by David Dixon and Mike He of FBR & Co.

Summary:

On October 22, 2016 AT&T (T) entered into an agreement to acquire Time Warner (TWX) for cash and stock valued at $107.50/share. AT&T trades at 6.5x EBITDA and despite expecting $1B in cost and revenue synergies over three years is paying an unprecedented high 13.5x EBITDA multiple to enter the programmed content business.

However, we believe this is a necessary defensive decision driven by:

(1) greater regulatory pricing pressure that restricts management’s ability to raise wholesale interconnection and business data service prices in the wireline segment,

(2) a constrained capex budget that limits AT&T’s ability to roll fiber fast enough to address a competitively disadvantaged broadband product relative to cable,

(3) a strategic 5G wireless threat from cable, and

(4) higher programming costs.

Management hopes this expensive acquisition can help defend its wireline and wireless franchise value to a greater extent than it can organically. While we see significant regulatory scrutiny, it is hard to see how this deal could be blocked following approval (with remedies) of the Comcast/NBC deal.

Bottom line, we view this as modestly negative for AT&T because absent this deal management faces an even greater strategic threat to its core business.

Key Points:

■ A hedge against streaming risks as the market moves away from programmed media. Over time, streaming bills may match cable bills as customers sign up for multiple streaming subscriptions. We think AT&T is likely planning to morph HBO into a streaming competitor to Netflix, combining DC Comics/Warner Bros/Cartoon Network/HBO’s content. We see a network and strategic advantage owning in content deployed closer to edge at low cost versus interconnection with third-party content. Benefits include ad insertion, more effective content distribution to the network edge, and the ability to package content that does not count against data caps.

■ High (but achievable) regulatory hurdle. We expect the deal to face significant regulatory scrutiny from the DOJ, though a lack of jurisdiction means the deal may not be reviewed by the FCC. CMCSA’s 2009 acquisition of NBC Universal will likely serve as the relevant precedent through which regulatory officials will assess the proposed merger amid a new era of media consolidation. While we see significant regulatory scrutiny, it is hard to see how this deal could be blocked by the DOJ following approval (with appropriate remedies to ensure nondiscriminatory content access) of the Comcast/NBC deal.

■ Acquisition details: TWX shareholders will receive $107.50/share under the terms of the merger, comprised of $53.75/share in cash and $53.75/share in T stock. The stock portion will be subject to a collar such that TWX shareholders will receive 1.437 T shares if T’s average stock price is below $37.411 at closing and 1.3 T shares if T’s average stock price is above $41.349 at closing. This purchase price implies a total equity value of $85.4B and a total transaction value of $108.7B, including TWX’s net debt.

■ Debt leverage a short-term concern. AT&T plans to issue $40B in new debt to fund the cash portion of the deal, which would increase its total debt to $175B. However, management plans to reduce debt to EBITDA to 2.5x one year after closing, which is slightly higher than current levels. While rates remain close to zero, interest rate risk is high, and AT&T will need to refinance $9B per year.

■ Sector implications of a successful transaction. We see this as a modest negative for AT&T, but absent this deal, we think management would face an even greater strategic threat to its core business. We view this deal as neutral for Verizon, Sprint, T-Mobile, and cable companies, as equal economic rights to content will likely be mandated by regulators as one of the key remedies. We see a potential negative outcome for LVLT and CCOI as Time Warner content migrates from third parties to AT&T. Lastly, aside from our negative (spectrum supply shock based) investment thesis for DISH, we view a successful outcome as negative for DISH, as an AT&T/DISH deal would be less likely.

■ Conference call:  AT&T hosted a conference call on October 24 at 8:30 a.m. ET to provide further details on the merger announcement and 3Q16 results.

Editor’s Note:

WSJ reported on Monday Oct 24th print edition:

Buying Time Warner Inc. will make AT&T Inc. among the most heavily indebted companies on earth.

• AT&T’s acquisition of TWX overshadowed soft 3Q16 results including weakness in wireless subscriber growth.
• Postpaid net adds were 21,000, and prepaid net adds were 304,000, compared to 23,000 and 466,000 in the year-ago period, respectively.
• Overall video connections declined a modest 0.5% year over year, but U-verse connections declined a whopping 22.9% year over year, which was partially offset by 6.2% year-over-year increase in DIRECTV. Weak 3Q video subscriber results underscore the competitive headwinds AT&T is facing in all facets of business in the U.S. market.
• While AT&T is at the forefront of IoT (Internet of Things) and should be the first to reap benefits, some of the potential upside could be offset as its core subscriber base continues to weaken. While management touts TWX as a content and distribution play, we believe it is largely a defensive decision driven by: (1) greater regulatory pricing pressure on wholesale interconnection and business data service prices in the wireline segment, (2) a constrained capex budget that limits AT&T’s ability to roll fiber fast enough to address a competitively disadvantaged broadband product relative to cable, (3) a strategic 5G wireless threat from cable, and (4) higher programming costs.
• Management banking on vertical integration as key to deal approval: While the deal will certainly face significant regulatory scrutiny, we believe regulatory approval is achievable given the precedence set by CMCSA’s acquisition of NBC Universal. Management appears confident given the distinction of vertical integration of premium content versus horizontal integration of the failed TMUS acquisition in 2011.
• Possibly other suitors for TWX: We believe AT&T’s rushed attempt to announce the TWX acquisition, only two weeks ahead of the presidential election, suggests there might be additional suitors for TWX. We think management agreed to a premium multiple to mitigate interest from other, less-capitalized bidders.

References:

AT&T Faces Political Barrage Over Time Warner Deal

Don’t Bring Time Warner Cable Into This AT&T Deal!

AT&T and Time Warner Seek to Mollify Deal’s Critics

Making Sense of AT&T’s Bid for Time Warner