What If The Acquisition Of Time Warner Falls Through?
Summary
- The benefits of a combination with Time Warner have been discussed extensively.
- If the takeover gets blocked, that wouldn't be a big problem for AT&T.
- The company has several other ways to utilize its vast cash flows and trades at a very inexpensive valuation.
Article thesis
AT&T (NYSE:T) is a solid and reliable income investment trading at a discount. The pending acquisition of Time Warner (TWX) has made some investors anxious, but AT&T looks like a strong investment even if the acquisition doesn't get approved.
Strong cash flows would allow AT&T to return value to its owners in other ways, and deleveraging would be an option as well. As interest rates are rising steadily, that might not be the worst option for AT&T in the long run. Last but not least, AT&T is not dependent on Time Warner for growth going forward, as the company's international expansion and investments in the US are about to pay off.
The Possible Fallout If The Acquisition Gets Blocked
The proposition for AT&T buying Time Warner is pretty clear and has been stated oftentimes. Combining a telecommunications company with a content provider has the potential to generate an entertainment giant. Such a move is not necessary, though, as AT&T is not in a bad position without Time Warner's assets, either.
If the acquisition gets blocked by regulators, the near-term impact on Time Warner's shares would likely be bigger than that on AT&T's shares. Time Warner's shares have been trading at a higher price since the acquisition was announced, AT&T's shares did not rise in the same time frame:
The market doesn't believe that the acquisition is a reason to buy shares of AT&T, as the stock reacted negatively after the takeover was announced. Time Warner, on the other hand, is trading at a substantially higher price compared to the price shares traded at before the takeover was announced.
A blocked acquisition would also have another impact: If the deal gets blocked by authorities, AT&T has to make a compensatory payment of $500 million to Time Warner. This would be a negative, but not a very material one in the long run:
T Market Cap data by YCharts
$500 million are neither a meaningful amount of money relative to AT&T's market capitalization, nor relative to its cash position. Apart from this compensatory payment, AT&T's financials wouldn't be affected, though the company would continue to operate the way it does right now.
AT&T's Cash Flows Will Grow Substantially Starting This Year
Both AT&T's ability to finance the acquisition of Time Warner as well as the company's potential to return a lot of money to its owners rest on its immense cash generation ability.
Source: AT&T's earnings presentation
AT&T has guided for $21 billion in free cash flows during 2018, substantially more than during 2017 ($18 billion). That is a realistic guidance, though, as there will be a sizeable positive impact on AT&T's cash flows from tax legislation changes going forward.
Source: AT&T's 10-K filing
AT&T produced free cash flows of $18.6 billion last year. Tax changes had a big impact on last year's net earnings, but that was a non-cash item (deferred income tax benefits). Operating earnings have been about $21 billion, pre-tax earnings totaled $15 billion.
T Effective Tax Rate (Annual) data by YCharts
In the past, AT&T has paid an effective tax rate of 33%-34%, whereas going forward, that tax rate will go down to the low 20s. Based on $15 billion in pre-tax earnings, net earnings should be positively impacted by about $2 billion going forward. Since those higher net earnings are the starting point for the calculation of cash flows, it makes sense to assume that those cash flows will rise by about $2 billion as well.
From a starting point of $18.6 billion in free cash flows in 2017, $21 billion in 2018 are thus looking achievable, even without any underlying growth.
The Dividend Is Very Well Covered, And AT&T Has Significant Surplus Cash Flows
With those roughly $21 billion in free cash flows during the current year, AT&T will pay about $12.4 billion in dividends: Investors are getting paid $0.50 quarterly, and the share count is about 6.2 billion. After making its dividend payments, AT&T thus has about $8.6 billion of free cash flows left over that it can spend otherwise. Capital expenditures for upgrades to its infrastructure and other growth investments are already paid for. This is thus cash that can be spent in numerous other ways.
If the takeover of Time Warner gets approved, AT&T will utilize these cash flows to integrate Time Warner and to pay down debt. The takeover will, after all, cost about $85 billion that is partially paid for by taking on new debt. Over the coming years, AT&T would pay down some of that debt.
If the acquisition gets blocked, AT&T has a lot of excess cash (debt that the company has already taken on) as well as excess cash flows that it can use for other purposes. One possibility would be the reduction of the company's share count:
T Market Cap data by YCharts
With a market capitalization of $220 billion, AT&T is a very sizeable company, but still, the share count could be shrunken meaningfully with those $8.6 billion in after-dividend free cash flows. AT&T could repurchase about 4.0% of the company's total shares annually, which would lead to two remarkable outcomes:
- AT&T's earnings would be divided over a lower amount of shares every year. This would make EPS grow by 4 percent annually all by itself. Assuming unchanged multiples, this alone would lead to share price gains of 4 percent annually, not accounting for any organic earnings growth.
- AT&T's total dividend payout would shrink. The company has been raising its dividend by 2 percent a year in the last couple of years, but if the share count shrinks by 2 percent annually, the total payout declines by 2% each year. This means that all future dividend payments get safer and that after-dividend free cash flows will continue to rise. AT&T could use the surplus cash for either more share buybacks or to increase the dividend growth rate going forward.
Share repurchases have been utilized by other huge companies successfully, e.g. by Apple (AAPL) and Cisco (CSCO). AT&T could theoretically do the same if the acquisition of Time Warner gets blocked. Shareholders seeking share price gains as well as those looking for a safe and growing income stream would benefit from such a move.
In the case of the acquisition getting blocked, AT&T could also utilize its cash pile and its cash flows to reduce its debt levels. The company's leverage ratio is not immensely high, but on an absolute basis, AT&T is heavily indebted:
Source: AT&T's 10-K filing
AT&T has total debt of about $164 billion on its balance sheet. If the acquisition of Time Warner would get blocked, the company could use a big portion of its cash pile as well as its excess free cash flows to reduce that debt pile drastically over the coming years. Through 2022, AT&T could reduce its debt levels by close to $90 billion by combining the following:
- $45 billion of its cash pile
- $8.6 billion annually over the next five years through its after-dividend free cash flows
AT&T's debt levels would drop down to about $75 billion in that scenario, which is less than half the company's current debt. This would not only lead to a vastly stronger balance sheet, AT&T would also see a big positive impact on its earnings.
According to its most recent earnings presentation (page 10), AT&T is paying an average interest rate of 4.4%. Reducing debt levels by $90 billion would therefore lead to cost savings of $4.4 billion. When we account for taxes, the positive net income impact would still be about $3.5 billion annually, or $0.56 per share a year.
By focusing on bringing down its debt, AT&T could thus become a much stronger and, at the same time, a significantly more profitable company.
The Growth Outlook Is Positive Even Without Time Warner And The Valuation Is Very Low
Without Time Warner, AT&T would not diminish over the years. The company still would have a solid outlook. The company continues to hold a very strong position in the US market and keeps growing abroad. In Mexico, AT&T has added more than three million subs during 2017, and growth will likely remain strong: AT&T is about to complete its LTE network in the country, which makes it even more attractive as a carrier going forward.
Churn rates in AT&T's US business are at a record low, which means that apparently AT&T's offering is attractive relative to what peers are offering right now - otherwise AT&T's customers would not be sticking with the company. Very low churn rates also mean that AT&T doesn't have to invest a lot into acquiring new customers through promotions or other activities that can pressure margins.
AT&T's huge investments into infrastructure in the US are poised to pay off as well, AT&T now has more than seven million locations with fiber access. The company is, in its own words, trying to build the world's premier gigabit network. These costly investments will lead to a superior competitive position against its peers in the coming years, which should result in market share gains and higher margins.
All of these facts combined make me believe that even without Time Warner, the outlook for AT&T is not bad at all. Yet, surprisingly, the company trades at a very inexpensive valuation:
T PE Ratio (Forward) data by YCharts
Both AT&T's forward earnings multiple as well as the company's EV to EBITDA multiple (which accounts for the high debt levels) are quite low at 10.5 and 6.4, respectively. When we focus on cash flows, we see that AT&T trades at just 10.5 times this year's FCF, which means a free cash flow yield of 9.5%.
Bottom Line
AT&T has good reasons to acquire Time Warner; those have been discussed extensively. If the acquisition gets blocked, that isn't a big problem for AT&T, though:
There are other ways for the company to utilize its cash flows in ways that are very beneficial for its shareholders, e.g. through buybacks or debt reduction.
AT&T will not lose much if the acquisition gets blocked, and since the company is trading at a very low valuation despite having a solid outlook, shares are looking attractive right here.
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This article was written by
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Disclosure:
I work together with Darren McCammon on his Marketplace Service Cash Flow Club.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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Comments (53)
shareholder will be very pleased. The company needs to stop looking towards the past and focusing on the future, which means focusing on what consumers and business really want.
Regardless of outcome, T will be ok. The management team may be feeling a little anxiety though...
Excellent article, JW.
Or, it’s up $10 from a different date.
Or, it’s down $10 from yet another date.
