AT&T's Video Subscriber Growth Is Unsustainable

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AT&T (NYSE: T) is the largest pay-TV provider in the United States. Between DirecTV, U-Verse, and DirecTV Now, the conglomerate had over 25 million subscribers as of the end of 2017. AT&T added 161,000 to that total in the fourth quarter.

But AT&T is seeing thousands of subscribers leave its legacy linear TV products every day. DirecTV and U-Verse lost nearly 1 million subscribers combined last year. Those subscriber losses are made up for with lower-priced DirecTV Now streaming subscriptions, which increased nearly enough to completely offset losses for the full year, and more than enough to offset it in the fourth quarter.

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Management is optimistic that trend will continue. "We expect to pick up whatever video losses we have and more than that with DirecTV Now," CFO John Stephens said on the company's fourth-quarter earnings call.

While net additions are one thing, profits are another. And it's hard to see how AT&T can make a profit on DirecTV Now, which calls into question the sustainability of the trend.

The costs add up

Speaking at Recode's Code Media conference, analyst Michael Nathanson presented an analysis of DirecTV Now's $35 per month "Live a Little" package. After adding up all of the costs -- content, subscriber acquisition costs, cost to deliver the content, and customer service expenses -- he estimates AT&T is losing about $0.26 per subscriber at that level.

Content costs are the big one, eating up about $30 as AT&T includes channels from Disney (NYSE: DIS), Twenty-First Century Fox (NASDAQ: FOXA), Time Warner (NYSE: TWX), CBS (NYSE: CBS), and NBCUniversal.

AT&T is also spending a lot to acquire new customers. It's offering free streaming devices like a Roku Streaming Stick to customers that commit to a month or three of the service. It's also offering hefty discounts to its unlimited wireless data customers.

While AT&T's margins are improved on its higher-priced packages, it's still unlikely to see the same levels of profitability as its legacy video products. AT&T doesn't disclose what percentage of DirecTV Now subscribers choose its bigger bundles, and it leaves the service revenue and subscribers out of its average revenue per user calculations.

Content will only get more expensive

What makes things worse is that the content partners AT&T chose for DirecTV Now have the most pricing power in entertainment. Live sports is far-and-away the most viewed content on television, and that trend is only getting stronger as users can now easily get quality scripted television on demand via numerous streaming services.

ESPN, Fox, NBC, and TNT all have sports, and they all charge a premium for it. Nathanson expects Fox, NBCUniversal, Disney, Time Warner, and CBS to account for 94% of the total increase in industry affiliate fees through 2020. Those are the media companies that make up the core of DirecTV Now's smallest package.

In other words, the cost of goods sold for DirecTV Now is climbing more quickly than the average cost of goods sold for its legacy products (which fill out the bundle with media companies with less pricing power).

"We're convinced the economics will continue to improve as we move over the next couple of years," AT&T CEO Randall Stephenson assured investors on the fourth-quarter earnings call. He's hopeful that high-margin add-ons like cloud DVR coming later this year will not only improve profits for existing customers, but attract new customers as well.

But there's nothing to suggest DirecTV Now customers are interested in premium services -- quite the opposite. 50% of DirecTV Now customers are cord-cutters or cord-shavers, indicating they're price motivated. The other 50% are cord-nevers, who may be less price conscious but have also shown a willingness to completely do without a cable package in the past. So, price increases -- whether via compulsory add-ons or just increases in the base price -- might not go over well with existing and potential customers.

The bottom line is that AT&T's expectation to pick up its legacy video losses with DirecTV Now additions is either unprofitable or unsustainable.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Walt Disney. The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.