We have recently learned that the AT&T (NYSE:T) which has insurmountable debt it seems, and the Time Warner (TWX) merger, was approved by Chilean authorities. This is welcomed news. This news follows last week’s news that Mexican authorities had also approved the merger. With the latest approval, that brings the number of major nations’ regulators to sign off on the mega-merger to 17 altogether. Of course, we are still awaiting the United States’ approval, though at this juncture talks have reached the latest stages from what we understand. However, we have been forced to admit that we got it wrong, as we believed the deal would close by the end of the third quarter. Why is this no longer going to happen? Well basically this possibility was all but eliminated thanks to Brazilian regulators. In this column we will discuss the status of the merger but more importantly, discuss what the company must do post-merger.
As you may recall from our coverage (some may accuse us of whining), Brazilian regulators threw a metaphorical wrench in the cogs of the merger machine. This is because Brazil’s antitrust agency ‘CADE,’ the Administrative Council for Economic Defense, believes the merger poses a high risk to competition. While the risk to competition is certainly a concern, the number of regulators signing off without conditions should be telling. However, AT&T and TWX must abide by the decisions of course. As you probably are aware, Brazil has expressed concerns before. Back in the spring Anatel wanted changes in the terms as AT&T has an indirect controlling stake of Brazil’s Sky, and so the merger could severely hamper competition. Now it seems CADE is on board with these same objections. So, the end of Q3 is all but impossible because the merger terms will be rejected unless the companies agree to changes. These changes won’t be ready in time. In addition, CADE has until Nov. 22 to issue a final ruling, though that deadline can be extended by 90 days under Brazilian law. It is likely that to make the deal work, AT&T will sell off some Brazilian assets.
The question ultimately is not whether the merger will occur, as it is pretty much a done deal, but when. Should Brazil want to take its time, we could see the drama unfold into 2018. What should you be doing here? Well look, the stock has fallen $7 from $44 to $37, almost putting the name close to bear territory. As the stock has fallen, the yield has crept up, and is back over 5%. In fact, with today’s decline, the yield has now crept up to 5.3%. We believe that when the merger is approved, finally, that the stock will move higher. There are those that disagree with this notion, who see the stock moving lower in either case, but we think a floor is being reached, unless the merger somehow falls through.
The fact is that the merger is a major step in AT&T’s path to innovation. We have discussed this numerous times over the years. The purchase of DirecTV was a game changer, but that also isn’t why we own it. No, the reason we own this name is that AT&T pays its nice and slowly growing dividend. That dividend is getting hiked again in a few months, make no mistake. The TWX acquisition is the next key piece of the puzzle as the company moves to become the leading telecommunication company on Earth. Let’s not forget it is leading the way on 5G. This is very expensive and we have estimated that about $4-$6 billion dollars will be spent between testing, infrastructure and rollout. Exact costs are tough to pinpoint.
While the company has quite simply fundamentally changed in the last five years, we are in it for the payout. We bought it for the income, to compound our interest. However, we don’t want to lose principal, even on paper. Thus, the question becomes, what becomes the focus post-merger?
Since we are going to finish the year with no merger it seems, or maybe close it just before year end, we can look at the rest of the year based on AT&T’s performance alone. Considering year-to-date performance, we are likely to see flat revenue growth with adjusted earnings growth in the mid-single digits. As for cash flows, the company is aiming for $18 billion for the year. So, it is not a banner year, but after the stock has fallen from $44 to $37, this is baked in. Once the merger is approved, the uncertainty around the fate of the merger goes away. And yes, there are still those holdouts thinking somehow this thing falls through. We have seen stranger things, but this is exceptionally unlikely.
Once this deal is done, the company must prioritize debt. There is zero debate here. While some of the asset sales in Brazil to get the merger done will put a tiny debt in its incredible debt burden, the fact is the debt is astronomical. Make no mistake, the debt is the largest risk factor when considering an investment in this company. If AT&T does not take steps to remedy the situation, disaster looms. This is a generally well accepted fact among both AT&T bulls and bears.
At the end of Q2 2017, the company’s debt was just shy of a whopping $144 billion. It is only going to expand. Remember AT&T needed financing for the merger. While the merger is costing in the ballpark of $85 billion, AT&T is raising $22.5 billion through a seven-tier bond offering. This is all new debt being added to the pile. For the stock to move appreciably higher post-merger, there will need to be a clear plan. While cash flows will be more than sufficient to cover debt payments and the dividend, the future growth of the dividend and sustainable health of the company will be called into question without a plan.
This is what we will be watching for post-merger.