It’s official now. The U.S. Justice Department’s antitrust lawsuit to block AT&T’s (T) merger with Time Warner (TWX) was rejected by U.S. District Court Judge Leon on June 12 with no conditions attached. AT&T plans to close the $85 billion mega-merger on or before June 20, altering the company’s future trajectory, for better or worse.
Shares of AT&T sold off over 6% yesterday as investors digested the news. In many ways, there isn’t much new information to analyze today. After all, AT&T’s offer for Time Warner was accepted all the way back in October 2016, providing plenty of time for investors to assess the strategic ramifications of the merger, and the deal’s terms haven’t changed.
With that said, it’s worth taking another look at how the merger might affect AT&T’s dividend safety and long-term outlook now that we know it’s actually happening. With the jump in AT&T’s debt load, plus the fast-changing pay-TV market, acquiring Time Warner has a number of important implications to consider.
Since most investors are attracted to AT&T for its high yield and track record of distributing higher payouts for more than 30 consecutive years, let’s start with the dividend.
The biggest concern from a dividend safety perspective is AT&T’s ballooning debt load. AT&T is issuing $40 billion in long-term debt to finance part of the deal, and the company is also taking on Time Warner’s net debt of about $20 billion. In total, I estimate AT&T’s debt burden will jump to around $180 billion.
Fortunately, AT&T and Time Warner are both cash cows. Over the last 12 months, AT&T and Time Warner generated $18.3 billion and $4.2 billion in free cash flow, respectively. Before accounting for higher interest expenses and some integration spending, the combined company would have racked up $22.5 billion in free cash flow during this period.
However, the dividend is a significant consumer of that cash flow, reducing the company’s financial flexibility. As part of the deal’s terms, AT&T will issue 1.437 shares of stock to Time Warner investors for every share of the company they hold.
As a result, AT&T’s share count will increase from approximately 6.1 billion shares outstanding to 7.3 billion shares, with Time Warner investors owning around 15% of the company. Each of those freshly issued shares has a $2.00 annual dividend obligation attached to it, pushing AT&T’s annual dividend obligation up from $12.3 billion to $14.5 billion.
Using the combined company’s unadjusted free cash flow figure from over the past year, AT&T’s free cash flow payout ratio would stand at 64%. If you drop the firm’s free cash flow by $2 billion to account for higher interest expenses and some integration spending, AT&T’s free cash flow payout ratio rises to about 71%, not far from where it sits today as a standalone company.
That’s not unreasonable for most telecom companies, which generate stable, recession-resistant cash flow. However, in AT&T’s case, its hefty dividend doesn’t leave much cash flow left over to reduce its elevated debt load.
Specifically, if the combined company generates around $21 billion in free cash flow but pays out $14.5 billion in dividends, only $6.5 billion of cash flow is retained to begin restoring the balance sheet. That’s not much compared to AT&T’s $180 billion total debt pile, especially if interest rates rise.
Slap on a 5% interest rate to AT&T’s total estimated debt burden, and the company’s interest expense would run around $9 billion per year (compared to $7.9 billion spent on interest for the combined companies over the past year).
Should rates move higher, a 6% average debt cost would demand $10.8 billion in annual payments (an incremental $1.8 billion expense, pressuring AT&T’s free cash flow). Those are staggering amounts for any company.
Simply put, AT&T is walking a very fine line with its balance sheet. Should the company run into unexpected costs, fail to deliver on its expected synergies from the deal ($1.5 billion of annual cost synergies expected by the end of the third year after close), or encounter larger headwinds in its existing businesses (e.g. pay-TV), pressure on the dividend will rise.
After all, debt payments always take priority of dividends, and companies will often prioritize maintaining their credit rating over paying their dividend as well.
Over the next few years, AT&T has a relatively high dependence on credit markets. Moody’s estimates that the company’s average annual maturities will top $9 billion beginning in 2018, which exceeds the $6.5 billion or so of retained free cash flow the company will have available in the early years. In other words, AT&T faces a meaningful level of refinancing risk and needs credit market conditions to remain accommodative.
Per an Oppenheimer research report cited by the Wall Street Journal, growth in Time Warner’s media assets and AT&T’s cost-cutting initiatives could allow the company to repay as much as $10 billion per year in debt over the next four years, which would be a welcome development.
Regardless, AT&T’s leverage ratio (debt-to-EBTIDA) will now rise to a multiple around three from its previous level near two times. As CreditSights noted, that is higher than Verizon’s leverage ratio of 2.6, and Moody’s believes that AT&T’s “organic leverage reduction is limited to around 0.1x to 0.2x annually” given its limited excess cash after dividends and modest growth potential.
Higher leverage metrics typically result in a credit rating downgrade, especially with an increase this big. Fortunately, The Wall Street Journal reported that AT&T said all major ratings firms are only looking at single-notch downgrades (rather than two notches), which would keep the company’s rating well above junk status.
So, yes, AT&T’s debt burden and refinancing risk are very important issues to monitor over the next several years. However, for the time being, AT&T should have the free cash flow and the credit rating to continue paying its generous dividend while meeting its other financial obligations, especially as the world remains awash in relatively low interest rates. Management has also stated they plan to divest some assets over the next two years to raise cash that can be used to further assist with debt reduction.
Little to no dividend growth should be expected over this time, depending on how well the integration process goes, as well as developments in the company’s other markets. However, investors worried about the deal jeopardizing AT&T’s ability to pay safe, growing dividends may find some comfort in commentary management made during the past year:
“We continue to have strong cash flows, and we view that very positively, particularly as we have great coverage on our dividend. And as we go to that time of year, we want to make sure that we continue and we will be able to continue to provide our board the opportunity to continue raising our dividend if they so choose…”
All things considered, it’s possible (although far from probable, based on what we know today) that AT&T’s dividend could come under pressure within a few years if the merger goes awry, core markets encounter more meaningful headwinds (pay-TV declines accelerate, wireless services increasingly commoditized), cost-cutting fails to deliver expected savings, and credit market conditions head south.
As I wrote in my initial thesis, AT&T has become “more dependent on favorable credit market conditions and potentially has less wiggle room to invest as heavily in future initiatives (e.g. 5G infrastructure, spectrum) or acquisitions.
AT&T not only needs to deliver on its expected cost synergies, but it needs to hope that its big bets on bundling, pay-TV, and content are the right ones to keep it relevant in a fast-changing technology world.”
Given these increased risks, AT&T’s Dividend Safety Score drops (but still remains at a safe level) as a result of the merger’s approval. As AT&T makes progress deleveraging, the firm’s score should improve. For now, it’s a waiting game.
Perhaps the biggest development since the deal was first announced in late 2016 is the accelerated decline in traditional pay-TV subscribers, which has adversely affected AT&T’s DirecTV business.
According to data cited by Variety.com, U.S. cable, satellite, and telecom operators are estimated to have lost between 3.1 million and 3.5 million traditional TV subscribers in 2017 as more consumers migrate to lower-cost streaming services.
While that drop only represents a 3.7% decline in the total base of pay-TV subscribers, it was more than a 50% increase in subscriber losses compared to the 1.9 million people who cut the cord in 2016.
In other words, AT&T’s core businesses is under increasing pressure to adapt. Leveraging Time Warner’s media properties to increase the profitability, appeal, and growth trajectory of its own streaming services is all the more critical to the firm’s long-term outlook today.
Closing Thoughts on the AT&T and Time Warner Merger
There is plenty not to like about AT&T’s mega-merger, especially since most large acquisitions fail to create value for shareholders. The company’s ballooning debt load and higher refinancing risk, management’s inexperience managing media businesses, a potential clash between two very different corporate cultures, even less mobility to adapt to changing conditions across its various markets, and accelerating declines in pay-TV subscribers are all valid reasons to potentially steer clear of AT&T.
However, given the amount of pessimism weighing on AT&T’s stock and its still-safe dividend, I think the reward-to-risk ratio is looking favorable. If management’s efforts to develop AT&T into a content and distribution powerhouse, complete with profitable businesses in over-the-top streaming and advertising, are even somewhat of a success, the stock will deserve a much higher valuation.
Of course, the future often contains surprises even for steady-state companies, much less a business like AT&T that is making substantial capital allocation bets on the future of the evolving telecom and media industries. Therefore, my preference is to keep my investments in these situations fairly limited to reduce my risk in the event that the worst-case scenario plays out.
In our Conservative Retirees portfolio, AT&T represents just under 2% of our portfolio’s total value and 3.3% of its annual dividend income. We are hardly swinging for the fences here, and I will continue to monitor the safety of the firm’s dividend and long-term strategy as integration work with Time Warner finally begins.