AT&T & Time Warner: Prepare For The Worst
When news broke that AT&T (T) was purchasing Time Warner (TWX) in a cash and stock deal valued at $ 107.50 for Time Warner holders I felt very confident that the move would improve AT&T’s profitability and widen its moat. AT&T was (and remains) one of my largest positions, so the news was welcome as I previewed the prospective ecosystem where premium original content and provider flowed seamlessly together permitting AT&T to leverage both as a compelling consumer package.
AT&T has a lucrative history marketing ‘bundle deals’ via DirecTV/U-verse, phone and internet. Adding Time Warner’s content to the mix was like adding another weapon to their arsenal. The move would fortify their position in an era where content is king and the average American residence has nearly 3 TVs per household.
With more and more customers embracing OTT services like Netflix (NFLX) and ditching cable, AT&T recognized the writing on the wall and (potentially) acquired Time Warner to help mitigate the impact and diversify them away from their reliance on legacy telecom services.
Perhaps it was not only adding a weapon to their arsenal but adding a shield to insulate them from the evolving landscape. I credit the management team led by CEO Randall Stephenson for their proactive approach getting ahead of the curve.
Obviously Time Warner’s stock popped immediately on the news while AT&T’s gyrated as investors digested the antitrust risks and whether or not AT&T overpaid.
Let’s take a look at those risks now.
Did AT&T Overpay?
The buyout offer did not come cheap ($ 85B) and some analysts groaned that while Time Warner was a nice asset, it came at too high a cost. But obtaining regulatory approval would be no walk in the park and AT&T knew they were in for protracted litigation. Let’s look at the EPS and Revenue numbers for the last two FYs for Time Warner:
You will note that on an EPS basis, Time Warner jumped about 9% year over year from $ 5.86 to $ 6.41. Time Warner grew EPS over 20% the year before that. When the $ 107.5 price tag was initially applied to the prior 4 quarters of earnings in October 2016, the P/E ratio stood at approximately 21.
That did look a bit steep.
However, the deal has not closed and when applying today’s earnings to the buyout price, the P/E ratio dips to 16.7. That looks much healthier. You have to tip your hat to AT&T’s management here since they had the prescience to realize that while the initial premium to Warner shareholders seemed lofty, it allowed them to garner unanimous approval from both boards by offering a rich enough premium to Warner holders while not seeming reckless to AT&T holders.
Stephenson and company knew earnings would continue to rise for the content king and before (IF) the deal closes, they will look like geniuses as earning would have grown into the multiple applied at the time of the offer.
And that brings us to the elephant in the room: whether AT&T can out-litigate the DOJ in their pending antitrust case. President Trump has been vocal in his opposition to the buyout and may see it as fulfilling a campaign promise to defeat the deal. But Trump will not have the final word, it will be adjudicated in the courtroom not the political arena, however you would be naïve to believe that those worlds don’t intersect despite our system of checks and balances.
In the interim, AT&T has tried to curry favor with the Trump Administration by announcing bonuses to its employees and lauding the President for the tax bill. Nevertheless, the antitrust team is pushing ahead with bluster and bravado to paint the government as underdogs thwarting corporate strong-arming.
In November of last year I penned a post in the immediate aftermath of DOJ filing suit recommending purchasing shares of Time Warner during the turmoil called, “Time Warner: Heads I Win, Tails You Lose”. In just two days TWX share price plummeted from $ 95 to below $ 87. I quickly logged into my brokerage account to pick up shares of Time Warner in the $ 80’s.
In the post I explained why the volatility generated a perfect arbitrage opportunity, in summary:
This remains mostly true today, however Time Warner’s share price has since rebounded near $ 95 thereby shrinking some of the potential returns if the buyout is approved. While I have contacts within the antitrust division of the DOJ from my Washington days, they are not at liberty to speak about the case and therefore I know only as much as the public announcements trickling out on a daily basis.
And it is my opinion that the deal looks less likely to succeed now than it did 4 months ago when I wrote that post. But that reminds me of a saying by Clive Davis:
Prepare To Take Action:
During the previous dip, I was on vacation with my wife refilling the gas tank when I checked the market news to find out that Time Warner was selling off. We waited at that pit stop probably longer than she preferred so I could buy shares since I knew that the dip was an overreaction and would not last.
This time, I am planning ahead by placing limit buy orders at $ 85 and below that are good-til-cancelled in the scenario where the DOJ wins and/or impactful news hits the stock causing a knee-jerk reaction. In essence the hypothetical case looks like this:
In the portion of the chart above circled, you will see a red candlestick where news adversely impacted a stock sending it cascading into free-fall. But you will also notice the rapid rebound where the stock recovered quickly above that price.
The window to pounce and take advantage of the dip was small. That is why I am preparing to maximize the opportunity if it presents itself again. I believe that owning Time Warner shares at $ 85 and below provides a margin of safety if the two parties are forced to go their separate ways.
Time Warner Flying Solo?
Will I be saddled with overvalued shares of Time Warner purchased at $ 85? I doubt it. Here’s why:
Growth for Time Warner shows no signs of abatement as each operating division increased revenue and profits in the latest quarter (yet again). HBO’s subscription revenues increased 11% and its unparalleled show Game of Thrones is not due back until 2019. I expect an even larger increase in the months building up to the premiere.
Additionally, on the heels (pun intended) of Wonder Woman’s success, and in the backdrop of the #metoo movement, I believe Warner Bros. has incentive to continue to produce content with powerful heroines. HBO produced an amazing women focused hit with Big Little Lies and it’s due back for a second season featuring Meryl Streep. HBO made a savvy move by riding the coattails of Reese Witherspoon’s success.
On the cable news front, CNN was rated the #1 network in primetime and total day viewership among young adults and tops in digital news as well (from their 4Q earnings release). Whether you believe the treatment of the Trump Administration is favorable or not, it has been favorable to the bottom line of CNN.
And those are just a few samples of the many reasons why I remain bullish on Time Warner.
No one knows for certain how the trial will shake out, but I am positioning myself for success no matter the outcome.
Disclosure: I am/we are long T, TWX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.