AT&T completed its acquisition of Time Warner on June 14, 2018. Under the merger agreement, Time Warner shareholders received $53.75 per share in cash and 1.437 shares of AT&T stock for each TWX share held. In total, Time Warner shareholders received 1.126 billion shares, equivalent to a 15.5% stake in AT&T. Together with the cash, Time Warner shareholders received $79.1 billion in total consideration. In addition to the consideration paid to Time Warner shareholders, AT&T assumed $50.6 billion of liabilities, including $22.8 billion of debt, bringing the total cost of the acquisition to $129.7 billion. AT&T ended the second quarter (June 30) with total assets (post-merger) of $534.7 billion.
Although AT&T has made other large acquisitions over the past decade, the Time Warner acquisition can be characterized as transformative. It gives AT&T control over a large portion of quality content (e.g. HBO, CNN, TBS, TNT) offered to both its own video subscribers and other distribution networks (cable providers, over-the-top (OTT) networks and direct-to-consumer). In part, the acquisition represents the purchase by AT&T of one of its largest suppliers. (Revenues generated by Time Warner from delivering content to AT&T will be eliminated in consolidation. On a net basis, AT&T now gets to keep the profits that Time Warner earned on those revenues.) It also gives AT&T some control over the content delivered to its competitors.
The New S&P Communications Services Sector. The AT&T-Time Warner merger was undoubtedly one of the factors in the decision by S&P Dow Jones Indices to remake and replace the S&P 500 Telecommunication Services (SPTS) index. Originally conceived in 2001 at a time when many telecommunication start-ups were perceived to have excellent growth potential (before they went bankrupt), SPTS now includes only three stocks (T, VZ and CTL). On Sept. 21, the index was replaced by the S&P 500 Communications Services index, which now consists of 22 stocks, including several previously included in the Technology sector (e.g. Alphabet (GOOGL), Facebook (FB), Netflix (NFLX) and Twitter (TWTR)) and in the Consumer Discretionary sector (e.g. advertising firms like Interpublic Group (IPG) and Omnicom Group (OMC), media companies like CBS, Discovery (DISCA), Disney (DIS), News Corp (NWSA), Twenty-First Century Fox (FOXA) and Viacom (VIAB) and video game stocks like Activision Blizzard (ATVI), Electronic Arts (EA) and Take-Two Interactive (TTWO)). Communication Services will also include other Telecommunications sector stocks (e.g. Charter Communications (CHTR), Comcast (CMCSA), DISH Network (DISH)). The total market cap of the new sector is roughly $2.5 trillion, compared with SPTS’s $500 billion, and will account for roughly 10% of the S&P 500’s market capitalization, compared with just 2% for SPTS. Alphabet and Facebook will constitute 50% of the Communication Services sector’s market capitalization.
The Strategy Behind the Time-Warner Acquisition. In its October 2016 press release announcing the acquisition, AT&T boasted that the combined companies would “lead the next wave of innovation in [the] converging media and communications industry.” A major focus of the combined companies will be delivering premium content to any device, especially mobile. AT&T aims to create new services that will be both personal and social, more relevant and targeted advertising, ad-supported content distribution models and personalized OTT and TV Everywhere offerings.
The closing of the acquisition was delayed by a challenge from the U.S. Justice Department, which said that the merger was anti-competitive. In June, Judge Richard Leon ruled in favor of AT&T, allowing the merger to close, but the Justice Department has filed an appeal. It is arguing that the merger will hurt competition as AT&T raises the prices that rivals pay for content and ultimately lead to higher prices for consumers. On Thursday (9/20), AT&T responded to the Justice Dept.’s claims by asking the appeals court to let the merger stand.
While I have not examined the court arguments in detail, I believe that the main issue focuses on the development of OTT services and “skinny bundles” that allow customers to pay less to receive more of the programming that they want (and less of what they do not want). The large video distributors, including AT&T, Comcast, Verizon and others, face a potential threat from nascent OTT services that could lead to considerable erosion in their franchises. AT&T has argued that it plans to offer its own OTT services and skinny bundles and that it expects to face tough competition in these offerings from both established competitors and new entrants. (Consumers still have the option of purchasing a digital television antenna to get local television channels and more for free.)
In April, AT&T launched AT&T Watch, a skinny bundle that offers more than 30 channels of live TV (but no local broadcast channels) and 15,000 on-demand movies and television shows for $15 per month. AT&T Watch complements its DirecTV Now service, which does offer local broadcast channels in packages starting at $40 per month (for 65 channels) as well as U-Verse and AT&T Unlimited mobility service, which now offers unlimited talk, text and data as well as 30 channels of programming.
Although I believe that the Justice Dept. has raised a legitimate concern, there is no proof that AT&T will behave in an anticompetitive manner. Market forces should help to keep AT&T in check. AT&T also has the right to protect its franchise. In my mind, therefore, Judge Leon ruled appropriately. Assuming that the appeal fails, the Justice Dept. and the Federal Communications Commission would face the burden of monitoring AT&T’s performance to ensure that it does not engage in anticompetitive behavior, which admittedly is a more burdensome task. AT&T has agreed to keep its existing operations separate from Time Warner until early 2019 to give the appeals court time to rule on this matter.
At a recent Goldman Sachs conference followed by an interview with the WSJ, CEO Randall Stephenson highlighted some of the ways that AT&T is looking to capitalize on its investment in Time Warner. With the vast trove of data that AT&T generates on its customers’ video and mobile engagement, he sees advertising analytics as a key opportunity. Although mindful about treading too much on Time Warner’s creative processes, Mr. Stephenson also sees an opportunity to use data analytics to guide Time Warner’s programming spending. AT&T also wants to focus more of Time Warner’s content development spending on HBO to beef up the premium network’s competitive position and devote more of TNT’s and TBS’s airtime to showcase HBO programs in reruns.
Recent Share Price Performance and Valuation. So far, the acquisition of Time Warner has not had a noticeable positive impact on the stock of AT&T. Since the October 2016 announcement of the deal, AT&T’s stock has delivered a total return of -0.2%, far worse than the S&P 500’s 42.2% total return. During that time, a 9.9% decline in AT&T’s share price has been almost entirely offset by dividends received. At the current price of $33.78, the stock remains at the low end of its $30.13-$39.80 one-year range.
At the current share price, AT&T certainly qualifies as a value stock. It is currently trading at 6.3 times trailing 12 month GAAP earnings, 10.3 times trailing 12-month non-GAAP earnings and less than 10 times forward earnings (for 2018 and 2019). Excluding the cost of the acquisition of Time Warner, the stock is also trading at 13.6 times trailing 12-month free cash flow per share. Its free cash flow yield is therefore 7.4%. Its annual dividend of $2.00 equates to a dividend yield of 5.9%.
Given its relative underperformance over the past two years, AT&T’s stock has been a value trap; but will it continue to be so going forward?
Business and Financial Challenges. There are certainly legitimate concerns about AT&T’s ability to sustain its revenues and profitability. The wireless and broadband markets have matured, while the legacy wireline business has been in a steady decline for over a decade. Although there is still considerable innovation that is driving new usage – e.g. 5G in wireless and the internet of things – it remains to be seen whether and when these innovations will provide sufficient incremental revenues to justify their capital costs. (Even if these investments fail to meet IRR hurdle rates, they may be necessary to preserve market share.)
High capital spending and dividend payments have pressured AT&T to raise prices for its services to a level that has sparked an erosion and shift within its Consumer Mobility subscriber base, which so far has been offset by growth in newer customer segments. The company has seen a steady decline in U.S. postpaid wireless subscribers, where the cost of the service is $70 or more per month for unlimited voice and data. Some postpaid subscribers have shifted to prepaid, which costs more per minute or byte, but allows them to control cost by limiting usage. Other subscribers have switched wireless providers to get a lower monthly rate.
The decline in AT&T’s U.S. postpaid subscribers has also been more than offset by an increase in connected devices (tablets and physical devices connected to the internet (aka the Internet of Things or IoT). AT&T added more than 10 million connected devices to its network in the 2018 first half, compared with 7.4 million added for all of 2017. While that boosts its total subscriber count, average revenue per unit (ARPU) for connected devices is lower than postpaid wireless. Prepaid wireless also provides less revenue and profit per subscriber.
AT&T’s Entertainment segment, which provides video, voice and internet services to consumers, suffers from the same market pressures. The regular cost of triple play service (voice, video and internet) now runs upwards of $140 per month. Over-the-top video services, such as Netflix, Hulu and Sling TV, are lower cost alternatives and demand for the “skinny bundle,” a more limited but less costly video network package, is on the rise.
AT&T doubled down on the video business with its acquisition of satellite provider DirecTV in 2015. It has since rolled out DirecTV Now, a service that allows subscribers to stream cable TV programming for $40 per month with no annual commitment and no required equipment. DirecTV Now has attracted over 1.8 million subscribers since its launch in 2016, but some of those subscribers have switched from DirecTV’s satellite service offering and perhaps from AT&T’s U-Verse residential TV and internet service. Altogether, AT&T has increased its total video subscriber connections at a 1.3% annual rate since the end of 2015 to 39.2 million at the end of the 2018 second quarter. Meanwhile, total broadband connections have been flat at about 15.8 million for the past four years.
One potential offset to these challenges is AT&T’s growth opportunities in its Mexican wireless and Latin American satellite video operations. Revenue and EBITDA growth in its International segment was strong from 2015 to 2017, but has levelled off recently, hurt in part by currency losses.
High Dividend Yield and A Goal to Reduce Leverage. With the average dividend yield on S&P 500 stocks at around 2%, AT&T’s 5.9% yield stands out. Several sectors – including telecommunications services – have traditionally offered above average yields; but AT&T’s high yield suggests a higher risk of an eventual dividend cut. Dividend yields for the two telecom giants – AT&T and Verizon have fluctuated between 4% and 5% on average for many years (except during the financial crisis when they spiked higher). Over the past few years, however, AT&T’s dividend yield has pushed steadily toward 6% as its stock price has lagged and dividends have continued to rise.
The lagging share price and increase in dividend yield reflects some concern about the increase in AT&T’s leverage over the past five years. With the acquisition of DirectTV in 2015, Time Warner in 2018 and another $10 billion of purchases of spectrum and other (smaller) companies in and around those years, AT&T’s total debt increased $75 billion at the end of 2013 to $190 billion at the end of 18Q2. Its debt-to-capitalization ratio over that time rose from 45.5% to 51.1%, peaking at 56.8% at 17Q3 but then falling due to the gain associated with the Tax Cuts and Job Act in 17Q4 and the issuance of stock to Time Warner shareholders in 18Q2. The most recent increase in debt (assumed in the Time Warner acquisition) prompted one-notch credit rating downgrades by Moody’s (from Ba1 to Ba2) and by Standard & Poor’s from (BBB+ to BBB) in early August.
Net debt-to-EBITDA, meanwhile, which is a key management focus, increased from 1.5 times in 2013 to 3.8 times in 18Q2. On a pro forma basis, which incorporates Time Warner’s earnings for the entire 2018 first half, I estimate that AT&T’s pro forma net debt-to-EBITDA ratio at June 30 would have been 3.0 times. Management says that it expects AT&T’s net debt-to-EBITDA to drop further to 2.5 times at the end of 2019 and then to historical levels – around 2.0 times – by the end of 2022.
From 2015 to 2017, AT&T generated on average $5.5 billion annually in cash from operating activities after capital expenditures and dividends. Management’s targeted 2022 net debt-to-EBITDA ratio probably anticipates some improvement in annual operating cash flow, which would allow the company to make some acquisitions or step up its capital spending and still meet its net debt-to-EBITDA target. In my opinion, AT&T should forego increasing its dividend until it achieves its net debt-to-EBITDA target.
If I assume, for example, 2% annual growth in EBITDA off of a 2018 base of $60 billion, modest growth in capital expenditures, an average interest rate on debt of 5.0% and a tax rate in the low 20s, my back-of-the envelope projections suggest that debt would decline by about $42 billion between now and 2022 to about $130 billion, which would reduce the company’s net debt-to-EBITDA to 2.0 times.
Network Upgrades. AT&T continues to upgrade its wireless network. Next generation 5G technology offers faster download speeds and lower latency that over time will facilitate the deployment of mission critical applications, such remote healthcare services, autonomous vehicles and other internet-connected devices (IoT). In time, 5G will also compete directly with fiber and cable. However, its adoption will require additional capital spending, especially to deploy the many thousands of small cell radio access nodes that will deliver the service.
While providers will charge a premium for 5G service, the bulk of their sign-ups will likely come from existing wireless customers, especially early on. It is not clear whether and when the incremental revenue and profits earned from 5G will be sufficient to generate an acceptable return on investment. Yet, there are first-mover advantages and the risk of market share loss for carriers who forego or are slow to implement 5G technology.
2018 Second Quarter Results and Outlook. AT&T reported 2018 second quarter GAAP earnings of $0.81 per share, up from $0.63 in the prior year period. Non-GAAP EPS, which excludes amortization of intangibles, merger costs and actuarial adjustments, was $0.91, compared with $0.79 in the prior year.
Several non-operating factors contributed to the increase in earnings. First, the adoption of the new revenue recognition accounting standard (ASC 606) increased second quarter earnings by $419 million or $0.06 per share. Second, I estimate that Time Warner, which was included in AT&T’s results for only 16 days, added about $0.05 per share in earnings (or $0.04 after estimated incremental interest expense). So net of ASC 606 and Time Warner, AT&T’s GAAP earnings increased an estimated $0.07 per share to $0.70; while non-GAAP earnings were essentially flat. Non-GAAP earnings benefited from a large actuarial gain on pension and post-retirement benefits, which more than offset intangible asset amortization and merger costs. AT&T also benefited from a decline in its effective tax rate from 33.9% to 22.6%.
In its 2018 second quarter earnings report, AT&T raised its 2018 adjusted EPS guidance to the high end of its $3.50 range. That compares with non-GAAP adjusted EPS of $3.05 in 2017. The guidance reflects the acquisition of Time Warner (backing out of additional intangibles amortization and other costs associated with the merger on a non-GAAP basis). It also reflects the positive impact of tax reform and ASC 606 (the new revenue recognition standard).
Putting It All Together. The maturation of the mobility and video markets combined with pressure from consumers to lower rates has brought AT&T’s revenue growth to a standstill in recent years and put downward pressure on its profitability. The acquisition of Time Warner provides AT&T with a better opportunity to shape the emerging structure of the media and communications industry at the lower price points for skinnier bundles, especially on mobile devices. It also enhances its opportunity to monetize its data through enhanced advertising analytics. While that should reduce downside risk, AT&T must show that it can stem the exodus of its lucrative postpaid mobility and video subscribers or at least generate sufficient revenues and profits from its newer lower-priced offerings, ancillary services and growth segments, such as its International segment and advertising analytics, to sustain its revenues and earnings.
As long as the economy remains a tailwind and assuming that the company prevails in the Justice Dept’s efforts to reverse the Time Warner acquisition, I believe that AT&T should be able to find a formula that will allow it to sustain or possibly grow earnings and reduce debt over time. If so, the stock market will eventually bid up the shares (or at least stop bidding them down). In that case, the stock would deliver solid returns, equal at least to its high dividend yield.
With successful execution of its strategy that achieves stability in revenues and earnings, I believe that a reasonable target share price for AT&T’s stock is $42, up 24% from the current quote. That would bring its forward multiple in line with Verizon.
A rebound in its forward multiple back to the peer group average of 14 would raise the share price further to $49. (In this case, I define the peer group as T, BCE, CTL, JCOM and VZ). This higher target price would be achievable if the company demonstrates that it is able to grow revenues and earnings, excluding acquisitions, on a sustainable basis.
September 23, 2018
Stephen P. Percoco
Lark Research
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