AT&T's Merger Creates A Buying Opportunity

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Ma Bell is what many people think of when they hear AT&T (NYSE: T). The old AT&T of years ago was a boring utility until it was broken up. Years later, AT&T is attempting to diversify itself into a growth and income story. With the announcement that AT&T will be allowed to acquire Time Warner (NYSE: TWX), the company’s growth profile should change for the better. As I’m writing this, AT&T’s stock sits nearly 18% below its 52-week high. Combine a discounted share price with a roughly 6% yield, and this “boring” company could be an exciting addition to any portfolio.

Favorable Figures

At first glance, the new AT&T doesn’t seem that impressive. If we combine AT&T and Time Warner’s most recent results, you get the following:

  • Total revenue $46 bil. – down 2.3%
  • Core Payout Ratio 61%
  • Operating margin 17.2%

These numbers don’t look to exciting. However, if we dig a little below the surface, the company’s potential becomes clearer. The combined company would have net income growth of just over 16% year-over-year. In addition, the combined company would have reported $5.9 billion in core free cash flow (net income + depreciation – capex.), which represents growth of just over 9%.

If the company’s income and cash flow are growing, what about AT&T’s balance sheet? Though the Time Warner deal is a large transaction, Verizon’s (NYSE: VZ) acquisition of the remainder of Vodafone’s stake in Verizon Wireless gives us a look at what AT&T might expect.

AT&T buys Time Warner

Verizon acquires Vodafone’s stake

Total Value = $85 bil.

Total Value = $130 bil.

Cash value = $42.5 bil.

Cash value = $58.9 bil.

Stock value = $38.2 bil.

Stock value = $60.2 bil.

(Source: AT&T details and Verizon’s details)

Verizon’s acquisition occurred roughly five years ago, and the company took on more debt than AT&T is for the Time Warner deal. If we look at a few key numbers comparing 2014 to 2017 at Verizon, there is a clear improvement in the company’s cash flow, debt profile, and interest expense.

Item

2014

2017

Core Free Cash Flow

$11.3 bil.

$30.3 bil.

Op. Margin

15.4%

21.8%

Interest as percentage of operating income

25%

17.3%

Long-Term Debt net of Cash

42.9%

43.4%

(Source Verizon Annual Reports: 2014 and 2017)

Now obviously Verizon’s acquisition of the remainder of an existing business isn’t the same as integrating AT&T and Time Warner. In addition, Verizon has made several other acquisitions and changes during this time frame. However, Time Warner’s business has a higher operating margin than legacy AT&T. In addition, Time Warner is expected to be free cash flow accretive.

After the acquisition, AT&T’s long-term debt profile totals roughly $180 billion versus roughly $134 billion previously. Though this sounds like a big difference, the combined company’s interest cost versus operating income shows a positive outcome for the new AT&T.

Item

Legacy AT&T

New AT&T

Quarterly interest cost

$1.8 bil.

$2.3 bil.

Operating income

$6.3 bil.

$8.1 bil.

Interest as percent of operating income

28.6%

28.4%

(all numbers per quarter)

It seems clear the new debt that AT&T is taking on won’t be a significant drain on the new company’s resources.

Red or Blue who are you going to choose?

For a long time, investors have lumped Verizon and AT&T into the same group. These two companies are solid dividend choices, but they don’t exactly set the world on fire with growth. The Time Warner merger has a chance to turn some heads toward AT&T.

If investors are concerned that AT&T’s value already reflects the potential of this merger, nothing could be further from the truth. In 2016, after the merger was announced, AT&T stock was at about $38.60. Today, those shares are nearly 16% lower. In the same time, AT&T’s dividend has increased from $1.92 to $2.00 annually.

It also seems the combined company isn’t getting much respect in the growth department. Most analysts expect AT&T to grow earnings next year by a measly 1.5%. Time Warner is expected to grow earnings by less than 1%. If we compare AT&T’s prospects to Verizon (NYSE: VZ) it seems analysts think these two companies move in lockstep. Verizon is expected to grow earnings next year by just over 2%.

It is worth noting AT&T has beaten earnings estimates by an average of 6% the last four quarters. Over the last year, Time Warner has done even better than its suitor, beating estimates by an average of 17%. Given the cost savings potential, vertical integration, and potential of the Warner Bros movie lineup, AT&T will likely keep beating estimates into the future.

Let’s all go to the movies!

The old tagline “let’s all go to the movies” is the perfect comment for why AT&T wanted to acquire Time Warner. Among the movie studios, only Disney seems to have a better lineup of movies coming out in the next few years.

Warner Bros. has at least three major releases left this year. Whether the company makes money from the recently released Oceans 8, Fantastic Beasts: The Crimes of Grindelwald, or Aquaman, Warner Bros. should positively contribute for the remainder of 2018. In 2019, the studio has and enviable list of titles including: The Lego Movie 2: The Second Part, Minecraft: The Movie, Wonder Woman 2, and more.

In 2018 and 2019, Warner Bros. should add to the new AT&T’s growth profile. Between sequels we never thought we would see (Gremlins 3 anyone?), and new franchises being launched like a Joker Origin movie or Deathstroke, AT&T has the right to expect big things from it’s studio.

The bottom line

In the end, AT&T shareholders should be excited for the future. Time Warner has the potential to upgrade AT&T’s growth profile and diversify its revenue streams.

The cost synergies and new content bundles available to the combined company could be impressive. AT&T has already announced a “skinny bundle” of television programming free to its mobile customers that will be Turner content. DirecTV could have special access to movie trailers from Warner Bros. AT&T could bundle mobile, DirecTV, and HBO without having to negotiate with an outside party. Uncertainty around the stock today represents a buying opportunity. Faster growth, improved cash flow, better margins, and a 6% yield are rarely available, smart investors should take advantage.

Disclosure: I am/we are long VZ.

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.