The Grand Experiment Failed: Why AT&T Spinning off WarnerMedia to Discovery for $43 Billion Won’t Help its Stock
Remember when AT&T tried transforming itself into a TMT giant by buying everything that had any nexus with content?
There was its infamous acquisition of DirecTV in July 2015. The $60B+ price tag was mammoth even in those days. At the time many industry observers thought it was a massive strategic blunder. From a consumer perspective, satellite was already being replaced by broadband at an accelerating pace. Management, however, justified the deal as a conduit to get content to its mobile phone subscribers, through acquiring the streaming rights through the purchase of DirecTV.
And, while DirecTV’s free cash flows exceeded $4B annually at the time of the acquisition’s announcement, AT&T’s leadership failed to fully grasp the impact that cord-cutting would have on the future sustainability of those cash flows. In essence, management bet on the stability of these cash flows as a means of maintaining what was quickly becoming a very highly diversified business.
The crazy thing about it is that people knew [AT&T buying DirecTV] was a bad deal when it was happening…It’s not like people at the time didn’t see cord-cutting coming.”
Craig Moffett of MoffettNathanson in an interview with CNN Business, February 2021.
Seemingly, AT&T’s leadership team realized its mistake early on and had tried to unload its ownership stake within the first few years of having acquired it. The saga finally came to a close in February 2021 when AT&T announced it was selling a minority stake in DirecTV to private equity fund, TPG. That deal valued DirecTV at less than a third of what AT&T paid for it back in 2015.
Now, management has announced yet another disappointing end to one of the media sector’s most high-profile corporate marriages in the last twenty years. AT&T will now be spinning off its WarnerMedia assets to Discovery, with potentially yet another impairment charge set to hit its balance sheet in the quarters that lie ahead.
A Brief History of the Troubled Union
AT&T took its first major dive into the content space with its acquisition of Time Warner Inc. AT&T made its first bid in 2016. At the time, Time Warner operated the likes of Turner, HBO, and Warner Bros. AT&T also received Otter Media Holdings as well as the advertising platform, AppNexus.
AT&T’s leadership labelled the merger as “transformational” and said that the access to Time Warner’s vast library of content and its production studios would pair well with AT&T’s distribution network of TV, mobile, and broadband subscribers. Then CEO, Randall Stephenson, saw the Time Warner deal as a natural extension of its pipes to content strategy, beginning with DirecTV.
After some wranglings with the Department of Justice over anti-trust claims as well as public battles with then President Donald Trump, which culminated in a victory for AT&T when a federal court upheld the arrangement, the deal closed at a price tag of $85.5 billion.
The Time Warner deal was poised to place AT&T at the nexus of an exciting convergence between the telecommunications, media, and entertainment industries. Unfortunately, it didn’t play out as well as it had hoped.
To complete the acquisition, AT&T needed to raise debt to the tune of $40 billion. The increased leverage made some shareholders uneasy. While management assured Wall Street that it would be able to service the debt and pay one of the largest dividends on an annual yield basis in the entire S&P 500, skepticism abounded. After failing to meaningfully move the stock following DirecTV, analysts were expecting more results in the immediate term. Waiting years to potentially harness the value from the Time Warner deal did not seem like a wait that was worthwhile.
On top of internal shortcomings failed execution and an inability to increase revenue per user, AT&T faced external pressure to keep up with its peers in the telecommunications space. We witnessed the merger of T-Mobile and Sprint, creating the third largest telecom provider in the United States in April 2020. T-Mobile’s stock has soared since this period, gaining almost 200 percent in two-and-a-half years.
While Verizon has not witnessed as stellar growth in its share price and has had its fair share of failed deals (cf. the massive impairment it will be taking on its balance sheet for its Yahoo! and AOL assets), its stock has gone somewhat flat during this same period.
AT&T’s stock chart, however, has looked awful in comparison.
Details Surrounding the Spin-off of WarnerMedia
On Monday, May 17, 2021, AT&T announced it will be selling its WarnerMedia assets to Discovery. The merger will create one of the largest media companies in the world, with scale to compete in advertising and content.
Under the proposed terms of the deal, AT&T would receive $43 billion in cash, subject to adjustments, in a combination of cash, debt, and the spun off company’s retention of certain debt.
The cash will be helpful for AT&T’s efforts to deleverage its balance sheet. Discovery, on the other hand, will benefit from being able to increase its content library with premium scripted originals as well as news assets and American sports broadcasting rights. Discovery can add these capabilities to its backbone of reality TV production.
While Discovery’s reality TV content is admittedly below the quality bar set by HBOMax in terms of scriptwriting and cinematography, the “non-fiction” genre is extremely popular across various demographics. Most importantly perhaps is the fact that Discovery’s audience is more global, something that HBO has struggled with due to its US-centered library.
What could the Combined Discovery/WarnerMedia company Look Like?
Based on last year’s numbers, the combined Discovery/WarnerMedia would be spending roughly $20 billion annually on new content. Discovery’s CEO, David Zaslav, has hinted that he plans to spend more in the years to come. Given what others are doing in the space, this news should come as no surprise.
The combined content slate of the new Discovery-Warner company will have 6 of the top-rated 8 channels on cable including TBS, TNT, ID, HGTV, Food Network and CNN. This scale should benefit Zaslav in negotiations with advertisers and distributors.
A lot of both AT&T and Discovery’s plans regarding the deal will hinge on the timeline for completing the paperwork. There are rumblings that this will need to clear anti-trust hurdles, although those do not appear to be as high as they were when AT&T acquired Time Warner back in June 2018. Nonetheless, antitrust adds hurdles to the integration plans and a hiccup in terms of timelines could derail the expectations in terms of value creation.
Under the terms reported for the WarnerMedia spin-off, AT&T shareholders are said to be receiving 71% of the newly created company, while Discovery’s shareholders will get 29%. Is this enough for loyal shareholders to stick around?
How will Management Explain Yet Another About-Face?
Given the incredibly lacklustre performance that AT&T’s stock has demonstrated over the last 3 years, its difficult to see how the divestiture of DirecTV and now the spin-off of WarnerMedia can be seen as value creation. It also signals to investors that management seems to have resigned itself to the reality that its M&A strategy has failed miserably. But management won’t say so.
Instead, AT&T’s CEO, John Stankey, is calling this move a value-unlocking move for WarnerMedia’s high quality content assets. The divestiture will allow management to focus on the core business of telecommunications services and become the leading broadband company in the United States. Stankey was COO before taking over for Stephenson after the latter’s retirement in June 2020.
If stock performance is any indicator of track records for generating shareholder wealth, AT&T’s chart paints a grim picture. Over the past five years, AT&T shares have fallen more than 20% in the past five years.
Shareholders had hoped that the company’s shares would be re-rated based on the make-up of its diversified business but AT&T’s stock performance has proven otherwise. The market seemingly is convinced that management is incapable of unlocking value with these hobbled together acquisitions.
AT&T’s Generous Dividends will be “Resized” to Reflect the Change in Business Model
To add insult to injury for long-term shareholders of AT&T, the company’s industry-leading dividend will get slashed as a way to shore up cash and fuel investments in 5G technology for its core business. At current market prices, AT&T’s stock has the most generous dividend yield amongst the S&P 500 at roughly 7%. Analysts are expecting the cut to be to the tune of $7 billion annually.
“Resizing” of the dividend caught the ire of one industry observer, who called the original merger “one of the dumbest mergers in recent history”. After the WarnerMedia sell-off news was announced, CNBC’s Jim Cramer went off about AT&T’s poor judgment over the last few years.
Cramer called the move an “insult” to their shareholders, many of whom, he suggested, were retirees who relied on the dividends.
Projections call for AT&T’s dividends to fall in line with its peers, which will be close to half of its current yield.
He went on to say that negative pressure on the stock in recent days is not technical traders but, rather, long-time AT&T shareholders who have seen enough. With declining earnings per share and numerous headwinds from a capex perspective, it feels as though there is room to the downside for the stock.
What Tech Companies can Learn from AT&T’s Mistakes
AT&T’s M&A activity over the last decade is a classic example of chasing trends. In this case, the trend was to try to vertically integrate the “pipes plus content” businesses into a single conglomerate, much like Comcast had done with NBCUniversal.
Unfortunately for AT&T, its business mix has been suboptimal in comparison to its peers. DirecTV, being a satellite provider, was at a technological disadvantage to Comcast’s broadband cable networks and, as such, has bled subscribers more quickly. Comcast has also chosen a penetration strategy for its streaming platform — Peacock — which offers both paid and ad-supported options; AT&T’s HBOMax, while one of the most prestigious in terms of content quality, targetted a premium pricing demographic, which brought it head-to-head against Netflix and other SVOD platforms owned by much better capitalized competitors like Apple, Amazon, and Disney. And, although HBOMax is set to roll out an ad-supported version later in June, it clearly wasn’t enough for AT&T to push for it to be carved out from its proposed sale of WarnerMedia.
Both the DirecTV and WarnerMedia divestitures should serve as clear reminders to corporate executives that horizontal M&A is a high-stakes game. You run the risk of over-estimating the synergies that you think you can achieve on a revenue side and not properly assess the impact that declining profitability in a cash cow business unit will make it difficult to finance your growth portfolio assets.
In the case of AT&T, the mergers did not create value and, instead, distracted management from jumping ahead with its core business offerings (i.e. telecommunications services), when it could have used its position in the United States as an opportunity to become a leader in its legacy industry (i.e. by investing in fiber optic and 5G infrastructure).
Now, AT&T is back to the drawing board and hoping to find a way to maintain its position an increasingly competitive and highly capital intensive telecom marketplace.
