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Analysts debate AT&T's M&A strategy as shareholder agitates for change

Activist investor Elliott Management Corp. recently questioned AT&T Inc.'s growth strategy, saying the company should streamline its portfolio and focus on both debt reduction and shareholder returns. While debt analysts agreed AT&T is in a precarious leverage position, they also said its diversification strategy could yield positive outcomes in an evolving media landscape.

The company has added debt as it expanded into satellite TV with the 2015 DIRECTV acquisition and content creation with its more recent Time Warner acquisition, and its stock has suffered during that period. Meanwhile, competitors like T-Mobile US Inc. and Verizon Communications Inc. have focused on wireless competition and gained market cap.

AT&T is facing several obstacles across its businesses, according to Moody's analyst Neil Begley. Its pay TV business is deteriorating. Its WarnerMedia content business is undergoing a fundamental shift across the content landscape, and AT&T executives are new to managing an entertainment company. The company's legacy wireless business also is in the thick of heavy investment as AT&T and its peers build out next-generation 5G wireless networks under heavy competition to capitalize on rapidly swelling demand for mobile data.

"That's great if everything else is going fine, but they have a pretty sizable balance sheet here," he said, agreeing with Elliott that AT&T should make debt reduction a top priority. The company has undergone three Moody's ratings downgrades since it acquired DIRECTV, he noted.

Cost of doing businesses

However, Begley disagrees with Elliott's views on AT&T's shareholder-return program. Elliott argued that AT&T should continue paying its "highly attractive" dividend of about 6%, and it should also continue to increase that dividend by 2% a year and commit 50% of post-dividend free cash flow to share buybacks.

Begley said the company should, in fact, consider constricting its shareholder-return program until it can get its leverage back down to reasonable levels, particularly considering the threat of a market downturn. In the event of a recession, Begley estimated the company had about a year of run-rate on its credit facilities before it had to tap markets to continue operations at current levels. AT&T's total debt-to-EBITDA ratio climbed from 1.60x in 2013, prior to the DIRECTV acquisition, to 3.5x in the June quarter of 2019, according to S&P Global Market Intelligence.

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However, that was after a debt-to-EBITDA peak of 3.64x in 2017 and a retreat to 3.15x in 2018, leaving analysts at Fitch more optimistic about AT&T's financial and vertical operational trajectory.

"I think they're being fairly aggressive," Fitch analyst John Culver said in an interview, noting that the main issue is not the company's focus on debt reduction, but how it can achieve that while maintaining assets it believes are core to its strategy.

DIRECTV

Operational execution at some of the company's new lines of business has not panned out the way AT&T or its shareholders hoped. Subscribers for pay TV have dropped steadily, with its DIRECTV and U-verse video services down to about 21.6 million subscribers in the second quarter from 25.3 million in the same period in 2016. While its virtual pay TV service DIRECTV NOW gained subscribers in its first several quarters, that growth turned negative in the last quarter of 2018 and has continued downward.

"It has become clear that AT&T acquired DIRECTV at the absolute peak of the linear TV market," Elliott said in a letter to AT&T's board. "Despite describing DIRECTV NOW as a replacement for DIRECTV, the natural-substitution narrative has not played out."

Elliott said AT&T should consider divesting DIRECTV, though analysts said given the deterioration of the business and the limited buyer pool, that is unlikely to happen.

WarnerMedia

The company also added WarnerMedia assets for over $100 billion in 2018. Elliott argued that the company has failed to articulate a clear strategy for the acquisition.

Begley said AT&T could have achieved similar results through licensing and partnership deals with Time Warner. However, AT&T maintains WarnerMedia will support its video ecosystem across mobile, pay TV and online.

Fitch analyst Patrice Cucinello said that could happen.

"I don't necessarily view all the parts to be so disparate, but I think the vertical combination strategy that AT&T is pursuing is a function of the changes that are going on in the media ecosystem," Cucinello said, agreeing with AT&T that it can bundle its wireless, TV and streaming plans across platforms while selling advanced advertising products, which will become an increasingly important part of the digital video ecosystem. "I think execution is the question, and that's what this inquiry is hitting on."

Convergence strategy

As it has diversified, AT&T has suffered ratings downgrades under its immense leverage as well as a deteriorated market position in wireless. T-Mobile, which has focused on disrupting the wireless business with low prices, no-contract plans and cross-media partnerships, has seen the best performance among the big four wireless providers, with shares up about 137% since the beginning of 2014. Verizon, which has focused on a premium wireless offering and advancing its 5G strategy, has seen a market-cap gain of about 22% in that time. AT&T, even while gaining wireless subscribers, saw shares up just about 10%, while Sprint Corp. posted a share-price drop of about 36%.

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During the company's second quarter earnings call, AT&T Chairman and CEO Randall Stephenson outlined the company's plans for a new broadband TV service AT&T TV, and said it would have a nationwide 5G network by the first half of 2020. He also announced that its upcoming WarnerMedia streaming platform HBO Max would include live sports.

While Elliott argued that the company's 5G wireless efforts are unrelated to its video and content ambitions, Stephenson argued otherwise on the call. The executive noted that 5G deployment is a high priority for the company, and HBO Max will be "a key part of this wireless strategy as we get into next year and pairing a very unique premium video content with our wireless and our TV and broadband business."

Though skeptical of the strategy, Begley acknowledged that it could prove viable.

"Nobody really knows what's going to happen to these [media] companies," said Begley. "It's going to be trial and error for a long time."