Debt Is The Obstacle to AT&T (HBO Max) Buying Lionsgate (Starz)

A counter to my business rationale for the acquisition: Lionsgate may be too expensive for AT&T to acquire

On Tuesday I argued that Starz CEO Jeffrey Hirsch was selling a future for bundling Starz in the OTT streaming marketplace because:

Given how much tier two and tier three services rely on channels services (60% to 75% of subscribers!), it is hard to believe that bundling will become much of a presence. So, the real revelation here is all evidence points to an outcome where Starz can win without being stuck in Tier Two: that outcome is Starz being sold to HBO Max. I think Hirsch is trying to make that case subtly here. That will be a win-win which results in a revenue-generating relationship for both sides.

The Counterargument: Look at AT&T and Lionsgate Debt

Today, I want to dive into what gets in the way of that argument: debt. AT&T is one of the world's most highly leveraged companies, is currently carrying $147B in debt, and is working with activist shareholders like Elliott Management to actively pay it down.

The Elliott Management demands are a key obstacle to any acquisition, if not the obstacle. Starz parent Lionsgate is carrying $5.2B in debt, $3B of which is long-term, and has a market capitalization of 1.6B. Any acquisition of Lionsgate would result in AT&T taking on more debt, not less. Lionsgate also does not offer much cash for future debt service: $318MM on the balance sheet, and $584MM in Free Cash Flow including cash from issuing debt.

Moreover, it will be hard to convince AT&T and Elliott Management to take on additional debt for Lionsgate's Television Production business, which accounts for 25% of its revenues, WarnerMedia and there continue to be questions about how WarnerMedia's creative culture and production businesses will thrive within AT&T (MoffettNathanson envisions the entire WarnerMedia division being sold in five years).

Those two reasons, alone. are dealbreakers.

But, How It All Could Work

The only remaining question is whether Starz offers HBO Max as a valuable incentive for signing up for an AT&T Wireless plan. As I wrote in Tuesday's newsletter:

Starz offers premium, bespoke content targeting women and African-Americans, making Starz content unusually valuable for targeted marketing of AT&T wireless subscriptions as HBO Max itself. In the short-term, a bundle is less risky than ownership of Starz, and has more upside to AT&T than ownership. For this reason, I think it reasonable to predict we will see a Starz bought by AT&T, and Starz added to the HBO Max menu by Q1 2021.

This framework would mean that a free year of Starz's Power would be as valuable as, if not more valuable than, a free year of HBO Max to African-American customers. These consumers, according to Pew Research, are increasingly reliant on smartphones for Internet Access. That, in turn, would grow the African-American consumer base and reduce churn within that segment.

What is Starz worth to AT&T?

AT&T defines the success of HBO Max in terms of wireless growth and lower churn, Their last reported ARPU in postpaid plans is $50.63, and $55.63 for phone-only postpaid plans. Which would mean, AT&T could buy Lionsgate, bundle Starz with HBO Max, and capture more of a growing target customer base and reduce churn by handing out a bundle worth $23.98 to target customers at no additional marginal cost. That would generate a return of $50.63 to $55.63 per user per month. Of course, the trade off would be taking on more debt and perhaps a cash buyout for Lionsgate Shareholders. But, it would mean an even more valuable "giveaway" to important segments of the smartphone consumer base. And, it would add Starz subscribers to HBO Max's scale, helping it get closer to Netflix levels of market penetration in the U.S. (assuming there is little overlap between Starxz and HBO max customers).

So, solely through the lens of revenue growth and reduced churn with a valuable target customer, the financial logic of a Starz acquisition on the revenues side of the equation could make sense. But looking at the balance sheet and investors, it is harder to imagine AT&T shareholders being ok with owning another Television Studio, and taking on more debt at a time when the objective is aggressively paying it down.

Why I Wrote This

I like stories and developments that have an inherent tension to them. Starz CEO Jeffrey Hirsch arguing for a bundle made little sense to me: bundles do not accomplish much for the consumer. But, shows with target demos like Power and Outlander can attract valuable target audiences at a scale that would be beneficial to an owner.

AT&T offers the best economics for monetizing those users, regardless of its debt. And, it is the only Tier one streamer who can offer a "bundle" to consumers that would make the most sense for it in terms of revenues.

Is the additional debt and likely shareholder uproar worth it to AT&T? It is hard not to imagine they are kicking the tires of Starz as we speak.