Commentary

Will AT&T And DirecTV Form A More Perfect Union?

John Malone's Liberty Media may be crossing paths again with AT&T, the thrice-reborn telephone giant that acquired his cable systems more than a decade ago, as the country's dueling satellite services--EchoStar Communications and DirecTV--become more pivotal in the intensified battle for the living room.

Growing speculation that AT&T will acquire EchoStar Communications, the sole rival to Liberty's DirecTV, has sent both stocks soaring. But the ramifications of such a deal reach way beyond EchoStar founding CEO Charlie Ergen cashing in on his career-long bet against cable. The financial and strategic firepower that AT&T and Liberty would throw behind EchoStar and DirecTV, respectively, would take the telephone companies' assault on video-led bundled service to new levels. It would be especially injurious to Comcast, which secured its dominance by acquiring AT&T's cable systems, and 56% of whose overall footprint encompasses the major teleco's addressable video households.

EchoStar's infrastructure and Dish Network would give AT&T a technological leg-up on Verizon, which is aggressively rolling out its FiOS broadband and video service in more than 21 markets. Given the companies' ongoing deal talks, AT&T is expected to give EchoStar the nod as its sole distributor, since many of their services are already integrated.

However, there are other intriguing consequences to an AT&T-EchoStar union.

The newfound video strength AT&T would enjoy would make it a more formidable competitor, especially in mobile services. At this early stage in telephone companies' video assault, its ability to cater to and include wireless service outside of the home is a grossly underestimated edge. Cable operators are slowly ramping up their otherwise tepid wireless efforts primarily with Sprint, although Comcast is accumulating its own spectrum as a backup. Indeed, EchoStar and DirecTV each will need to invest in wireless broadband services, should they remain in their current state.

Another potential byproduct to a merger would be a decision by Malone, a consummate dealmaker, to enter the bidding in order to seize control of all domestic satellite services. It is debatable whether such a monopoly union would pass regulatory scrutiny.

The proposed creation of a new Liberty Capital tracking stock to acquire the shares of DirecTV it doesn't already own would pave the way for Liberty DirecTV and EchoStar to merge into a new satellite financial vehicle. Liberty assets, such as Starz, RSN, GSN and the rural broadband infrastructure WildBlue, would be a strategic fit for DirecTV.

In fact, Citigroup analyst Jason Bazinet, whose report to investors titled "Expect AT&T to Acquire EchoStar" rekindled deal speculation this week, calculates that Ergen would be justified in requiring a $10-a-share premium from AT&T. That would boost the acquisition price to about $65 a share, or 40% beyond where it has been trading, for foregoing synergies EchoStar could otherwise realize in a stand-alone union with DirecTV. DirecTV has been most aggressive with the rollout of HD channels, portable satellite television and Internet access and voice over Internet Protocol. DirecTV's complete package has unmatched potential once newer services are rolled out nationwide.

EchoStar's recently announced consideration of a tax-free spin-off of its non-core, mostly equipment and international assets--which would isolate its 11 core, fully owned satellites (valued at about $1 billion)--forces AT&T and Liberty to make their moves. Bazinet predicts there is a 65% chance AT&T will acquire EchoStar within the next 12 months. "A spin of EchoStar's assets significantly increases the odds of an EchoStar-AT&T tie-up," Bazinet says. Wedbush Morgan Securities' William Kidd also is a believer. "With competition rising and satellite television quickly maturing, we believe CEO Ergen should strongly consider being a seller," Kidd said.

Detractors include JP Morgan analyst Jonathan Chaplin--who, after meeting with AT&T management, said he considered an AT&T-EchoStar deal "unlikely" since financial benefits would be "modest" (initially $200 million in annual savings). Bernstein Research analyst Craig Moffett says the logic behind such a deal doesn't hold up. "How exactly would a telco--with a terrestrial wired network--gain competitive advantage versus a single platform competitor (cable) by buying a satellite network that operates with an entirely separate cost structure?" But anyone who recalls AT&T's painful foray into cable knows logic isn't always a prerequisite for the phone company's moves.

Further consolidation among cable, satellite and telephone players is inevitable in the maturing of the multichannel video industry, with homes representing about 80% of total U.S. households. Cable subscriber trends are weakening from a year ago. "Triple play is not having as much of a positive impact on basic subs as many expected, and that share gains by the Telcos are having a greater impact than many expect," JP Morgan's Chaplin observes. Verizon and AT&T are expected to gain 8 million video subscribers, while cable loses an estimated 5.3 subscribers by 2010. Bear Stearns expects cable to capture only half the broadband market.

That is what makes satellite so interesting. DirecTV is most aggressively rolling out a quadruple play using existing power lines that will eventually give it unmatched potential. EchoStar needs to be part of a larger competing entity if it wants to keep pace--despite its recent $380 million acquisition of Sling Media, a portable video application most reliant on the high-speed broadband connections of cable and telcos.

At the most fundamental level, pricing for multichannel services from all players will be impacted, regardless of how deals line up. Bernstein's Moffett expects competitive pricing will be less aggressive since none of the players--telcos, cable or satellite--can economically justify aggressive pricing strategies on the basis of market share gain, market elasticity, or retention of other products in the bundle. But the circle of competition is widening to more fully include wireless broadband (Wi-Max) and broadband power line (BPL). "New pathways to the home for video and other entertainment could also reduce the value of cable's video distribution bottleneck. Deeper fiber deployment by the (telephone companies) will impact cable subscribers and revenue growth rates, and could occur more quickly, or have more significant impact, than we have forecast," Moffett observes.

Those fluid dynamics make EchoStar and DirecTV wild cards, not just on their own merits, but as part of bolder competitive plays by Liberty, AT&T and other media blue chips.

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