AT&T: Don't Sell Before The Warner Bros. Discovery Spin-Off

Mar. 21, 2022 11:18 AM ETAT&T Inc. (T), T.PA, T.PC, TBB, TBCWBD, VZ194 Comments64 Likes

Summary

  • AT&T's Analyst and Investor Day Presentation last week stoked mixed investor sentiment for the stock.
  • On one hand, dividend- and income-focused investors were taken back by AT&T's decision to slash dividends on the lower range of its original post-close dividend pay-out guidance.
  • On the other hand, the company has provided assurance for a return to GDP+ growth in coming years as it regains focus in capitalizing on 5G and fiber momentum ahead.
  • While dividend-focused investors who have put their money into AT&T for generous yields in the first place may not be interested in the upcoming Warner Bros. Discovery spin-off, we believe there are attractive upsides in the newly combined company that could potentially more than offset AT&T's dialed-back dividends.
  • Meanwhile, AT&T's dividend yield, despite the trim down, still beats those of its industry peers and other dividend-paying stocks on the market. Paired with its sustainable growth outlook ahead, the stock remains a candidate for improving annual dividends and share performance over the longer-term.
AT&T To Merge Warner Media With Discovery

Justin Sullivan/Getty Images News

AT&T's stock (NYSE:T) has consolidated around the $23 to $25 level in recent months following management’s confirmed choice of a spin-off for the fast-approaching Warner and Discovery (NYSE:DISCA / DISCK / DISCB) merger. While its value has declined a bit (about 15%) since the early January rally, AT&T's stock has remained relatively resilient against the recent surge in volatility across the broader market.

The completion of the upcoming Warner Brothers Discovery (“WBD”) spin-off will officially mark the end of AT&T’s foray in media and entertainment. Based on the company’s latest Analyst and Investor Day Presentation, AT&T will divert its focus on expanding its 5G and fiber connectivity capabilities and market share, while maintaining its deleveraging strategy to restore flexibility needed to support additional growth going forward.

In our latest series of analyses on the stock, we see multiple advantages from the upcoming WBD transaction. As part of the transaction, AT&T will receive $43 billion in cash for contribution towards its deleveraging efforts. Additionally, AT&T shareholders will get to partake in high-growth opportunities stemming from WBD through a 71% ownership in the new combined company. Meanwhile, AT&T’s “RemainCo” post spin-off will restore focus on its communications and connectivity roots once again, which comes at an opportune time as the industry continues to accelerate transition towards 5G and fiber opportunities ahead of growing digitization trends.

In today’s analysis, we will focus on the granularity of how the upcoming spin-off will take place and what it means for investors of AT&T RemainCo and WBD. Essentially, the breakup of AT&T and its WarnerMedia unit will put an end to years of stifled growth for both. On one hand, WarnerMedia will move on with Discovery to create the industry’s largest and most attractive content library, which is slated to command a meaningful share of the fast-growth video streaming market. Meanwhile, on the other hand, AT&T will be able to return to what it does best ahead of a transformational era for telecommunications and broadband connectivity buoyed by digitization demands as mentioned above.

While some are concerned about AT&T’s slashed dividends following the WBD spin-off, we see it as a fair, temporary price to pay for greater upside ahead. The company remains an attractive investment under the current macroeconomic backdrop as growing price pressures and rising interest rates encourage investors on a flight to quality stocks like AT&T, which engages in a predictable business with robust cash flows and attractive dividend yield. Meanwhile, the upcoming transaction is poised to place AT&T on a track towards renewed growth in coming years.

We believe both AT&T’s communications and connectivity business, as well as WarnerMedia business remain undervalued given their respective growth outlooks on a standalone basis, which should emerge following the spin-off that is expected to complete in April. With improved upside potential ahead for AT&T as it moves on with its communications-focused business, and expectations for an upward valuation re-rate for WBD following completion of the spin-off, AT&T's stock remains one of the most attractive investment opportunities of the year.

What You Need to Know About the Warner Brothers Discovery (“WBD”) Spin-Off

After having jumped past multiple regulatory hurdles since announcing the proposed spin-off in May 2021, both AT&T and Discovery shareholders gave their blessings for the transaction last week, sealing the deal for completion coming in April. Upon completion of the transaction, 100% of AT&T’s current WarnerMedia unit will be spun-out for consolidation with Discovery to create a “standalone, global entertainment company”, and become a “key media-industry player” with its unmatched content library.

With ownership of iconic franchises ranging from DC Comics to household favourites like the Food Network, the combined company enables a compelling offering that is poised to take existing business growth to a new level. In addition to strengthening existing distribution and advertising revenues from both WarnerMedia and Discovery’s legacy businesses, the most enticing offering enabled by the merger will be WBD’s joint advantage in penetrating opportunities arising from the fast-growing direct-to-consumer (“D2C”) video streaming market. Both WarnerMedia and Discovery have rolled out their respective D2C streaming services over the past year with impressive results. WarnerMedia’s HBO and HBO Max have together acquired close to 74 million global subscribers, while Discovery’s discover+ has acquired more than 22 million global subscribers.

As on-demand video streaming platform offerings continue to surge toward all-time highs, the merger of WarnerMedia and Discovery is expected to provide some insulation against rising competition and further WBD’s reach into subscribers’ wallets. We believe both WarnerMedia and Discovery’s unparalleled content library will enable further price discrimination within the fast-growing, yet highly competitive, on-demand video streaming market. While both HBO Max and discovery+ currently generate dual revenue streams by offering "ad-lite" and "ad-free" options for their respective global subscribers, the combination of both companies is expected to enable additional tier options - such as films only, sports only, or a premium all-in package - that can cater to different user needs and budgets, and maximize its global share of on-demand video streaming subscription volumes. And over time, the potential amalgamation of the two platforms into a “single-app” service could even lead to additional operational efficiencies and related cost-savings, while maintaining the multi-tier offering strategy for subscribers to support maximized market share gains. With global demand for over-the-top media services like video and audio streaming expected to accelerate at a compounded annual growth rate (“CAGR”) of more than 18% over the next five years, WBD is looking at a total addressable market (“TAM”) of $190 billion for its D2C business alone by 2026, which makes strong tailwinds ahead of its upcoming combination.

The Anticipated Spin-Off Structure

Upon completion of the transaction, AT&T will receive $43 billion in a combination of "cash, debt securities and WarnerMedia's retention of certain debt" as part of the total consideration. 71% of Warner Bros. Discovery will be owned by AT&T's shareholders upon completion of the transaction, while 29% of the remaining ownership will be allocated to Discovery shareholders. Each AT&T share will be eligible for 0.24 of a WBD share following the spin-off.

Based on back of the napkin calculations, WBD is expected to be valued at about $55 billion with 2.4 billion shares outstanding (i.e. ~$23/share) right out of the gate:

  • AT&T shareholders will be allocated 1.7 billion shares of WBD: With 7.1 billion outstanding AT&T shares eligible for 0.24 of a WBD share each, AT&T shareholders will be allocated 1.7 billion shares of WBD. The 1.7 billion shares of WBD allocated to AT&T shareholders will represent 71% ownership of the spun-out entity based on the transaction structure discussed above.
  • Discovery shareholders will be allocated about 700 million shares of WBD: With 1.7 billion WBD shares attributable to AT&T shareholders representing 71% of the combined entity, Discovery’s remaining 29% ownership will be represented by about 700 million shares of WBD.
  • Therefore, WBD is expected to begin trading with 2.4 billion shares outstanding.
  • WBD’s estimated market value upon completion of the spin-off is approximately $55 billion: Recall that each AT&T share is eligible for 0.24 of a WBD share. AT&T shares are currently valued at about $24 each – multiply that by 0.24 and you get about $6 per AT&T share that is attributable to the value of WarnerMedia. Multiply the $6 per share attributable to WarnerMedia by 7.1 billion AT&T shares outstanding, you get about $42 billion in value attributable to WarnerMedia. Paired with Discovery’s current market value of about $13 billion, WBD is expected to IPO at about $55 billion, or about $23 per share based on 2.4 billion shares outstanding as calculated in earlier points.
Warner Brothers Discovery Valuation

Warner Brothers Discovery Valuation (Author)

Upside Potential to WBD

Management has guided 2023 revenues of $52 billion and EBITDA of $14 billion for WBD, which is consistent with our respective base case forecasts for WarnerMedia and Discovery on a standalone basis. Specifically, in our previous analysis on AT&T’s fundamental prospects following its release of fourth quarter results, WarnerMedia is expected to reach revenues of $45.7 billion by 2023. Meanwhile, our base case projection for Discovery forecasts revenues of $12.9 billion by 2023. This drives WBD’s combined 2023 revenues toward a potential of as much as $58.6 billion. However, the figure is expected to land in between management’s guided $52 billion and our base case projection of $58.6 billion, considering there may be some adjustments to existing pricing strategies, especially in the D2C business, following the merger, among other things. Our base case forecast also projects combined 2023 EBITDA of as much as $15.2 billion after taking into consideration the anticipated post-merger cost synergies, as well as joint top-line growth prospects as discussed in earlier sections.

Warner Brothers Discovery Projected Revenue and EBITDA

Warner Brothers Discovery Projected Revenue and EBITDA (Author)

As discussed in further detail in our recent coverage on the Discovery stock, the resulting WBD entity post spin-off has promising upside potential of exceeding $100 billion in value soon after completion of the transaction. This is based on the anticipated upward valuation adjustment for WBD post spin-off to reflect its industry leadership in media content creation, commercial distribution, and D2C streaming. Specifically, under a conservative base case scenario, which applies an industry average forward price-to-sales ratio of about 2.0x (compares to current 1.1x based on estimated $55 billion market value for WBD as discussed above and AT&T’s 1.0x) to management’s guided 2023 revenues of $52 billion, WBD has potential to reach a valuation of $102.5 billion or $42.46 per share based on an estimated 2.4 billion shares outstanding as derived in earlier sections.

Applying the 0.24 AT&T to WBD share ratio to the $42.46 price target for WBD, AT&T shareholders can expect upside potential of 77% from their WBD shares received upon completion of the spin-off:

Warner Brothers Discovery Upside Potential

Warner Brothers Discovery Upside Potential (Author)

Considering WBD’s industry-leading content library and accelerating market growth opportunities in coming years, the post spin-off stock could be looking at a higher premium to the industry average forward price-to-sales multiple of 2.0x applied in our base case analysis above, driving greater valuation prospects ahead.

What Happens to AT&T Post Spin-Off (“RemainCo”)?

The upcoming completion of the WBD spin-off will be the last formality until AT&T dedicates its full attention to renewed telecommunications and broadband connectivity growth opportunities ahead. As discussed in detail in our previous coverage on the stock, 5G and fiber will become the backbone of AT&T’s bullish thesis going forward. The COVID pandemic has accelerated global digitization significantly due to rapid adaptation to changing work and collaboration dynamics enforced by strict social distancing measures. Wireless mobility and fiber broadband services have essentially proven to be critical enablers of emerging digitization trends ahead during the trying pandemic times.

Key digitization trends like rapid transition to a cloud-first world, and the emergence of nascent technologies like the metaverse will only increase reliance on 5G and fiber broadband technology going forward. The faster connectivity speeds and competitive economics enabled by 5G and fiber broadband unleashes an upgrade cycle in coming years buoyed by the demands of digital transformation, driving favourable growth trends ahead for AT&T.

And the $43 billion cash consideration received as a part of the WBD spin-off transaction will only further AT&T’s efforts in capitalizing on 5G and fiber broadband growth opportunities ahead. In addition to making a material contribution to AT&T’s ongoing deleveraging efforts, which would strengthen its balance sheet, previous investments into its digital media and entertainment efforts can now be redeployed towards further expansion of its existing 5G and fiber connectivity efforts. As disclosed in AT&T’s latest Analyst & Investor Day Presentation, its fiber business aims to penetrate more than 30 million customer locations by mid-decade, with much of its growth efforts dedicated to consumer opportunities stemming from demands of emerging technologies like virtual reality, and increasingly remote and cloud-based collaboration trends in the post-pandemic era. And on the 5G front, AT&T is looking at covering 200 million mid-band spectrum PoPs by 2023, which would enable faster connectivity speeds across a wider field of coverage and drive greater customer adoption accordingly. Together, the company is looking at restoring consistent GDP+ growth levels in coming years, while continuing to generate robust cash flows. In addition to supporting business advancements, the stellar growth prospects would also contribute to greater shareholder value ahead, including potential annual increases to already-generous dividend yields.

AT&T’s Slashed Dividends Post-Close

As mentioned in earlier sections, AT&T’s decision to slash its dividends following the WBD spin-off has been a turn-off for some existing investors. The board has approved an “expected post-close annual dividend of $1.11 per share”, which approximates 40% of AT&T’s anticipated free cash flows. This settles at the lower range of management’s previously guided post-close dividend pay-out structure of about 40% to 43% on more than $20 billion in projected free cash flows. Based on the WBD spin-off transaction structure discussed in earlier sections, AT&T is expected to be valued at about $18 per share post-close (i.e. current AT&T share price of about $24, less approximately $6 attributable to WarnerMedia at an adjustment factor of one AT&T share to 0.24 WBD shares). Considering post-close annual dividends of $1.11 per share and a post-close share price of $18, this would represent a dividend yield of about 6.2% as projected in our previous analysis.

While AT&T’s dividend yield will be reduced following the WBD spin-off, it is expected to be higher still compared to industry peers’ like Verizon (NYSE:VZ). At a projected dividend yield of about 6.2% post-close, AT&T’s dividend pay-out will also remain on the higher range compared to dividend-paying stocks on the broader market. In addition, the company is also expected to emerge with a stronger balance sheet following the WBD spin-off. This will accordingly enable better capitalization on opportunities arising from accelerating 5G adoption and increasing fiber broadband demand in coming years. Looking ahead, the strategy is expected to restore growth in AT&T, which will accordingly translate into improving dividends as well as share performance over the longer-term.

Valuation Prospects for AT&T Post-Close

Drawing on our fundamental and valuation analysis in a previous coverage, which takes into consideration AT&T’s growth plans and priorities going forward, we believe the stock has potential to exceed $22 within 12-months’ time following the completion of the WBD spin-off in April. This would represent upside potential of 23% based on the projected post-close AT&T share price of $18. The completion of the WBD spin-off expected in April will mark an inflection point for the stock, as AT&T’s underlying business returns its focus on expanding market share within the increasingly competitive wireless communications sector.

AT&T Post-Close Valuation

AT&T Post-Close Valuation (Author)

AT&T Post-Close Price Target

AT&T Post-Close Price Target (Author)

Conclusion

The upcoming WBD spin-off should bring all-around gains for AT&T shareholders. While most AT&T shareholders are “dividend-focused retail investors and income-focused funds”, the attractive upside potential on WBD can make a promising fling with growth stocks, and possibly also compensate for the telecom giant’s slashed post-close dividends. And especially at current price levels, which would put AT&T at about $18 per share post-close, the stock is looking at gaining much more after it is freed from legacy digital media and entertainment baggage and takes on renewed growth opportunities in 5G and fiber connectivity for years to come.

Author's Note: Thank you for reading my analysis. Please note that I am in the process of planning a subscription service with Seeking Alpha's Marketplace. The service will allow you to follow my model portfolio, interact with me directly, and participate in chat rooms with other subscribers. I'll be launching in the near future with a legacy discount for early subscribers and I'll be sharing more details as we ramp up to launch in the coming months.

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Disclosure: I/we have a beneficial long position in the shares of DISCA either through stock ownership, options, or other derivatives. 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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