Last week, news broke of a proposed merger between AT&T (T 1.25%) and Time Warner (TWX +0.00%), bringing distribution and content together in one of the biggest deals of 2016. This major announcement follows the $50 billion buyout of DirecTV, which AT&T only closed last summer.
On this episode of Industry Focus: Consumer Goods, Vincent Shen and Daniel Kline break down some key details behind the transaction, the potential behind the combined entity, and the major regulatory challenges the two companies will need to overcome in the coming year.
A full transcript follows the video.
This podcast was recorded on Oct. 25, 2016.
Vincent Shen: This episode of Industry Focus is brought to you by Criquet. Criquet makes perfect, classic, and easy-going polo shirts. For 20% off your first purchase, go to criquetshirts.com/fool and use the promo code FOOL.
Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It is Tuesday, Oct. 25, and I'm your host Vincent Shen. With me in spirit and beaming into the studio via Skype from South Florida is fool.com contributor Dan Kline. How are you doing, Dan?
Dan Kline: Hey, Vince! How are you?
Shen: I'm doing well. I think, for today's show, sometimes we have those weeks where the topic for our episodes is taken out of our hands, and essentially mandated or preordained by the market. This is one of those weeks.
Kline: This might be the most surprising show that we've ever done, given that when we talked on Friday, we barely had an inkling that this could be a show.
Shen: That's true. Our story for today, without further ado, is the proposed merger between telecom and entertainment giants AT&T and Time Warner. This is about an $85 billion deal, and if you include Time Warner's debt balance, it balloons over $100 billion. It has dominated headlines over the weekend and early into this week. To give listeners who aren't as familiar -- I think you've all heard the names -- with the businesses, I wanted to give you a bit of an idea of the scale and the scope, and what this deal really brings together in terms of their assets and what each company has to offer.
First, we have AT&T. Over $200 billion market cap. Their trailing 12-month revenue is $164 billion, net earnings of about $14.5 billion. They have over 25 million video subscribers to the largest pay-TV player worldwide. They have over 12 million Internet and broadband subscribers, over 40 million wireless subscribers, making them second only to Verizon, and they have a network coverage in the U.S. of 350 million people, pretty much anyone out there. You can add to that another 20 million wireless and video subscribers in Mexico and Latin America.
On the Time Warner side, you have a company with about a $60 billion market cap, at least prior to the deal's news. Trailing 12-month revenue of $20 billion. Net earnings of $4 billion for that same period. They have three major segments: Turner, which includes networks like TNT, TBS, Cartoon Network, Adult Swim, CNN, all their affiliated digital properties, which are becoming bigger and bigger, and all those networks reach at least 90 million domestic television households. HBO has grown its subscriber base over the years with tons of famous, very popular content. Think Game of Thrones, Silicon Valley, the new Westworld, which I have been watching and really enjoying. They have over 130 million subscribers worldwide. Warner Brothers is the last segment. It's the largest TV and film studio in the world. They produce a ton of popular TV series, like 60 different TV series. I think they're the No. 3 video game publisher for last year. Their movies, you know some of the famous franchises, including the DC Comic Universe, Harry Potter, Lord of the Rings, tons of major franchises, huge names for Time Warner and the Warner Brothers Studio.
So, that is the potential here for everything that's coming together. It's a ton of properties in a ton of assets. What do you think?
Kline: To put this into perspective, this is a giant distribution company buying a giant content company -- a premium content company. It's really a case of, AT&T has the pipeline. You mentioned video subscribers. Most of that is DirecTV. They purchased DirecTV fairly recently. So this is all about giving them the premium content which they can use to justify, let's say, price increases, or keeping prices the same. It's really a way to control both sides of the transaction. I'm not a shareholder, but for shareholders of either company, I don't love the deal, partially because there's not a lot of history of distribution companies understanding content.
Look at HBO. HBO, sure they have blockbuster shows, but they also make very smart, very niche deals. Bill Simmons would be an example I would give. He has a show, Any Given Wednesday. He has a bunch of digital platforms with them and without them. But there's a couple million people who he means a lot to. When you're just a corporate AT&T guy used to subscriber revenue and balance sheets, a deal like that doesn't make sense. It makes me very nervous as a fan of a lot of content put out on the Time Warner side, for AT&T running the show.
Shen: If you look at the deal announcement press release, both CEOs of AT&T and Time Warner -- that's Randall Stephenson and Jeff Bewkes, respectively -- they've been making the rounds, trying to sell regulators and the public at large on this deal, why it's great for the two companies, why it's great for the shareholders, and allegedly great for consumers as well. I think the deal announcement, the press release rattles off plenty of the benefits. But when it comes down to it, what do you see as the core rationale of how this would work, especially on the AT&T side, when it's a combined entity?
Kline: On paper, there are lots of benefits. On paper, when Time Warner and AOLmerged, there were lots of benefits. It looked great. On the AT&T side, what they're getting is the differentiators as to why you would put DirecTV over another service. If they could have a premium HBO offer -- maybe HBO would only be $7.99 a month, whereas on Comcast, it would be $14.99 a month. There's obviously some regulatory concerns with that. You look at the HBO deal with Jon Stewart, which is going to be exclusive content. HBO would have all sorts of ways to entice subscribers. They might be able to say, "TBS, TNT, CNN, those don't count against your data plan if you're streaming them over our wireless network." So, they get all that leverage when it comes to content. It's easy to see why you would think that would work. But it's also hard to see how the two cultures are going to match. That's ultimately why AOL and Time Warner fell apart. It was an old-line media company with a new-line media company. Now, you've got this incredibly creative content company -- which Time Warner has become, you can make fun of the creative level of the DC movies all you want, but that's what it is -- and you're matching it with this subscription, numbers-driven business. That's not such an easy fit, but on paper, it looks great.
Shen: Absolutely. Just right there, you mentioned three revenue synergies, or ways that they could package that distribution and content creation side. Honestly, that's just the tip of the iceberg. Some of the possibilities, if you really think about the number of properties and the reach that AT&T specifically has with its various wireless and Internet subscribers, it's pretty mind-boggling, some of the different ways they can find to innovate and offer attractive services, exclusive content to consumers.
Kline: Yeah, if you just take something really small like Adult Swim -- the challenge with cable is reaching Millennials. Adult Swim has those kids as they grow up, when their parents are still paying for cable. If you could take some of that content, which is, of course, already available online and all sorts of other formats, but port it over onto an AT&T-exclusive video platform, then all of the sudden you have an AT&T product that maybe T-Mobile or another cable rival can't offer. So it really gives AT&T an awful lot of tools that they can leverage, if they're willing to figure out the content game. And that's the part that scares me.
Shen: Absolutely. Before this becomes finalized, we also have a lot of challenges, and some precedent too, that we wanted to discuss for what the AT&T and final Time Warner combined entity might look like. Before we dive into that, I wanted to give a big thanks to Criquet for supporting our show. Criquet shirts are made with 100% certified organic cotton in a fit that is just right, not too baggy and not too skinny. They are super soft, comfortable, and sharp-looking polo shirts that mix old-school style and modern design. Like a proper dress shirt, the last thing you want is a ruffled bacon style collar. It is these finer details, such as the removable collar stays on Criquet shirts, that really take their offerings to another level. As a special offer to our listeners, you can get 20% off of your first purchase by going to criquetshirts.com/fool and using the promo code Fool. And, on top of all that, Criquet offers free, no hassle returns and exchanges. Thanks again to Criquet Shirts for supporting Industry Focus.
So, Dan, one precedent that I really latched onto when I was reading about this deal and thinking about how things could work in terms of the regulatory side, if it were to get approved, some concessions would likely need to be made, even though these two companies don't compete with each other directly. This isn't the case of the recently scuttled deal between Staples and Office Depot, for example, where people felt like the last two office supply stores coming together would mean a lack of competition. But, the precedent I was thinking of was Comcast and NBCUniversal.
Kline: It's absolutely the same deal, but to an extended area. Comcast and AT&T are already the top two cable providers. With AT&T, you have their huge base of wireless subscribers as well. That is how AT&T is going to sell this deal. They're going to say, "You allowed to Comcast to buy NBCUniversal, with all of their associated cable networks and entertainment properties." You can also point a little bit to Disney buying Capital Cities/ABC, where they're matching content with distribution. But ABC already had some of its own content. So there is some precedent.
And you're right: This does not take a player off the board. This is not the FCC telling Sprint and T-Mobile that they can't combine because they don't want to see three wireless carriers instead of four. That said, the regulatory hurdles here are going to be enormous, mostly just because of the current mood. The idea of companies getting bigger and wielding this much power has actually been something that both presidential candidates -- two people who can't even agree to shake hands before a debate -- both are coming out and saying, "Wait a minute, let's look at this really hard."
Shen: Yeah. I think, with the Comcast and NBCUniversal deal serving as a precedent that AT&T can point to and say, "This worked," the only difference being that AT&T has that wireless side as well. But, there's also some negative aspects to that deal that I think some regulators will point to and say, "Actually, that deal makes us uncomfortable." So, it's important to note that the Federal Communications Commission, the FCC, they made Comcast agree to certain concessions before they approved that NBCUniversal deal. Among others, that included an affordable broadband-service-only offering, keeping some content on local stations, and also, a big thing was limiting its input on the Hulu joint venture, which was originally created by Disney and Twenty-First Century Fox and NBCUniversal. I, frankly, was not surprised to learn that in the year or two after the deal was approved, the FCC essentially had to take Comcast to court because they failed to follow through on any of those promises.
Kline: If you look at AT&T's history, concessions scare me because they have been dragged into the mud about not bringing internet service to certain areas, pricing concessions. First of all, you're going to see a concession, almost definitely, about how they price, where they can't give themselves sweetheart deals. Basically, they can't say, "Alright, we'll eat the cost of AT&T TBS for our subscribers, but we're going to charge $3 a head to Comcast or Dish Network to put them out of business." I think you're going to see some rules about that. It also wouldn't shock me if they were forced to spin something off. I think HBO is the logical candidate here. HBO would be a very logical stand-alone company, and it really is the jewel of all of this. So, you're going to see some pretty big concessions, and that might cause AT&T to walk away from this deal.
Shen: Yeah. Something else I've seen brought up as a potential pain point in terms of the regulatory considerations has actually been CNN, and the idea that news networks should, as much as they can, be neutral and have a fair playing field. That was an issue that came up in the Comcast deal, too. Comcast, through their acquisition, took over CNBC, the business news network.
Kline: MSNBC as well.
Shen: Yeah. As you can imagine, the better the ratings for CNBC, the bigger the financial contributions it makes to the business through advertising and various fees. So Comcast was supposed to carry all news networks in the same neighborhood, so to speak. The idea was, if you're going to flip through news channels, they should all be together. If you have another news channel way off, in terms of those neighborhoods, consumers or viewers are unlikely to go there. What they did there was they isolated Bloomberg Television off into television Siberia, as they called it. And Comcast got dinged on that.
Kline: I think you're going to see the same rules applied to this deal. That said, we know what the major networks are. I love Bloomberg. It's actually what I watch or listen to a lot of the time. But it is a very niche station. At some point, I think we have to say: all the major channels are together, all the sports networks are grouped together, but the ACC Network is on channel 11,253. I have DirecTV, and it is actually that ridiculous in terms of how the channels work. There's going to have to be some rules here. The problem is, CNN is maybe not viable as a spinoff. And it's not like you can say, "Who is a better owner for CNN?" I don't see a home for it. But they're going to have to look long and hard at how they put this all together.
The other big factor -- and I know that you and I talked about this before -- is, as an AT&T shareholder, this is a crushing amount of debt they're taking on. From a Time Warner point of view, when a company buys another company -- and we just saw this with UFCbeing bought out, the Mixed Martial Arts people -- when a company buys another company and takes on a huge debt, the first thing that happens is cost cutting. When you're producing Westworld and Games of Thrones and other shows with lavish budgets, where the payoff is a little bit in the mist -- you don't directly correlate subscribers with spending $6 million on a Game of Thrones episode vs $4 million. I think, and I've said this from the beginning of this episode, you're going to see some very bad news on the content side with how they spend money.
Shen: Yeah, absolutely. Stepping back from the Comcast example, in general, right now, there have been a huge slew of big M&A announcements in 2015 and 2016 -- some successful, some not successful. But, I think overall, people would agree, in terms of the Justice Department and the FTC, they are very closely scrutinizing these big deals. Just think about, the tie up with Walgreens and Rite Aid, Bayer and Monsanto, Dow and DuPont, Anheuser-Busch and SABMiller, these all required a minimum of one-year review periods, if not more, and are currently in the process for a lot of those. Comcast and Time Warner deal scuttled. Staples and Office Depot did not come out. Halliburton and Baker Hughes, Pfizer and Allergan. All these examples are of deals that did not make it through. As the climate, like you mentioned, two major presidential candidates can't agree to anything, but both of them are like, "You know what? This might not be the best idea."
Kline: Yeah. The current climate says this deal does not get approved. But the reality is, not that long from now, a few weeks from now, we're going to have a new president and we might see control of Congress switch hands. So, the climate that we're operating in isn't necessarily the climate we're going to have going forward. There's a lot of reasons to say no to this deal, but we don't see a monopoly. They don't knock out a clear competitor. Consumers would still have the ability to go get a Verizon phone or, in most markets, get a different cable company, or subscribe to Showtime instead of HBO, or Netflix. So this isn't eliminating competition directly, but it does give them a huge wedge to eliminate competition. I mean, if I was Dish, I would not want this deal, because when you're making a deal for Sling TV, which has HBO, oh boy, the terms might get very different when DirecTV is marketing against you.
Shen: Yeah, absolutely. I want to end the show, for any investors and shareholders out there invested in those two companies, with specifics for the deal for Time Warner. Total deal size: about $85 billion. Time Warner shareholders, in terms of the consideration they will receive based on the current deal parameters, they would receive part cash -- $53.75 per share in cash -- and then $53.75 in AT&T stock. So, total consideration, about $107.50 per share. Special conditions, though, lie therein that the stock portion of consideration has a collar -- basically meaning, when the deal closes, if AT&T shares are trading below about $37.41, approximately, you would get 1.437 AT&T shares, and if it's trading above about $41.35 at closing, then you'll only get 1.3 shares. So, a small consideration there. And overall, for the combined entity itself, Time Warner shareholders will hold about a 15% stake of that final company.
On the AT&T side, I think, they just completed a $50 billion deal for DirecTV last year. You mentioned the debt balance.
Kline: The debt terrifies me on this. You're going to have to -- they say they're going to cut about $1 billion in expenses. What's $1 billion when you have $200 billion? So, they'll catch up to their debt in 200 years? (laughs) I mean, it's not a good number.
Shen: Yeah. So, to give you an idea there, AT&T right now, their cash balance is about $6 billion. Net debt is $120 billion. They would have to take on Time Warner's $22 billion of net debt. And then, the cash consideration for this deal alone is over $40 billion. So, Dan, that $200 billion number you threw out, throw it all together, you're getting pretty darn close --
Kline: I'm rounding up a little bit. But this is one of those deals where you have to assume everything is going to go right if you're a stockholder and you want to hold this long term. You have to assume that not only does AT&T buy this, but they can integrate properly, they can cost-cut without hurting quality, and they can leverage that to gain subscribers or advertising and more viewers. That's a lot of things that have to go right before you have kind of a debt crisis.
Shen: Final takeaway, for me personally, as it stands: I think, if the two companies come together in their total current forms, there are a ton of benefits. Personally, I might not agree with it. We've seen some issues with the acquiring company not living up to some of the promises that they make to get a deal through regulatory hurdles. I think there's a lot of problems with that, in terms of enforcement. But overall, if you are a shareholder here, in terms of the premium that you're getting, and also this megadistribution-content-creation conglomerate that you get, I think it's a very powerful entity to have in the market. But whether the deal will go through -- like you mentioned, Time Warner being able to keep every piece of its business, the three major segments, between Turner, HBO, and Warner Brothers -- remains to be seen. And what concessions AT&T will have to do, what do you think?
Kline: I see the plus side for AT&T shareholders. They get premium content, which is very hard to come by. If I was a Time Warner shareholder, I don't think 35% is enough. I think spinning off HBO might be worth more than that, in terms of a premium. If you are a Time Warner shareholder who is a little bit dicey about the future of the company and are looking for an exit, this might be a wonderful strategy. But if you are a buy-and-hold investor who believes that HBO and TBS and TNT and CNN and all these properties had a future ... I don't know, I don't have a lot of faith in AT&T management. I know that Jeff Bewkes said he was going to stay on for at least a year, but content is not the same as subscriptions. You can't apply the same metrics. If you're HBO, TBS, TNT, you're going to have to lose money on a certain amount of prestige programming so HBO can keep saying "It's not TV, it's HBO." That's very hard for a traditional company to swallow. I've said it since the beginning -- it makes it a very uncomfortable marriage.
Shen: Absolutely. That's a very fair point. I think anyone who's trailing either company, or both, and just following this deal in general, we'll just have to see what happens with the regulatory hurdles and how things change as that part of the process develops. But, thank you, Dan, for your thoughts. Huge deal, very interesting. That's all the time we have for today, but you can continue the conversation with us, ask any questions to the entire Industry Focus crew, at Twitter @MFIndustryFocus. You can send us any questions or comments via email, too, at [email protected]. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!
