it eventually would be able to compete with Netflix.

AT&T CEO Randall Stephenson said DirecTV's defections have been on a par with those at cable-TV rivals.

"Where we are losing subscribers is where we don't have a broadband play with it," he said. "Where we pair an over-the-top product with a wireless product, it does quite well."

Given the fact cord-cutting has accelerated at a faster rate than anticipated, this assertion seems rather dubious. The experience of fellow cable TV provider Comcast is instructive for an understanding of why AT&T's gamble that DirecTV would facilitate its entry into the steaming market.

Comcast added 260,000 broadband subscribers for its second quarter last year, up 49% from the 175,000 added the previous year. The bad news? The company lost 140,000 cable subscribers, its fifth straight decline. AT&T is in the same boat as Comcast; both offer customers broadband, but this revenue can't supplant what is lost from the mass exodus leaving cable TV.

Even though Comcast had anticipated viewers would be leaving the service and planned accordingly, the rate of departures has increased dramatically. The numbers tell a frightening tale for cable providers.

According to research company eMarkerter's forecast, the number of Americans who have cancelled their cable subscriptions will increase 32.8% this year. This represents a leap from 8 million to 33 million departing customers.

The researcher also predicts that 45 million Americans will have left pay-TV for other digital direct-to-customer services by 2020. These numbers account for more than 17% of the population.

In light of these stark numbers, why does Stephenson feel AT&T will be immune from this phenomenon?

If AT&T hopes to make a smooth entry into the digital streaming business, it is going to need to pare back and simplify its subscription offerings while, at the same time, use its Time Warner assets to roll out original content.

Disclosure: I have no position in any of the securities referenced in this article.

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This article first appeared on GuruFocus.