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The arbitrageur's case for AT&T, Time Warner shares

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A hurricane of criticism has engulfed the AT&T-Time Warner deal, with Wall Street mostly opposing it for the usual reasons when huge mergers are announced. The skeptics believe, first, that government regulators won’t approve it, and, second, that AT&T (T) is overpaying by a large margin for Time Warner (TWX).

Morningstar analyst Michael Hodel estimates that AT&T is paying about “$18 billion more for Time Warner than what it is worth on a stand-alone basis.” He figures that’s equal to $2.90 per AT&T share. Since he’s skeptical of the strategic benefits of combining content ownership and distribution, Hodel says he’ll likely lower his AT&T “fair value estimate” to around $35 a share, once he finishes sifting through the details.

Impact of AT&T-Time Warner merger

That’s just about where AT&T is trading now, down from $38 a few days ago when deal news emerged. A year ago, the stock was trading at around $43 on its own steam. But for the long-term investor, AT&T’s valuation has become attractive precisely because of it latest initiative to “do something.”

Even before the Time Warner deal, equity analyst Angelo Zino at CFRA Research (formerly S&P Capital IQ) had recommended AT&T as a buy. He put a price target of $46 on the shares, encouraged by what he described as “margin expansion, new integrated mobile/entertainment product offerings and strategic business services growth.”

After the deal became public, Zino became even more bullish, listing several “positives” for the phone giant’s acquisition of Time Warner that argued strongly against all the criticism it has attracted. 

“We feel that AT&T made the deal to make sure it was well-positioned ahead of the powerful shift that will see more millennials change how they watch content,” Zino pointed out. 

It will be “transformative in nature for AT&T,” said Zino, and could “further pave the way for more consolidation within the media and communication space.”

Here are three positives Zino sees:

Diversification. He believes the Time Warner acquisition offers some opportunity for AT&T to diversify away from its core business. He figures Time Warner will represent about 15 percent of the combined company’s revenues, offering new content as well as business from outside the U.S., including Latin America. The combination could lead to new growth opportunities and more expansion through “over-the-top” offerings (OTT, or TV programming delivered over the internet), the analyst noted.

Ownership of attractive content. The deal gives AT&T access to Time Warner’s media content and, more important, the ability to create new premium content that connects with the company’s pay-TV subscriber base, wireless subscribers and broadband distribution. Time Warner’s attractive brands include CNN, HBO, TNT, TBS, Warner Bros. International and Cartoon Network. Owning them will allow AT&T to become more “innovative and move much faster” when offering customers new premium content on its network.

Mobile video. AT&T will be better positioned to meet fast-changing trends in mobile video, which accounted for just over half of local mobile data traffic in 2015. But that’s expected to jump 75 percent by 2020. So Zino said it’s imperative for AT&T to expand its OTT offerings over the next decade given the rise of cord cutters (people who abandon cable in favor of OTT services), and could help accelerate a new avenue of growth. Time Warner’s storehouse of content is a big part of the answer. AT&T’s leading wireless network, combined with Time Warner’s history of content generation, offers a very compelling proposition, said the analyst.

The big negative that opponents of the deal raise is the prospective jump in leverage in AT&T’s balance sheet. Cash requirements of more than $40 billion related to the acquisition, coupled with Time Warner’s net debt position of about $22 billion, will add considerable weight to AT&T’s already hefty $126.8 billion total debt. 

And, of course, the union will need government blessing. Zino believes it will gain regulatory approval but that AT&T will need to accept a slew of conditions to ensure that it isn’t getting an unfair competitive advantage. But this is a “vertical integration,” and he noted that the regulators haven’t rejected such arrangements.

Are consumers the losers in the AT&T - Time Warner merger?

AT&T expects the deal to add to earnings in the first year after it closes, with anticipated annual cost synergies of $1 billion within three years. “We see potential of the combination to unlock a new revenue stream over time,” said Zino. After one year, the deal is expected to show net debt to adjusted EBITDA of around 2.5 times, said Zino, and he sees the deal modestly improving the dividend coverage ratio. Currently, the AT&T dividend yield is a hefty 5.12 percent.

AT&T’s stock should command a higher price as the deal’s approval becomes imminent. Here’s the strange thing about arbitrage and arbitrageurs: When a deal is rejected, the stock also attracts buyers because that means the acquiring company won’t have to add that much leverage or debt. So the stock often goes back up.

After initially rising on the announcement, shares of Time Warner are down to $88 now, from as high as $92 when the deal news leaked. But its stock is also attractively valued, precisely because of the deal with AT&T.

CFRA Research maintained its “buy” recommendation on Time Warner’s stock after the deal was announced, with a price target of $100 a share. That’s above the stock’s 52-week high of more than $94. So for the optimists, shares of Time Warner, like those of AT&T, are attractively valued because of the deal -- even though it is possible that the regulators may totally reject it. 

For the long-term investors -- rather than the savvy short-term professional traders -- shares of both AT&T and Time Warner are opportunities that should be taken advantage of as soon as possible. If you buy at their currently discounted prices, you’ll win because chances are good the deal will get approved, and the stocks will swing higher.

And if it’s rejected, they also should spring upward because of the critics’ argument that they’ll fare better as independent companies. And maybe Time Warner will receive an even sweeter offer from another company. For AT&T, the field of potential acquisitions is now unlimited, given its new role as an active and serious buyer -- and no longer just a stodgy telecom giant.   

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