Click to enlarge
On October 20th, Bloomberg reported on rumors that AT&T (NYSE:T) was looking to buy Time Warner (NYSE:TWX). The news sent Time Warner soaring, while AT&T shares reacted with far less enthusiasm.
T data by YCharts
Let's take a look at why AT&T might be interested in acquiring Time Warner, but most importantly why such a deal isn't likely to benefit investors in either company.
In theory the deal makes sense
AT&T has long been a high-yield dividend growth favorite thanks to the utility like rock steady cash flow provided by its telecom business. And with management's bold acquisition of DirecTV, as well as its push into the faster growing Mexican wireless market, the company has the potential to accelerate its dividend growth rate from the anemic 2% it's been delivering over the last few years.
By acquiring Time Warner AT&T would be doubling down on its plans to become a global media giant, thanks to Time Warner's rich content, and intellectual property.
For example, purchasing Time Warner would bring the following under AT&T's tent, and turn it into a potential rival for Disney (NYSE:DIS):
- HBO and Cinemax
- Turner broadcasting, including CNN, TBS, TNT, Cartoon Network, AdultSwim
- Broadcast channel the CW
- DC Comics
- Warner Studios and its growing DC cinematic universe, as well as the Harry Potter franchise
In a fast changing media landscape, where cord cutting is a major concern for cable providers such as AT&T, the ability to acquire content, (and thus boost pay TV margins by cutting content costs), is potentially very valuable.
Which is why Bloomberg is reporting that AT&T CEO Randall Stephenson "is looking to add more content and original programming." Specifically, over the next three to five years, the company is planning on acquiring media companies, with a targeted market cap range of $2 billion to $50 billion.
...but the math just doesn't work out favorably for shareholders
However, as much sense as it makes for AT&T to continue to diversify its cash flows, and build a vast, globe spanning media empire, we can't forget that its recent acquisition spree. This included $49 billion for DirectTV, and $18 billion in wireless spectrum, has left its balance sheet with far more debt than management is comfortable with.
|AT&T||$126.8 billion||$53.1 billion||$4.754 billion||2.39||11.17|
|Time Warner||$24.5 billion||$7.8 billion||$1.388 billion||3.14||5.61|
|AT&T + Time Warner||$151.3 billion||$60.9 billion||$6.142 billion||2.48||9.91|
AT&T currently has only $7.2 billion in cash and cash equivalents on its balance sheet. And given its high debt load it's highly likely that any acquisition of Time Warner would have to be an almost entirely stock based deal.
But even then, Time Warner's $24.5 billion in debt would be added to AT&T's, which would create one of the largest debt levels in corporate America.
Now, that isn't to say that it would necessarily be a dangerous level of debt. After all, the average telecom's leverage ratio (Debt/EBITDA) is 2.59, and even before any synergies the larger AT&T would have a lower ratio than that.
However, the fact that AT&T would be reversing its recent deleveraging efforts could result in another credit downgrade, potentially leaving the company open to higher refinancing costs as interest rates gradually rise.
That's especially true given that AT&T has $5.77 billion, $6.5 billion, and $7.4 billion in debt coming due in 2017, 2018, and 2019 respectively.
However, I will admit that the combined AT&T and Time Warner would make for an attractive group of assets, with some of the highest sales, earnings, and free cash flow, or FCF in the world.
|Company||Sales||Earnings||Free Cash Flow|
|AT&T||$162.3 billion||$14.2 billion||$16.7 billion|
|Time Warner||$27.9 billion||$4.1 billion||$3.6 billion|
|AT&T + Time Warner||$190.2 billion||$18.3 billion||$20.3 billion|
Of course the real issue with a potential buyout of Time Warner is whether or not the deal can be structured in such a way to benefit shareholders in both companies.
|Company||Shares Outstanding||EPS (Post 10% Synergy)||FCF/Share (Post 10% Synergy)|
|Time Warner||808 million||$5.02||$4.44|
|AT&T + Time Warner||8.552 billion||$2.35||$2.61|
So let's take Time Warner's current market cap of $70 billion, add a 25% premium, and then figure out what an all stock deal would mean in terms of EPS, and FCF/share accretion.
As you can see, the large amount of shareholder dilution needed to acquire Time Warner actually results in minimal EPS accretion, and a small decrease in AT&T's FCF/share.
The reason that matters is because FCF/share is what secures, and funds the dividend and its growth; the primary concern of AT&T investors.
In other words, without first deleveraging its balance sheet, which would allow AT&T to borrow heavily to buy Time Warner, the dilutive nature of such a deal means there really is not benefit to AT&T shareholders.
As for Time Warner investors, they might also end up feeling screwed.
|Company||Yield||TTM FCF Payout Ratio||Projected 10 Year Dividend Growth||Projected 10 Year Total Return|
Academic studies show that a good rule of thumb for long-term total returns is yield + dividend growth. And while long-term analyst growth forecasts always need to be taken with a grain of salt, as you can see Time Warner is a much faster growing company.
So in a mega-merger its shareholders would end up with a much higher-yield BUT lower total return potential.
BUT WAIT! Maybe AT&T buying Time Warner could boost its own dividend growth rate and make up for the slower payout growth rate. After all, AT&T is still working on cost cutting in order to achieve synergies from its DirecTV acquisition and management expects its free cash flow to hit $20 billion in 2020.
Source: AT&T investor presentation.
In other words, over the next four years AT&T thinks it can squeeze another $3.3 billion in costs out of its assets. And assuming a conservative 10% synergy cost savings from eliminating redundant positions, and inefficiencies at Time Warner, by the end of 2020 the new, larger, AT&T could be looking at free cash flow of $25.6 billion per year.
|Scenario||Projected 2020 FCF||Share Count||2020 FCF/Share||2020 Dividend||4 Year Dividend CAGR||4 Year Projected Total Return|
|No Merger||$20 billion||5.77 billion||$3.47||$2.43||6.1%||11.1%|
|Time Warner Merger||$25.6 billion||7.96 billion||$3.22||$2.25||4.0%||9.0%|
From 2007, right after AT&T restructured, to 2014, just before it acquired DirecTV, AT&T's net buyback rate was 2.36% CAGR.
Using this as a likely ongoing buyback rate, we can determine the likely number of shares outstanding at the end of 2020, and thus the ultimate FCF/share if AT&T does, and doesn't buy Time Warner.
Then using a 70% FCF payout ratio, which still leaves $7.7 billion a year in excess FCF to fund buybacks, pay down debt, or just build up a war chest of cash, we can predict a likely dividend in both scenarios.
As you can see, a Time Warner merger, because of the high shareholder dilution it would require, would in fact result in the far slower payout growth rate, and thus the worse long-term total return.
Bottom line: AT&T buying Time Warner would likely end up hurting investors in both companies
Don't get me wrong, as an AT&T shareholder I'm not entirely against the idea of adding Time Warner's strong brands, content, and cash flow to our own. At the right price, and after AT&T has de-levered its balance sheet enough to regain its previous credit rating, such a deal might make sense due to less shareholder dilution and greater FCF/share accretion.
BUT so soon after AT&T's most recent mega deals, the likely economics of this acquisition simply don't seem to make sense; for investors in either company.
For Time Warner shareholders they would end up owning a higher-yielding, but far slower growing company. Meanwhile AT&T dividend lovers would end up suffering from slower dividend growth for many more years due to the large dilution, and debt this deal would add to our balance sheet.
Disclosure: I am/we are long T, DIS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.