Interesting Friday news. Moody’s Investors Service, said that the US Department of Justice’s (DoJ) extended review of AT&T Inc.’s (Baa1, review for downgrade) pending $85 billion acquisition of Time Warner Inc. (Baa2, stable) creates uncertainty and could result in negative consequences. However, Moody’s believes the near term financial impact to AT&T of a broken deal would be relatively minor. Should AT&T abandon the transaction and not change its capital allocation or pursue an alternate deal, it is likely that Moody’s would confirm AT&T’s senior unsecured rating at Baa1 with a stable outlook. Let us discuss further:

If regulators block AT&T’s purchase of Time Warner it could harm, but not derail, AT&T’s long term strategy to bundle video. Without content ownership, AT&T would have less leverage over content costs and distribution rights. But, since AT&T will still need to acquire a significant amount of its content rights from third parties, with or without owning Time Warner, its business plan will not be ultimately derailed if the deal breaks apart. The direct financial implications of the deal not being approved are relatively mild. Should the deal not close, AT&T would pay Time Warner a $500 million break up fee. Additionally, AT&T must redeem a large portion of the debt issued to fund the cash component of the deal at 101% of the principal amount, plus accrued but unpaid interest. This could total roughly $300 million. Further, while the legal review continues, AT&T’s cash flows will be pressured as it services over $30 billion of incremental debt without the acquired cash flows from Time Warner.

If the uncertainty drags on for long, this could have negative consequences for AT&T, but the impact will be limited if the deal is ultimately approved. The company has indicated it could mount a legal challenge to the DoJ, which could cause increased legal costs and delay AT&T from realizing the benefits of the Time Warner merger. Any remedies to regulatory objections that would dilute the cash generative power of Time Warner could undermine the economics of the deal and create negative credit implications for AT&T. Moody’s does not anticipate AT&T will agree to divest a meaningful amount of Time Warner’s business segments in order to satisfy the DoJ.

The direct financial implications of the deal not being approved are relatively mild. Should the deal not close, AT&T would pay Time Warner a $500 million break up fee. Additionally, AT&T must redeem a large portion of the debt issued to fund the cash component of the deal at 101% of the principal amount, plus accrued but unpaid interest. This could total roughly $300 million. Further, while the legal review continues, AT&T’s cash flows will be pressured as it services over $30 billion of incremental debt without the acquired cash flows from Time Warner. Further,

AT&T’s Baa1 senior unsecured rating reflects its strong competitive position, stability, scale and diversity of revenues that result in tremendous qualitative credit strength. AT&T is the market leader in nearly all of its businesses and has valuable assets, predictable revenues, healthy margins and consistently invests for the long term. Yet, these qualitative strengths are offset by weak financial metrics, anemic growth and a broad vulnerability to disruption. Its balance sheet size could test the depth of the credit market, while its free cash flow after dividends is limited. AT&T is susceptible to tighter credit, further competitive pressure, technological disruption and macroeconomic trends.

AT&T’s ratings are on review for downgrade related to its agreement to purchase Time Warner. We expect the review to continue until deal close is certain or if it is terminated. Moody’s review will focus on AT&T’s pro forma capital structure and its willingness and ability to reduce leverage back towards 3x (Moody’s adjusted), AT&T’s current limit for its Baa1 rating. Moody’s expects AT&T’s leverage to increase to slightly above 3.5x (Moody’s adjusted) pro forma for the Time Warner acquisition. Moody’s expects any potential downgrade of AT&T’s senior unsecured rating to be limited to one notch.

Moody’s could downgrade AT&T’s rating to Baa2 if free cash flow is negative or if leverage remains above 3x, both on a sustained basis. Moody’s could raise AT&T’s rating to A3 if leverage is sustained below 2.5x and free cash flow improves to 5% of debt. A ratings upgrade would also be predicated on management demonstrating a commitment to lower leverage over a long time horizon.

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