First of all, it feels great to get back to writing. At this point we aren't sure if this article is a one-off or would be the start of a rejuvenated urge to write. Time will tell.
The same way, time will tell if AT&T's (NYSE:T) mega deal with Time Warner (NYSE:TWX) is good for both companies or only the latter. It's hard to blame AT&T investors for being somewhat skeptical. However, after following this story on Seeking Alpha over the last few days, there is way too much negativity (some of it misplaced) around this. We intend to clear up a few things in this article. Let's get started.
Wait, another "cable" company for AT&T?
Once and for all, AT&T is not buying a cable company in this deal. Time Warner cable no longer exists as a stand-alone company. While the deal still has to be approved by regulators, AT&T is not monopolizing the cable market.
The company being acquired in this deal is the marquee name that owns the likes of HBO, CNN, Warner Bros, and (unknown to many) 10% of the on-demand service provider Hulu.
But why is AT&T interested in this?
As hinted in the point above, AT&T is now going after more original content. AT&T, the parent company, still has its network, wireless, and mobile platforms to provide the bandwidth needed for content delivery and consumption. DIRECTV is the service provider and broadcaster. As things stands now, AT&T has no control over the content that is delivered through its own provider and on its own network/bandwidth. That is about to change with Time Warner coming into the picture.
Here is a simpler example. Let's say your local grocery store buys produce (content) from 5 suppliers, puts them all in one basket (network), and delivers them to you (broadcast). At this point, the store owns the basket and the delivery vehicle but has little control over the actual produce you consume other than shopping around for the best deal. Eventually, the grocery store decides to grow its own produce or acquire a local farm (Time Warner). Now, the bigger and stronger grocery store (AT&T) has more (if not full) control over its entire cycle. Is this a good proposition? On paper, yes. It comes down to how well the grocery store executes the plan.
I bought AT&T for income, is it safe?
The proof is in the pudding. AT&T has already sent a message to the market by announcing a 2.1% dividend increase. It's not earth shattering but it's what most long term investors expected given the recent history and the DIRECTV merger. The newly minted annual dividend of $1.96/share gives investors a yield of 5.20%. If the market takes down AT&T further as a result of the Time Warner deal, the yield will get more tempting for income investors and funds.
We've written many times in the past that capital heavy companies like AT&T tend to have fluctuating earnings per share each quarter. Free cash flow gives a better picture when it comes to dividend coverage, sustainability, and growth. Below are some numbers to consider (Source: YCharts.Com):
- AT&T's outstanding shares since the DIRECTV merger has been steady at around 6.1 Billion (4 quarters in total)
- Based on the new dividend per share of 49 cents, AT&T needs about $3 Billion in free cash flow to cover its dividends.
- The average quarterly free cash flow over this period was $4.2 Billion. So, dividends consumed about 70% of the free cash flow. While some might say that's still a high number, it is much better than the picture conveyed by earnings per share.
Let's see how Time Warner is doing in this regard:
- Shares outstanding: 777 Million
- Quarterly dividend per share: 40 cents
- Free cash flow needed to cover dividends: $312 Million
- Average Free cash flow recorded over the past 4 quarters: $900 Million, which is three times the dividend requirement.
Putting those two sections together, the combined "AT&Time" should have sufficient room for covering dividends and also continue dishing out yearly increases. Obviously, there are other negative things to consider like AT&T's debt and other capital expenses. However, we are also discounting potential cost and revenue synergies. Synergy doesn't only mean cost-cutting opportunities but also the chance to up/cross sell the services.
Make no mistake about it, we are indeed witnessing the demise of the old AT&T. The good news is that it's not the competitors that are causing it nor is AT&T committing suicide. What we are witnessing is a company that is at least reacting quick to the changing world, if not being entirely proactive. AT&T is entering a territory with higher risks but it's also one with higher rewards. Content is king but execution of the merger is the key.
We are staying long and adding more on pullbacks. This is a long-term story as AT&T is slowly building its own ecosystem.
Disclosure: I am/we are long T.
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.