Blue-chip communications giant AT&T (NYSE:T) has traded somewhat like a utility stock in recent years, and investors approached T stock as such. It has long been a reliable stock as a dividend aristocrat.
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Looking for new growth opportunities, AT&T made a huge push into entertainment three years ago with its transformational acquisition of Time Warner. The Time Warner acquisition was supposed to provide AT&T a new avenue of growth with sought-after entertainment properties such as HBO.
The takeover did not translate into the prescribed amount of growth AT&T had hoped, while also saddling AT&T with a mountain of debt.
Now, AT&T is merging its WarnerMedia business with publicly traded Discovery (NASDAQ:DISCA, NASDAQ:DISCB). The merger will create a streaming powerhouse to take on Netflix (NASDAQ:NFLX), Disney (NYSE:DIS), Amazon (NASDAQ:AMZN), Comcast (NASDAQ:CMCSA) and others in the ongoing streaming wars.
Because of this, we reiterate our view that AT&T stock is a buy.
The merger between WarnerMedia and Discovery was announced on May 17 with the combination to be structured as a Reverse Morris Trust transaction. In essence, a Reverse Morris Trust is simply a way for a parent company to spin off assets and then combine them with an entity that is interested in acquiring those assets. In this case, the parent company is AT&T, with the assets to be spun off being WarnerMedia, and the acquiring company represented by Discovery.
Importantly, the Reverse Morris Trust allows for this to occur tax-free, which is likely why AT&T went this route in the combination with Discovery.
Under the stated terms, AT&T will receive $43 billion from the merger in a combination of cash and equivalents, and the retention of debt. In addition, AT&T shareholders will receive 71% of the outstanding stock in the new company, with Discovery shareholders retaining the balance of 29%.
The mega-merger will combine powerhouses in the streaming business, including HBO and its related properties, Discovery , CNN, HGTV, Food Network, and other leading non-fiction programming.
The transaction is complex and will take time to complete, with an expected close date sometime in the middle of next year. Following the combination, the company expects the new entity to have more than $50 billion in annual revenue.
For AT&T, the combination means ceding control over WarnerMedia and the growth potential it provided. However, AT&T still expects to see low-single digit revenue growth and mid-single digit adjusted earnings-per-share growth following the transaction.
The merger with Discovery has the above-stated benefits for AT&T, including significantly reduced debt. The acquisition of TimeWarner cost AT&T nearly $80 billion when all cash and stock considerations had been met, and AT&T came out of the merger with a staggering $180 billion in long-term debt.
AT&T believes it will exit this process with a net debt to EBITDA ratio of 2.6x, which is well down from its prior levels that were bordering on unsustainable.
In addition, AT&T will resize its dividend to account for the distribution of WarnerMedia, which it believes is something like 40% of annual free cash flow. That implies a projected dividend payment of $1.15 per share, give or take, in comparison to the current $2.08 per share.
The merger has important benefits for the new entity, as it combines very valuable streaming properties under one roof. However, for AT&T, we still believe the company has growth opportunities in the remaining business.
The merger will allow T stock to focus on its core connectivity and telecommunications businesses, and with much less debt. AT&T will have the ability to step up investments in its growth areas, which are mobile connectivity and fixed broadband services, without the distraction of trying to be a world-class entertainment company at the same time. AT&T was heavily focused in recent years on growing its entertainment business, but will no longer face such a choice and can instead invest in its most important growth initiatives such as 5G.
In addition, AT&T’s capital structure is going to be significantly improved following the transaction, given it will receive $43 billion in cash and equivalents with which it can reduce leverage. This will not only save the company money on debt servicing costs, but will position AT&T well among its 5G competitors, which include Verizon (NYSE:VZ) and T-Mobile (NASDAQ:TMUS).
Billions of dollars of investment are needed to remain competitive in this environment, and AT&T, we believe, will be better positioned to make those investments following the merger.
T Stock Valuation
Following the merger, and even before, we still find AT&T to be attractively valued. This year, we expect the company to produce $3.20 in EPS. Next year’s results will undoubtedly be messy given the transaction that is supposed to take place, and related charges. But in the long run, we expect AT&T to be able to pay down debt gradually, pay its dividend to shareholders, and potentially buy back stock.
We think the Discovery transaction is an admission of sorts that the foray into entertainment didn’t work, and that AT&T is more interested in being a pure-play telecommunications business again.
Shares trade for just 9.2x this year’s earnings estimate of $3.20 per share, which is well under our estimate of fair value of 11x earnings. We think a pure-play AT&T that focuses on telecommunications, and with tens of billions of dollars in reduced debt, is still quite attractive, and shareholders receive the further benefit of owning the majority of the new entity.
Given these factors, we reiterate our buy rating on AT&T following the announcement of the merger.
T stock is in a period of significant transformation today. The WarnerMedia merger didn’t work out as planned, but we see the remediation of it via the Reverse Morris Trust transaction with Discovery as attractive. Buyers of AT&T today get a cheaply valued telecommunications giant with a strong dividend, and 71% ownership of the new streaming-focused entity sometime in the middle of next year.
With these characteristics, we are reiterating our buy rating on AT&T.
On the date of publication, Bob Ciura did not have (either directly or indirectly) positions in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Bob Ciura has worked at Sure Dividend since 2016. He oversees all content for Sure Dividend and its partner sites. Prior to joining Sure Dividend, Bob was an independent equity analyst. His articles have been published on major financial websites such as The Motley Fool, Seeking Alpha, Business Insider and more. Bob received a bachelor’s degree in Finance from DePaul University and an MBA with a concentration in investments from the University of Notre Dame.