Key Takeaways
AT&T has agreed to acquire Time Warner for $85.4 billion in cash and stock in a deal that is expected to close by the end of 2017. Strict regulatory scrutiny can be expected.
The deal has the potential to disrupt the traditional pay-TV industry while setting AT&T apart from its competitors in the wireless telecom industry, where growth has become sparse for the firm.
The telecom industry is maturing, and price-slashing competition has changed the game as network differentiation has largely become a thing of the past.
We’re not fans of the debt that will come with the completion of the deal, but the prospects of what the combined entities could produce are certainly interesting.
We view the additional debt as a distinct negative to AT&T’s dividend health and the company’s Dividend Cushion ratio. We continue to be cautious on AT&T’s long-term dividend health.
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“While the AT&T-Time Warner deal has the potential to transform the media and wireless telecom industries, it does little to impact our newsletter portfolios. At Valuentum, we tend to be debt-averse, and though we recognize the capital-intensive nature of the telecom industry, the mountain of debt needed to build and maintain proper infrastructure, the regulatory nature of the industry, as well as the free cash flow generating abilities of telecom giants like AT&T and Verizon, we aren’t interested in adding exposure to an industry currently characterized by slowing growth and transformational mergers.” – Kris Rosemann
By Kris Rosemann
AT&T (T) has agreed to acquire Time Warner (TWX) for $85.4 billion, evenly split between cash and stock, or $107.50 per share. When considering the impact of Time Warner’s net debt, the total transaction value comes in at a whopping $108.7 billion. The deal is expected to close by the end of 2017, and is anticipated to result in the extraction of $1 billion in annual run rate cost synergies within 3 years of the deal closing.
On the surface, we like the deal for Time Warner shareholders, as our most recent fair value estimate for shares was $81, to which the deal price represents a substantial premium. The market appears to be currently pricing in a significant amount of regulatory pressure, however, as shares of both companies have reacted unfavorably to the announcement of the deal. We expect a modest haircut to our estimate of AT&T in light of its hefty price above our estimate of Time Warner’s standalone intrinsic value.
In acquiring Time Warner, AT&T is addressing its needs to diversify as its traditional wireless business has hit a point of maturation and slowing growth. Intense price-cutting competition from the likes of Sprint (S) and T-Mobile (TMUS) helped cause the company to lose 268,000 mainstream wireless phone customers in the third quarter of 2016, and it also lost a net 3,000 video customers. Since the acquisition of DirecTV in 2015, the company has lost nearly 200,000 video customers as new additions in the DirecTV business have not been enough to outpace losses in its more dated U-Verse service.
Part of what has held AT&T’s progress with its DirecTV acquisition back is its ongoing negotiations with content owners in its plans to launch an over-the-top video service that would allow users to stream programming on the Internet without a satellite dish called DIRECTV NOW. Such a service, expected to be launched by year-end, was one of the key drawings of the DirecTV deal, but negotiations with content owners have proved to be very difficult, which is where Time Warner comes in.
With the purchase of Time Warner, AT&T is gaining ownership of a premium content generator with impressive brands including HBO, CNN, TNT, and the Warner Bros. film and TV studio. The company is now “all-in” on its bet that mobile TV and video consumption will be the next growth driver for wireless telecom providers and is tying its future to the ownership of popular franchises such as Game of Thrones. The new AT&T aims to disrupt the traditional pay-television package market and push the boundaries in mobile content consumption in the US by creating an online-video bundle. While a deal in the $85 billion dollar range is certain to face regulatory scrutiny, AT&T officials believe that since the firm is not necessarily eliminating a competitor, concerns should be more easily addressable.
Those who remember Time Warner’s tie up with AOL in 2000 may be hesitant to praise the deal, as the firms’ endeavors eventually proved fruitless. However, proponents of the deal with AT&T, including Time Warner CEO Jeff Bewkes, have made a convincing case that Internet distribution has come a long way in the past decade and a half, and the platforms from which consumers access content have evolved significantly. “Video is the future of mobile and the future of mobile is video.”
In addition to the ownership of content significantly increasing the value potential of its own product offerings, AT&T expects to retain Time Warner’s traditional content distribution network. Just as AT&T had found it difficult negotiating with content owners over the licensing of content for its proposed mobile-TV network, now others will come to it to negotiate licenses for channels like TNT, Cartoon Network, and HBO, further diversifying its revenue stream. Though AT&T is already materially tied to the ongoing consumer trend of cord-cutting in personal entertainment, the acquisition of Time Warner also comes with its 10% stake in streaming service Hulu.
If the deal is completed, the resulting AT&T would generate more than 40% of its revenue from its entertainment business, helping reduce its reliance on success in its wireless business. However, the deal is also expected to bring on an additional $60+ billion in debt. We don’t like the idea of adding $23+ billion in Time Warner’s debt and $40 billion in loans for the cash consideration of the deal to a balance sheet with a net debt position of nearly $120 billion as of the end of the third quarter of 2016, but management expects its net debt-to-adjusted EBITDA ratio to be near 2.5x by the end of the first year after the deal closes and has suggested it could approach 1.8x by the end of year four after closing.
These are reasonable leverage ratios for such an elevated debt load, but they leave little margin for error in operational execution and integration. Moody’s (MCO) has since put AT&T’s debt ratings on review for a possible downgrade as a result of the increased leverage. According to the rating agency, the financing costs associated with the deal will consume the majority of the free cash flow stream acquired due to increased cash dividend obligations and material additional after-tax interest expense.
In addition to the growth that is expected to come with AT&T’s significantly enhanced video offerings, including the aforementioned bundling of mobile network and premium video content consumption, the Time Warner acquisition provides its business with diversification benefits. Time Warner will represent ~15% of total AT&T revenue, and Time Warner’s exposure to Latin America via HBO Latin America provides the company with additional exposure to the television markets in 24 countries. Time Warner’s business is also significantly less capital intensive and subject to fewer regulatory restrictions than AT&T’s, which should help improve the firm’s free cash flow margins and ultimately help it hit its deleveraging targets as well as improve dividend coverage.
The benefits of a combination of the transforming wireless network giant and a premium content generator are apparent when considering the fundamental shift in how consumers prefer to view video content, but AT&T’s decision to go after the mobile video space so aggressively also highlights an issue in the broader wireless telecom space itself. Intense competition has resulted in slowing growth for bellwethers in the industry, and as we noted previously, AT&T has struggled in recent quarters and rival Verizon (VZ) has experienced a similar fate. The telecom giant reported third quarter revenue fell nearly 7% as net postpaid subscriber growth disappointed and postpaid subscriber churn rose above 1% for the first time in six quarters.
Price-slashing competition from T-Mobile has been a key factor in AT&T’s and Verizon’s subscriber addition woes in recent quarters, and the firm reported 2 million total net additions including 851k postpaid phone net subscriber additions in the third quarter of 2016—Verizon added just 446k— which marks the 14th consecutive quarter in which it has added more than 1 million total customers and the 11th consecutive quarter in which it was the industry leader in postpaid phone subscriber additions. The lack of differentiation between the networks of industry leaders like Verizon and growing competitors like T-Mobile has been a core driver in the shift of growth in the industry. As of the third quarter of 2016, T-Mobile claims to have a 4G LTE network offers 99.7% of the coverage of Verizon’s competing network.
Such a dynamic is what has forced AT&T to become an aggressive player in the ‘bundling’ industry, which is likely to become a growing trend as companies continue to work to solve the new age consumer. Streaming services Netflix (NFLX) and Amazon (AMZN) are becoming increasingly vertically-integrated in creating their own content, and AT&T is searching for a similar dynamic with a mobile distribution focus. Apple (AAPL) has also been reported to be looking for its own original content creation, and while the future of Apple TV remains up for speculation, an integrated traditional-TV and mobile-based service from the company that has found its way into the everyday lives of consumers perhaps better than any other is somewhat easy to envision.
The AT&T-Time Warner deal also puts an increasing amount of pressure on Verizon to find its next step in differentiation. AT&T has beaten it to the punch in the mobile video content arena, and though Verizon remains the leader in the wireless telecom market, it cannot sit by idly as others slash prices and transform their business models. Cost cutting will inevitably be a focus as the industry continues to mature, and many expect Verizon to pull harder on the pricing lever to maintain market share.
The most important differentiator that Verizon may have up its sleeve is the acceleration of its 5G network deployment, which is currently not expected to be a reality until at least 2020. As the firm works to make its 5G network an actuality, it will continue to face an increasingly challenging operating environment. Recent weakness in subscriber additions could be foreshadowing a weaker revenue outlook for 2017, and it could force Verizon to look for inorganic growth prior to the launching of its 5G network, should management determine it is unable to continue enough positive momentum and maintain market share leading up to the network launch.
While the AT&T-Time Warner deal has the potential to transform the media and wireless telecom industries, it does little to impact our newsletter portfolios. At Valuentum, we tend to be debt-averse, and though we recognize the capital-intensive nature of the telecom industry, the mountain of debt needed to build and maintain proper infrastructure, the regulatory nature of the industry, as well as the free cash flow generating abilities of telecom giants like AT&T and Verizon, we aren’t interested in adding exposure to an industry currently characterized by slowing growth and transformational mergers.
Though AT&T recently upped its quarterly dividend, we continue to be of the opinion that its best dividend growth years are behind it. Shares currently yield over 5.2%, which is sure to attract plenty of income-minded investors, but we are wary of what a substantial increase in debt will do to an already debt-heavy balance sheet. At last check, AT&T’s Dividend Cushion ratio was below 0 as a direct result of such a lack of balance sheet health. We don’t find Verizon’s dividend any more attractive than AT&T’s, even as it, too, continues to hike its quarterly payout. Verizon’s shares yield ~4.8%, but the firm’s Dividend Cushion ratio is also below 0 due to it holding just over $100 billion in net debt on its balance sheet. We recognize AT&T’s strong free cash flow generation, and its net debt-to-adjusted EBITDA sat at 2.3x as of the end of the third quarter of 2016, but debt service costs, capital spending, and dividend obligations should not be underestimated by investors.
All things considered, the AT&T-Time Warner deal has captured our interest in the sense that it has the potential to further change the way we consume video content, but it has not captured our interest from an investment standpoint. Too much uncertainty on the regulatory front exists, as evidenced by the lack of favorable market reaction, and AT&T’s lack of positive momentum following its DirecTV acquisition does not bode well for the integration of another massive acquisition. We’re content with watching this story unfold from the sidelines. We’re huge fans of the current selections already in the Dividend Growth Newsletter portfolio.
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