On Monday, October 24, the U.S. stock market expressed its doubts that the AT&T (T) bid for Time Warner would go through/should go through. But despite those doubts I think the mere fact of the bid increases the likelihood that Verizon (VZ) will buy Yahoo (YHOO) no matter how big Verizon’s doubts may be about the $4.8 billion deal after Yahoo confirmed that it had been hacked in 2014 and that the hackers had made off with user names and passwords on 500 million accounts.
Time Warner (TWX) shares dropped 3.06% to $86.74 on October 24. That’s far south of the $85.4 billion–or $107.50 a share in cash and stock–that AT&T has offered. Seems like Wall Street isn’t convinced the deal will go through. Or that it should. (Time Warner shares closed at $87.47 on Friday, October 28.)
The deal would face very tough review from Washington just at a time when a new president is taking office. The desire to make a mark that characterizes new administrations would make sure that this deal gets a thorough going over. Republican presidential candidate Donald Trump has said he would “look at breaking this deal up” if he were elected president. Tim Kaine, Hillary Clinton’s vice-presidential nominee, also expressed concern about the tie-up. “I’m pro-competition. Less concentration, I think, is generally helpful, especially in the media.” Senators Mike Lee and Amy Klobuchar, the Republican chair and ranking Democrat on the Senate antitrust subcommittee, have said their committee would hold a hearing on the takeover in November.
The deal would add more debt to an already debt-laden AT&T balance sheet. For example, Moody’s Investors Service has warned it is reviewing AT&T for a downgrade because of doubts over the merger. It said the company’s credit rating could be cut to Baa2, the second lowest investment grade. When AT&T bought DirecTV last year, the company added $48.5 billion in debt. The debt portion of any Time Warner purchase looks to add another $40 billion in debt. That would bring the debt of the combined company to an estimated $175 billion after the acquisition. AT&T has said that it would be able to bring the post-deal debt load down to something like the current leverage within a year of the closing of the acquisition.
And then, of course, there’s just the little issue of whether or not this acquisition makes strategic sense. The deal would certainly bulk up content at AT&T–and the consensus on Wall Street right now is that it’s worth paying up for content. Just look at what original content is doing for Netflix (NFLX) and Amazon (AMZN). But AT&T would be playing a different game with regulators than Netflix. When Netflix produces or buys content, it can offer it exclusively to subscribers. It’s pretty clear that AT&T would not be allowed to prevent cable companies such as Comcast from offering Time Warner’s HBO, for example, to their subscribers and under terms substantially similar to those it charges to its own subscribers.
But even with all those problems and doubts it’s easy to see why AT&T has to do something like this deal if you look at Verizon’s most recent quarterly earnings report. And why Verizon has to do its best to follow suit.
Verizon’s core wireless business has gone flat.
Here were the troubling numbers in Verizon’s third quarter numbers. Smartphone penetration looks to have hit a plateau: Verizon reported a drop of 36,000 in what are called “post-paid” subscribers. (Which is what the industry calls the folks like most of us who pay a bill each month for the service we used in the previous month.) Plus a pricing war among AT&T, Verizon, Sprint (S) and T-Mobile has eroded profitability at Verizon. Revenue in the company’s wireless unit fell 3.9%. The end of most subsidies from phone makers to wireless companies has also hit profitability. Given all these trends, Verizon told Wall Street to expect revenues to grow at about the same pace as U.S. GDP.
Now this wouldn’t be as big a problem as it is for Verizon–if pretty much every company across the space wasn’t feeling these trends.
For example, here’s what Morningstar cautioned about AT&T before the proposed deal. Like Verizon, AT&T has been losing fixed-line customers for years to cable providers and now provides service to less than a quarter of the households in its service area. Recently, AT&T has been losing ground to its cable rivals–including in the market for Internet access–and, by Morningstar’s estimate, the company has been steadily losing ground in the amount of profit it takes out of neighborhoods in its service area to cable operators. There’s a vicious cycle visible here: if you take less profit out of a neighborhood than a rival, you have less incentive and less cash to upgrade services in that neighborhood. Which just accelerates the rate at which you lose ground on customer numbers and profitability to your rivals.
So how do you fix this immediate growth problem and reverse the long-term negative trend versus the competition?
The solution d’jour is content. If you have content, you can, theoretically, bundle it to make more people pay fees to subscribe to your network. And you can, theoretically, increase your ability to target ads to consumers and charge more for those ads.
It’s not surprising that this is the solution of choice at the moment. If you’re competing with Netflix (NFLX) and Amazon (AMZN), and losing, to their content-driven strategies, what would come to your mind first? Netflix and Amazon are already vertically integrated–with ownership of content and distribution. The AT&T/Time Warner tie up would create a similar vertically integrated distribution and content company.
But, and this is a big BUT, there’s a crucial difference between the Netflix/Amazon content solution than that exemplified in the AT&T pursuit of Time Warner. Netflix and Amazon are investing in creating original content. AT&T is buying it.
But the imperatives for a AT&T/Time Warner deal don’t come just from the need to compete with Netflix and Amazon. Cable giant Comcast (CMCSA), which swallowed content company NBC Universal, is planning to launch a Wi-Fi based mobile service in 2017. Charter Communications (CHTR), which recently bought Time Warner Cable, is also planning a mobile service.
In Time Warner AT&T is getting an amazing package of content that the company clearly hopes is sufficient to ward off these threats. As AT&T listed those assets in its recent earnings guidance slideshow they include: The world’s largest premier cable network (HBO), 3 of the top 5 basic cable networks, and the largest film and TV studio (Warner Brothers) with leading franchises and content library.
That kind of asset doesn’t come cheap. Credit Suisse calculates that at $107.50, the offer price, 2016 multiples for Time Warner are a 19.6 price to earnings ratio. The media peer group comparison, Credit Suisse figures, is about a 12.4 price to earnings ratio. Looking at other multiples such as free cash flow and enterprise value to EBITDA, Credit Suisse projects that AT&T is paying 40% to 70% higher multiples that those at other media companies
Which is what you might expect if you’re buying a premiere media asset when buying content seems to be the best solution to your growth problem and when there aren’t a lot of other media content packages up for sale. Disney (DIS) has said it’s a potential acquirer rather than a seller. Twenty-First Century Fox (FOX) has said the same. Good luck buying Viacom (VIA) from the current dysfunctional ownership and then straightening out the mess at that company as it tries to reintegrate CBS and find new growth in flagging properties such as Nickelodean.
So what do you do if you believe you have to compete on content to fend off Netflix and Amazon, and when a Big Dog in the wireless distribution space has snagged, at least until regulators speak, the best package of content available?
You sure don’t walk away from your purchase of Yahoo. It may not be the greatest asset, but it is available at a reasonable price ($4.8 billion versus $85.4 billion). Adding Yahoo to its previous purchase AOL does give Verizon the possibility of creating a believable vertical integration/ content response to AT&T and the current challengers in the sector. The price also does suggest that Verizon will have more cash on hand and more borrowing power than AT&T when the wireless industry gets around to building out the new 5G network sometime around or after 2020. As I wrote in an earlier post about the Verizon deal “Verizon’s stated goal is to reach 2 billion Internet eyeballs by 2020 and it’s hard to see Verizon getting to that number without Yahoo. Wall Street analysts estimate that if the deal closes in the first quarter, Verizon will have about 1 billion eyeballs from AOL and Yahoo.”
In recent days Verizon officials have gone from pushing back on the Yahoo deal and its price to talking as if it will go through. Speaking at a tech conference hosted by the Wall Street Journal in California on October 26 Marni Walden, an executive vice president at Verizon, said that strategically the deal still makes sense.
That’s especially true when you think about the lack of alternatives for Verizon if it decides it has follow a content strategy.
I added Verizon to my Dividend portfolio back on October 22, 2015. The stock price has gained 9.79%% through the close on October 28. The shares yield 4.79%.
Disclosure: After not owning any individual stocks while I ran my mutual fund (and then while I was shutting it down) I’ve resumed investing in individual names for my personal account. I own shares of Verizon in one or more of my personal accounts.