Last week was a big one for shareholders of AT&T (T). After what seemed like an eternity, the telecommunications behemoth finally got permission to close 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 each share of Time Warner they own. As for AT&T shareholders, they get full ownership of assets like HBO, Cartoon Network and Warner Bros. If my numbers are correct, then the final value of the deal is around $80b – equivalent to just over a hundred dollars per Time Warner share.
Despite the price tag, my opinion of this deal hasn’t really changed. It is good for AT&T’s underlying business because Time Warner is very good at generating surplus cash from its assets. Over the past five years, it has generated total revenue of circa $140b. That is from activity such as selling subscriptions to HBO; from its cut of movie ticket sales; and from advertising revenue generated by networks like CNN. Now let’s strip out all of the costs. That includes the money spent on producing content like Game Of Thrones and Justice League. Let’s also strip out the capital spending it needed to maintain its physical assets. After all of that, Time Warner took away $18b in surplus cash. Bear in mind that total invested capital averaged around $45b over that period.
This deal moves the needle in a fairly big way in terms of AT&T’s profit sources. For example, Time Warner generated free cash flow of $4.5b last year. At the same time, AT&T’s legacy business (i.e. the business excluding the new Time Warner contribution) generated something like $18.5b worth of free cash flow. If we add those numbers together, then it implies that around a fifth of the enlarged group’s free cash flow will be coming directly from Time Warner assets.
There is obviously a major caveat to this enlarged free cash flow: the debt load. As a result of spending north of $40b on the cash portion of the deal, not to mention the 2015 acquisition of DirecTV for $50b, AT&T’s balance sheet is loaded with debt. Indeed, the headline figure is an absolutely massive $180b. That is actually net of the company’s cash balance as well, so it really is a huge number.
Let’s say the enlarged company generates $23.5b worth of annual free cash flow. The increase in interest costs should clock in at around the $2.25b mark, though this is somewhat mitigated by the expected synergies from the combined entity. Let’s therefore take our total post-deal free cash flow baseline figure to around $22b. Now, that number is 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 6.15b shares, therefore pumps out $12.3b per year in dividend cash. Now we factor in the 1.185b new shares created as part of the deal. This takes the share count to around 7.34b, and therefore gives us a total cash outlay of $14.7b for the dividend.
So to sum up, we have $22b in annual free cash flow, dropping to around $7.3b 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 stock looks 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.
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