In October 2016, AT&T (T, Financial) announced a deal to acquire Time Warner (TWX, Financial). If the deal is completed, Time Warner shareholders will receive $53.75 per share in cash, as well as a similar amount in AT&T stock. The stock component is subject to a collar. Currently, with AT&T stock at approximately $35 per share, the equity component of the deal would have a value of approximately $50 per Time Warner share (total deal value of about $104 per share). If AT&T stock fell around 10% to $32 per share, the second component of the deal would have a value of approximately $46 per Time Warner share (total deal value of approximately $100 per share).
Throughout most of 2017, Time Warner traded for roughly $100 per share. That changed in November, when the Department of Justice sued to block the AT&T-Time Warner deal. Shortly after, the companies agreed to an extension of the termination date for the deal. Currently, if Time Warner accepted a competing offer, they would be on the hook for a break-up fee. After June 21, Time Warner can walk away from the deal without paying the $1.75 billion penalty.
I have read the AT&T and DOJ briefs. For what it’s worth, I think AT&T has the upper hand in this fight. But I don’t have an overwhelming degree of confidence in that conclusion. While I won’t bother trying to guess the probabilities, I think there are three potential outcomes.
In the first scenario, the judge sides with AT&T and the deal is approved. For Time Warner shareholders, that means somewhere in the range of $100 - $105 per share of value received in the next few months (the trial, which started March 21, should take six to eight weeks). From a current price of $92.60 per share, that’s a nice return in a short period of time.
In the second scenario, the case is not resolved by the termination date, giving Time Warner the option to walk away without penalty. If another bidder came to the table, it seems reasonable to assume the value of a deal would exceed $110 per share. Much like the first scenario, I think the value of this offer would be reflected in Time Warner’s stock price well before the end of 2018.
In the third scenario, the DOJ wins and Time Warner doesn’t (quickly) find itself party to another deal. AT&T would be required to pay Time Warner $500 million for failing to obtain regulatory approvals, but that’s peanuts in the context of an $85 billion deal (equity value). What I find interesting about the third scenario is we already have reason to believe that other knowledge parties would see value at today’s prices: in 2014, 21st Century Fox (FOX, Financial) (FOXA, Financial) made a takeover offer for Time Warner at $85 per share. That deal fell through, with the Wall Street Journal reporting Time Warner would not be willing to sell for anything less than $100 per share.
I think that’s an interesting data point because Time Warner’s profitability has significantly increased since that time. In 2014, the company reported adjusted earnings of $4.2 per share ($3.7 billion on 883 million shares). By comparison, the company reported adjusted earnings of $7.5 per share in 2017 ($5.9 billion on 791 million shares). Adjusted earnings per share have increased by roughly 80% since 2014. Free cash flow per share has increased by more than 40% over the same period to $5.6 per share. Management expects the solid results to continue, with 2018 guidance implying another year of double-digit earnings per share growth. That’s a long way of saying I am willing to bet Rupert Murdoch would be comfortable paying more than $85 per share for Time Warner today.
I’ll concede there’s one problem with that assumption: while Murdoch might want to take another run at Time Warner, he probably won’t have the opportunity if the 21st Century Fox – Walt Disney Co. (DIS, Financial) deal is completed. I do not think regulators would allow the combined company to acquire another large content provider. That leaves a handful of much less attractive content companies to potentially combine with, at least in my opinion. I think a potential investor should only be comfortable with the third scenario if they believe Time Warner, on its own, is worth more than $90 per share; I would not assume a horizontal merger with another content provider is in the cards.
That leaves us with two scenarios where you recognize a decent gain on your investment in a few months, or a less certain third scenario where you own Time Warner at a reasonable valuation (the free cash flow multiple is lower today than it was prior to the 21st Century Fox offer in 2014). I don't own the stock, but I think that sounds like a reasonable setup for Time Warner shareholders.
Disclosure: Long FOX, FOXA.
