AT&T’s (T, Financial) proposed merger with Time Warner Inc. (TWX, Financial) will add to the telecom company’s sizable debt burden, which already grew almost a year and a half ago when it leveraged to make another large acquisition.
The merger, announced Saturday and approved unanimously by the boards of both companies, would unite the second-largest telecommunications company in the U.S. and a global media and entertainment company. Executives have promised that the integration will make more premium content immediately available across mobile devices and provide bundled mobile broadband and video to customers.
“We’ll have the world’s best premium content with the networks to deliver it to every screen," AT&T chairman and CEO Randall Stephenson said in a statement. "A big customer pain point is paying for content once but not being able to access it on any device, anywhere. Our goal is to solve that.”Â
Deal terms
To acquire Time Warner, AT&T will pay $107.50 per share, with $53.75 in stock and $53.75 in cash. The total transaction amount is $85.4 billion for the company, but it will add up to $108.7 billion when including Time Warner’s $23.3 billion net debt.
AT&T also plans to fund the cash portion of the deal through a $40 billion bridge loan, which will sharply increase the liabilities mounting on its balance sheet. At the end of the second quarter, AT&T posted $117.31 billion in long-term debt, a year-over-year increase from $105.07 billion.
Using balance-sheet cash was not an option to fund the acquisition, as AT&T had only $7.21 billion at second-quarter end, down from $20.96 billion in the second quarter a year ago.
The company’s long-term debt and $123.4 billion in total equity gave it a high debt-to-equity ratio of 1.3, signaling that it has been aggressively financing its growth through debt, which often leads to volatile earnings due to interest expense.
Debt beginnings
Much of AT&T’s current debt accrued from its July 2015 acquisition of DirecTV (DTV), the world’s largest pay-TV provider. AT&T paid $49 billion for the company, with an additional $18.6 billion in DirecTV’s debt. AT&T financed roughly $48.5 billion in equity and the remainder with debt.
By the end of 2015, AT&T’s debt had ballooned to $118.52 billion from $76.02 billion at the end of 2014, of which it had paid off little more than a billion by the June quarter of this year.
AT&T’s acquisition may fit into a larger trend of more companies trying to boost their numbers but having few other attractive options, according to John Buckingham (Trades, Portfolio), CIO of Al Frank Asset Management.
“Keep in mind financing costs are so low these days with interest rates being where they are, so it behooves corporations to try to grow their top line and bottom line of course. And one way to do that if you can’t do it organically because global economic growth has not been all that great is to make an acquisition,” he told CNBC Monday.
AT&T revenue had risen less than 2% annually from 2010 to 2013, before rising to 2.87% in 2014. In 2015, the year DirecTV began contributing to its financials, revenue jumped 10.84%. EPS in 2011 and 2012 fell to its lowest since before 2001, before the company began buying back shares more aggressively. In 2014, EPS again declined to near its lowest since 2001, at $1.24. In 2015, with the acquisition of DirecTV, EPS nearly doubled to $2.37.
2014, the year prior to the Directv acquisition, also saw the company’s return on equity, net margins and gross margins fall to their second-lowest since 2001.
Downgrades
As a result, Moody’s downgraded AT&T’s bond rating in February 2015, when it announced the DirecTV merger. The acquisition would increase its leverage “well beyond the 2.5x (Moody's adjusted) upper limit of AT&T's prior A3 rating,” Moody’s said, and "weak organic free cash flow" could "heighten credit risk.”
Announcement of the Time Warner acquisition put AT&T’s senior unsecured rating again under review for a downgrade from its current Baa1 rating. In a statement, Moody’s estimated the deal would push AT&T’s gross leverage to around 3.5x by year-end 2018.
“The deal's financing costs will consume the majority of acquired free cash flow due to an incremental $2.3 billion in annual dividends and $1.3 billion in additional after-tax annual interest expense. Moody's believes that given AT&T's limited excess cash after dividends and modest EBITDA growth potential, that organic leverage reduction is limited to around 0.1x to 0.2x annually,” Moody’s said.
The ratings agency also expected its annual maturities to be greater than $9 billion annually, and cautioned that Time Warner faces disruptive changes from companies like Netflix (NFLX, Financial), Hulu, Youtube, Amazon (AMZN, Financial) and Apple (AAPL, Financial).
Dividends
Mounting debt may also jeopardize AT&T’s famous dividend. The company is the only “dividend aristocrat” (requires 25 or more consecutive years of dividend increases, S&P inclusion and size and liquidity criteria) in the telecom sector.
It currently has a dividend yield of 5.19% and pays out 82% of its net earnings to shareholders, which will be difficult to continue as it grows to around $14.5 billion annually from $12 billion prior to the merger, and would limit financial flexibility and ability to repay debt, according to Moody’s.
“Over a longer timeframe, Moody's continues to expect AT&T to reduce its cash dividends in order to remain competitive with its new peer group that includes other media and technology giants, many of which have very lean balance sheets,” Moody’s said.
Warren Buffett (Trades, Portfolio)
Buffett, for one, shied away from the stock. Berkshire Hathaway (BRK.A, Financial)(BRK.B) briefly owned shares he received in the third quarter of 2015 from the company’s acquisition of his holding DirecTV. He reduced the position the following quarter and sold out of his stake by the first quarter of 2016.
He holds another telecommunications stock, Verizon (VZ, Financial), which pays out 64% of its earnings and has a yield of 4.73%, making it the highest yielding in his portfolio. Both Verizon and AT&T currently have the same cash-to-debt ratio of 0.06, though that does not include the debt AT&T will take on with the Time Warner merger.
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