AT&T & Time Warner: Win-Win Or Lose-Lose?

Includes: T, TWX
by: Tarek El Sherbini

Was the AT&T/Time Warner merger necessary?

Who is benefiting more? AT&T or Time Warner?

Will AT&T's ballooning debt be manageable or will it bring down the company?

Is it all about the dividend?

AT&T has finally crossed the finishing line and acquired Time Warner, following a two-year protracted battle. As the final legal hurdle to the merger between AT&T (NYSE:T) and Time Warner has been cleared on 13 June, different stakeholders had starkly different reactions. While the management of AT&T and of Time Warner were exhilarated, investors of AT&T dumbed the stock, pushing it down more than 6% - one of it's deepest one-day drops since the financials crisis. Shareholders of Time Warner were not too thrilled neither; the share price increased by only 1.8% to $98, still well below the $107.5 initial bid price from AT&T.

And who can blame the shareholders on both sides? For the shareholders of Time Warner; every drop in AT&T’s share price has been a drop in their own payout. For the shareholders of AT&T; they will be diluted by new shares issued to Time Warner’s shareholders, and the combined entity will be carrying around $ 180 billion of financial debt at the conclusion of the deal, compared to $ 115 billion of net debt on AT&T’s balance sheet on 31 March 2018. Moody's almost immediately cut AT&T's credit rating to BBB - two notches above junk - and warned that AT&T will likely need to cut its dividend, slowdown its capex and sell assets, in order to avoid further rating downgrades, and possible financial distress.

Was this merger worth all the pain? Was it necessary for both AT&T and Time Warner? AT&T’s revenues, and share price, have been in a standstill for several years. AT&T needed to differentiate itself in the highly competitive and commoditised telecoms sector. In the past 5 years, with the help of acquisitions, AT&T’s wireless subscribers increased by 43% to reach 157 million subscribers in 2017. Over the same period, video subscribers increased 7 fold to reach 39 million subscribers. Revenues increased by 25%. All impressive. But in an intensely competitive market, operating income was volatile, and was 30% lower in 2017 than in 2013. Operating cash flow was just as volatile, reaching $ 39 billion in 2017, the same as in 2013 but 6% lower as a percentage of sales.

For Time Warner, the picture has been slightly better, but still pressure has been there. Revenues grew 20% between 2013 and 2017, with operating income to sales increasing from 23% in 2013 to 27% in 2017, and operating cash flow growing by 52% over the same period. However, Time Warner's ability cash generation ability is weaker than that of AT&T; despite impressive growth, operating cash flow was 16% of sales in 2017 for Time Warner compared to 24% for AT&T. And Time Warner's leverage and credit ratings are one notch weaker than AT&T; net debt to operating cash flow of Time Warner was more than 4x in 2017 compared to just below 3x for AT&T.

The hope is that the combination of both titans would help them improve financial metrics, and would make the merged entity more competitive than separated entities. While AT&T can benefit from Time Warner's ability to maintain and increase their profit margins, Time Warner can benefit from AT&T's better cash generation capacity. AT&T expects $ 1 billion in annual run rate cost synergies within 3 years of the deal closing. In addition, over time, AT&T expects to achieve incremental revenue opportunities though bundling services.

AT&T’s CEO has been clear that one of the main purposes of the merger (if not THE main purpose) is improving the dividend cover, in addition to diversifying business risks by going downstream in the value chain. It is about creating a floor underneath AT&T rather than pushing it to the sky. AT&T's impressively high dividend yield, one of the highest among blue chip companies in Western countries, is the key incentive for shareholders to hold the stock. And even if AT&T needs to cut its dividend in the future to protect it's investment grade - an unlikely scenario given the management's confidence dividend cover will strengthen - the dividend yield is likely to still be high enough to attract investors.

This merger highlights one of the most definitive trends of the modern media business: the push from tech and telecommunications giants to integrate downstream within the value chain, and to control the more profitable, popular content they once passively supplied. While it was a bold gamble for both AT&T and Time Warner, doing nothing could have been an even bigger gamble in the fast-changing and ever more competitive media and telecommunications sectors.

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.