Last week was a big one for shareholders of AT&T (NYSE: T). After what seemed like an eternity, the telecommunications behemoth finally got permission to close on its purchase of media giant Time Warner. Shareholders of the latter will receive $53.75 in cash plus 1.437 shares of AT&T for every Time Warner share they own. As for AT&T shareholders, they get full ownership of great assets like HBO, Cartoon Network and Warner Bros. If my numbers are correct then the final value of the deal is around $80 billion, or just over $100 per share of Time Warner.
Despite the price tag, my opinion of this deal hasn’t really changed: it is good for AT&T’s underlying business. As I’ve commented before, one of the major downsides to owning AT&T is that its core business is very capital intensive because there is a massive network of physical infrastructure that needs to maintained. We’re talking necessary capital expenditures of around $110 billion over the past five years just to maintain its assets in good order.
The deal to buy Time Warner helps enormously in that respect. The business is very good at generating surplus cash from its assets. Over the past five years it has brought in total revenue of around $140 billion. That is from activity such as selling subscriptions to HBO; from its cut of movie ticket sales; and from advertising revenue generated by networks such as CNN. Now let’s strip out all of the costs. That includes all the money spent on producing content like Game Of Thrones and films like Justice League. Let’s also strip out the capital spending it needed to maintain its assets. After all of that, Time Warner took away $18 billion in surplus cash. Bear in mind that total invested capital averaged around $45 billion over that period.
The good thing is that this moves the needle in a big way in terms of AT&T’s profit sources. Last year, for example, Time Warner generated free cash flow of $4.5 billion. At the same time, AT&T’s legacy business (i.e. the business excluding the new Time Warner contribution) made something like $18.5 billion in total free cash flow. If we add those numbers together, then it implies that around 20% of the enlarged group’s free cash flow will be coming directly from the Time Warner assets. In fact, given analyst estimates for Time Warner’s 2018 earnings, I would say that is an understatement.
AT&T: Debt & Dividends
There is one big caveat to the post-deal AT&T: the debt load. As a result of spending north of $40 billion on the cash portion of the deal, plus the 2015 acquisition of DirecTV for $50 billion, AT&T’s balance sheet is loaded with debt. Indeed the headline figure is an absolutely massive $180 billion. That is actually net of AT&T’s cash balance as well, so it really is a huge number.
Of course the flip side to the new debt load is the enlarged free cash flow. Legacy AT&T already generates around $18.5 billion per annum. Time Warner probably adds another $5 billion right off the bat. Increased interest costs should cost around $2-$2.5 billion, though this is mitigated by the expected synergies from the combined entity. Let’s therefore take our total post-deal free cash flow baseline figure to be around $22 billion.
Now, that number is of course before any shareholder dividends are taken into consideration. As it stands AT&T currently spends around $2 per share on its annual distribution. Legacy AT&T, with its 6.15 billion shares, therefore pumps out $12.3 billion per year in dividend cash. Now we factor in the 1.185 billion new shares created as part of the deal. This takes the share count to 7.34 billion, which therefore gives us a total cash outlay of $14.7 for the annual dividend.
So we have $22 billion in annual free cash flow, dropping to around $7.3 billion post-dividend. I think that sounds fairly reasonable, so income investors need not be overly concerned. In any case, with the shares throwing off a 10% earnings yield I’d say the shares look attractive enough anyway. You get 6% by way of cash dividends, and 4% that will (or rather should) go towards debt reduction. Add on some very modest long-term growth, let’s say in the 3% per annum range, and you have the makings of a good conservative investment. Doubly so given that the Time Warner deal improves the quality of the underlying earnings. I’m buying.