Profitability Falls by the Wayside With AT&T's DirecTV Now Offering

By Motley Fool Staff Markets Fool.com

AT&T(NYSE: T) now offers a new streaming service, DirecTV Now, with live cable channels at an attractive price. What role it takes -- a loss leader intended to help the company cross-sell customers on more profitable services versus a preview of the future of television -- remains to be seen.

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In this segment fromIndustry Focus: Consumer Goods, the cast explains ongoing trends in the cable industry, including falling prices and increasing competition, as well as the long-term outlook for DirecTV Now.

A full transcript follows the video.

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This podcast was recorded on Dec. 13, 2016.

Vincent Shen: I'm going to put on my optimist cap right now,because I do think there are a few thingsthat we can keep in mind in terms ofhow this becomes attractive. For example,AT&T having this diversified suite ofdifferent businesses, including itswireless business, some people argue thatthis can be a loss leaderbecause, guess what, AT&T has made it so that anything you watch,if you're signed up for DirecTV Now,does not count against your data capfor your wireless service.

Dan Kline:AndAT&T's ability to bundle,because they're not going to invest more money inphysical cable lines. They own DirecTV, which is asatellite product, and the biggest decliner in the cable business has been their wired cable business, because if you own DirecTV, which you can market nationwide,why would you spend money marketing locally? So,they can go to their phone customer and say, "Here's a promo, add DirecTV Now for $20 for the next three months, I'll give you a thousand channels," or whatever it is. They'll have a little bit of success with that, butthere's a ways to go on the product. I think that's important to point out. I tested Dish,I did a story for Fool.com on cutting the cord, and I lived with Sling and with Sony, and to say it's anunpleasant experience when it's your prime means of watching TV is putting it mildly.

People, when they watch cable, flip around. They don't sit down like they do with Netflix and binge-watch. They don't always watch whole programs. Even if you'rewatching your favorite football team, during the commercials you might flip to a home improvement show, or whatever it is. Doing that on these services is painful. It's a little better on Sling than it is on Sony. From the demos I've seen of DirecTV Now, there's a lot lacking. You also can only pause for five to 10 seconds on most channels.

Shen:Yes,that's something to keep in mind. DirecTV Now,at the moment, at launch,it does not have a DVRcapability built in,but that's supposed to be coming next year, as is support for some additional ...

Kline:And,to be fair, the reality is, nobody really does. Sony has some limited DVRcapability, better than others, but their price is higher. Sling is just this week testing some DVR. Butthe reality is, most of their deals with the cable companies preclude DVRs, pausing. There's some on-demand content. But generally, it's the type of on-demand content you could get with aHulu subscription.

Shen:Looks like we'regoing back to our pessimist angle.

Kline:(laughs) But hey, good job, AT&T.

Shen:I do want to addsome additional details onnumbers I was able to find. I think it's kind of interesting,in terms of the profitability,what the contribution might be in terms of their margins. You mentioned the $35 promotional deal for the 100 channels is quite compelling. The fact is, it's not coming cheap. One analyst I have, theybelieve the gross marginsfor the various packages will range anywhere from 2% to 15%. This is, for AT&T overall, theiroperating margin is about 17%, so not even close. The fact of the matter is,SNL Kagan, they estimate that that $35 monthly bill, even for the lowest tier, which I think is where a lot of people will end up signing on for those core 60 or so channels, that barely covers the cost of the programming, based on their estimates. Then you factor in things like the back-end support,customer service, theinfrastructure, and you're potentially looking atwhat is very much a loss leader.

Kline:I think there's one thing you can factor in there,I think we're about to see a bit of a come-to-Jesus. Thecable companies have had all the leverage.ESPNhas been able to say, "You can't get rid of ESPN. We want 10% more. We want to go from $5.80 to $6.25 to $6.45 per subscriber." Now, we're starting to see the cable companies say, "Wait a minute. We'regoing to offer a package without ESPN." Someone could go to one of these services andmaybe not get certain higher-priced channels. There are going to be reductions in some of those costs. You are not going to, as a low-watch channel --maybe VH1 Classic gets $0.02 per cable subscriber, and 80,000 people are watching it at the absolute best part of the day, they're either not going to exist because no one's going to pay them anything, or they're going to get lower fees. Even the big-ticket companies, ESPN ratings are down. So, you're going to see a trickle-down across the board.ESPN is either going to stay the same or take cuts, and they're going to spend less money on programming. So, you're going to see some of these college billion-dollar deals get lessened, and start to go down.

Shen:I will add that, big picture,there's two other things that I want to wrap up with. The first is, even if, I think DirecTV Now, with this service, they wanted to raise prices and boost margins, let's say it really does take off, and they're able to build up five to 10 million subscribers, and itstarts to make a bigger impact on their financials,it's only going to get more competitive in this space. Hulu is coming out with acompeting service. Amazon, you know, is coming out with one.

Kline:Appleis talking about one, Comcast is talking about one.

Shen:Amazon will put that out at or below cost, too, just to take market share.

Kline:Andthe problem is, when you're selling a servicebased on price, youlose a lot of pricing flexibility. So they are not goingto be able to slowly raise this so it costs what cable does, unless cable goes away, which,as we talked about earlier, the physical cable box might. But for that to happen,these services have to feel like the experience of watching TV.

Shen:That is a possibility, though, in terms of, looking out three to 10 years, as, they understand, or they see this as becoming the future without the cable box, no morewaiting for the cable guy,replacing their model, and this is their test.

Kline:Some of thisI blame on your generation,who is willing to watch television on an iPad when you have a 60-inch flatscreen sitting in front of you.(laughs) I've never understood this!

Shen:The second thingI did want to discuss was with the coming acquisition, stilluncertain, ofTime Warner, which will giveAT&T an incredible library of content. Think about what Time Warner runs -- HBO, Warner Brothers,they have some great networks like AMC. [Editor's note: AMC is owned by AMC Networks and not included in the Time Warner acquisition.] Obviously, there's going to be some rules and regulations about making sure that there's somewhat faircompetitive practices. But ultimately, Time Warner gives them that leverage to offer exclusive content to DirecTV Now subscribers. And that has worked for companies like Netflix.

Kline:And even, forget the ability to say, "Hey, you're going to get HBO shows two days early," orsome of the things that maybe will fall underregulation, though debatable, given the incoming administration and their stand on --

Shen:Call that uncertain, yeah.

Kline:Yeah. Tom Wheeler, the FCC chair, has been pushing a lot of this,and he is probably not in political favor going forward.But, forgetting that. The buying power of this combined company --one of the first deals they announcedwas a Taylor Swift Channel. Now, I know you're a big Swiftie. I am not so much. I am much more aGwen Stefani camp -- no,I'm teasing, completely. But that said,Taylor Swift has a decided audience. And they could throw the money at her. So, her backcatalog of performances, videos, exclusive interviews, whatever the heck it is,Taylor cooking Thanksgiving dinner, I have no idea, can be a channel. And that itself may not be a draw, but you start to pile two or three of those things together, and they have the ability,just like HBO has a deal with Bill Simmonsand Jon Stewart, some of those deals are very amorphous as to what the content is going to be. They could say, "Hey, look, Bill Simmons' podcast is going to be on video on a channel," the way they dowithThe Dan Patrick Showon Audience, which is the AT&T video channel. So, theirability to just buy up the marketplacein terms of content -- and I'm sure they offer Audience to other cable companies and none of them take it -- eventually, they might be able to tip the balance in favor of them. But it's still not going to make you buy an inferior, unpleasant service.

Shen:Yep. So, it seems, overall, you are not all that bullish on what this offer provides them.

Kline:Not for today.

Shen:My view is, it's an interesting step. I would watch itrather tentatively. But ultimately, this could be what thecompany sees as a step into what the future of distribution is going to look like.

Kline:I think every cable and wireless player believes in this a lot more than I do, to be positive.(laughs)

Daniel Kline owns shares of Apple. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com, AMC Networks, Apple, and Netflix. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.