AT&T (T) recently agreed to acquire Time Warner (TWX), and this deal has a number of implications for dividend investors.
AT&T believes it is buying “the world’s best premium content” and now has the largest film and TV studio in the world. Assuming the deal isn’t blocked by regulators, Time Warner will represent roughly 15% of AT&T’s total revenues.
While the strategic implications of this deal are very important, many dividend investors are wondering what it means for the safety and growth potential of AT&T’s dividend.
Shares of AT&T have sold off more than 10% over the last month, signaling some skepticism over the acquisition, and currently sport a high yield of 5.3%.
AT&T sent a positive message this past weekend when it announced a 2.1% dividend raise, marking its 33rd consecutive year of dividend increases. AT&T is one of the S&P Dividend Aristocrats (see analysis on all of the Dividend Aristocrats here).
However, with the company’s debt load set to rise even further and many of its legacy markets appearing saturated, will AT&T’s dividend remain safe in the years to follow?
Let’s quickly review the transaction before diving deeper.
Review of Time Warner and Transaction Terms
Time Warner is an iconic leader in media and entertainment and owns a great deal of content. Some of its well-known brands are CNN, HBO, TBT, TBS, Cartoon Network, and Warner Bros. Entertainment movie studio. Time Warner’s most notable franchises include Harry Potter, Big Bang Theory, and Gotham. The company also has rights to the NBA, MLB, and March Madness and a stake in Hulu.
AT&T is purchasing Time Warner with a combination of cash and stock. Time Warner shareholders will receive $107.50 per share, spilt 50/50 between cash and AT&T stock. These shareholders will receive between 1.3 and 1.437 AT&T shares, depending on the price of AT&T’s stock at closing. Time Warner shareholders will own about 15% of AT&T.
Including Time Warner’s net debt, the total purchase price AT&T is paying amounts to about $108.7 billion. The cash portion of the deal will be financed with new debt and cash on AT&T’s balance sheet.
Insights from AT&T’s Acquisition of Time Warner
In my opinion, AT&T’s bid for Time Warner is yet another signal that traditional pay-TV providers are worried about future growth.
As I noted in my thesis on AT&T in June (see my AT&T research here), DirecTV’s total U.S. subscribers grew just 1% per year from 2010 through 2015. Year-to-date, however, DirecTV has lost over 100,000 subscribers.
The rise of online streaming services caused the top six U.S. pay TV providers in aggregate to see a decline in subscribers in 2015 as well.
Other pay TV providers such as Comcast (CMCSA) have seen a slight dip in total subscribers (down 1% from 2013) but have continued to hold their ground for the most part – at least for now. However, investors remain skeptical and have kept Comcast’s stock flat since mid-2015 despite steady results and growth (see my thesis on Comcast here).
AT&T’s bid to acquire Time Warner, a content company, is further recognition that evolving consumer preferences could pose a legitimate threat to core pay TV markets over the next decade (remember that AT&T has the world’s largest pay TV subscriber base).
In theory, as the number of consumption outlets (e.g. online streaming services) for content increases, the more valuable it becomes. AT&T is betting on the continued convergence of the media and communications industries.
Here’s what AT&T’s CEO Randall Stephenson said about the deal:
“Premium content always wins. It has been true on the big screen, the TV screen and now it’s proving true on the mobile screen. We’ll have the world’s best premium content with the networks to deliver it to every screen. A big customer pain point is paying for content once but not being able to access it on any device, anywhere. Our goal is to solve that. We intend to give customers unmatched choice, quality, value and experiences that will define the future of media and communications.
With great content, you can build truly differentiated video services, whether it’s traditional TV, OTT or mobile. Our TV, mobile and broadband distribution and direct customer relationships provide unique insights from which we can offer addressable advertising and better tailor content. It’s an integrated approach and we believe it’s the model that wins over time.”
Over 100 million customers subscribe to AT&T’s TV, mobile, and broadband services, which allows the company to offer bundled subscription packages that can hopefully be even further differentiated with the increased content flexibility provided by Time Warner.
AT&T expects $1 billion in annual cost synergies to be achieved within three years of the deal closing. Corporate and procurement expenses will be the main source of savings. Revenue synergies (e.g. bundled sales; new advertising options; launch of streaming services) are also anticipated but are not quantifiable at this time.
Essentially, AT&T hopes to become a stronger alternative to pure-play cable TV providers with Time Warner under its wings. In my opinion, AT&T primarily chased this deal because of the growth challenges it is facing in its legacy wireless and video businesses.
Regardless, this is a bold move that will impact AT&T’s long-term fate for better or worse. It could redefine the future playbook for traditional cable companies (i.e. vertically integrate with content creators for more control over content costs and distribution), or it could reveal the challenges of trying to do two very different things well at once (i.e. produce great content and maintain relevant distribution networks).
Comcast’s acquisition of NBCUniversal in 2011 remains controversial, and it will likely take a number of years to see if these content chess moves pay off in the fast-changing media world.
Let’s take a look at the potential impact of AT&T’s acquisition of Time Warner on the company’s dividend safety and growth.
How AT&T’s Time Warner Acquisition will Impact the Dividend
Using our Dividend Safety Scores, AT&T’s dividend ranked among the safest in the market prior to the Time Warner acquisition announcement.
AT&T’s non-discretionary services, excellent free cash flow generation, and reasonable free cash flow payout ratio (67% over the trailing 12 months) all supported the company’s ability to continue paying down its high debt load while continuing to make dividend payments.
Time Warner also scored well for Dividend Safety. The company’s free cash flow payout ratio (35%) is even lower than AT&T’s, and the business is also a free cash flow machine.
The biggest risk of combining the two companies, in my view, is AT&T’s increased debt burden. The company’s total debt could further balloon from $120 billion to $170 billion, and AT&T’s credit rating from S&P was the third-lowest investment grade prior to the deal.
Adding more debt raises AT&T’s annual interest expense, could result in a credit rating downgrade (raising its cost of capital), increases refinancing risk, and leaves less margin for error if industry conditions change faster than expected.
Here’s what Moody’s noted:
“The deal’s financing costs will consume the majority of acquired free cash flow due to an incremental $2.3 billion in annual dividends and $1.3 billion in additional after-tax annual interest expense.
Moody’s believes that given AT&T’s limited excess cash after dividends and modest EBITDA growth potential, that organic leverage reduction is limited to around 0.1x to 0.2x annually….
AT&T’s funded debt balance could exceed $170 billion following the transaction close and average annual maturities will be greater than $9 billion starting in 2018…This may cause AT&T’s cost of debt to rise, especially in times of market stress. Rising benchmark rates, combined with wider credit spreads would put pressure on AT&T’s free cash flow.”
High debt burdens are one of the main factors to be aware of when trying to find safe dividend stocks (here are five other tips). AT&T expects its net debt-to-EBITDA ratio to hit 2.5 times one year after the deal closes.
However, AT&T has been here before. As seen below, courtesy of Bloomberg, AT&T’s key debt ratio has been at 2.5 or higher in the past. Bloomberg also noted that there are 159 companies in the S&P 500 with a net debt-to-EBITDA ratio greater than 2.5 times.
While the company’s debt burden is elevated, it doesn’t appear to be dangerous – especially in today’s yield-starved credit markets, which are eager to put capital to work. There is little chance AT&T’s debt gets downgraded from investment grade to junk status.
Despite higher financing costs and issuing more shares, AT&T also expects the deal to be accretive in the first year after it closes on adjusted earnings per share (EPS) and free cash flow per share basis.
The addition of Time Warner would alter AT&T’s revenue mix as well (Time Warner would represent 15% of overall sales), hopefully improving AT&T’s growth profile and lowering its capital intensity at the margin.
Management also expects AT&T’s dividend coverage will improve. The 2.1% dividend increase over the weekend was an indicator that AT&T expects to generate plenty of free cash flow over the next couple of years to work down its debt and continue paying safe and (moderately) growing dividends. Dividend growth will likely remain between 1% and 3% per year.
All of this is fine and dandy over the near term. However, long-term investors must not forget that AT&T’s acquisitions of DirecTV and Time Warner give it meaningful exposure to two companies that are facing their own unique sets of disruptive challenges.
If industry conditions take an unexpected turn away from the direction AT&T has bet on in a big way or management becomes distracted (two very different cultures and businesses are combining), the company’s debt burden and refinancing risk could become a big deal within the next 5-10 years.
Major acquisitions come with great risk. AT&T has taken two large bites recently with its DirecTV and Time Warner acquisitions. Neither of these deals jeopardizes the near-term safety of AT&T’s dividend.
However, my preference is to watch major transformations from the sideline for a while. AT&T has a lot of new businesses to digest and optimize between DirecTV and Time Warner. The media industry could certainly evolve the way AT&T is expecting (and in part trying to force with its deals), but there are plenty of other risks involved as well. Certainly no one can forget AOL’s disastrous merger with Time Warner.
For now, I prefer to stick with other high dividend stocks in our Conservative Retirees dividend stock portfolio.