AT&T (T) recently agreed to acquire Time Warner (TWX), and this deal has a number of implications for dividend investors.

AT&T believes it is buying “the world’s best premium content” and now has the largest film and TV studio in the world. Assuming the deal isn’t blocked by regulators, Time Warner will represent roughly 15% of AT&T’s total revenues.

AT&T Time Warner

AT&T – Time Warner

While the strategic implications of this deal are very important, many dividend investors are wondering what it means for the safety and growth potential of AT&T’s dividend.

Shares of AT&T have sold off more than 10% over the last month, signaling some skepticism over the acquisition, and currently sport a high yield of 5.3%.

AT&T sent a positive message this past weekend when it announced a 2.1% dividend raise, marking its 33rd consecutive year of dividend increases. AT&T is one of the S&P Dividend Aristocrats (see analysis on all of the Dividend Aristocrats here).

However, with the company’s debt load set to rise even further and many of its legacy markets appearing saturated, will AT&T’s dividend remain safe in the years to follow?

Let’s quickly review the transaction before diving deeper.

Review of Time Warner and Transaction Terms

Time Warner is an iconic leader in media and entertainment and owns a great deal of content. Some of its well-known brands are CNN, HBO, TBT, TBS, Cartoon Network, and Warner Bros. Entertainment movie studio. Time Warner’s most notable franchises include Harry Potter, Big Bang Theory, and Gotham. The company also has rights to the NBA, MLB, and March Madness and a stake in Hulu.

AT&T is purchasing Time Warner with a combination of cash and stock. Time Warner shareholders will receive $107.50 per share, spilt 50/50 between cash and AT&T stock. These shareholders will receive between 1.3 and 1.437 AT&T shares, depending on the price of AT&T’s stock at closing. Time Warner shareholders will own about 15% of AT&T.

Including Time Warner’s net debt, the total purchase price AT&T is paying amounts to about $108.7 billion. The cash portion of the deal will be financed with new debt and cash on AT&T’s balance sheet.

Insights from AT&T’s Acquisition of Time Warner

In my opinion, AT&T’s bid for Time Warner is yet another signal that traditional pay-TV providers are worried about future growth.

As I noted in my thesis on AT&T in June (see my AT&T research here), DirecTV’s total U.S. subscribers grew just 1% per year from 2010 through 2015. Year-to-date, however, DirecTV has lost over 100,000 subscribers.

The rise of online streaming services caused the top six U.S. pay TV providers in aggregate to see a decline in subscribers in 2015 as well.

Other pay TV providers such as Comcast (CMCSA) have seen a slight dip in total subscribers (down 1% from 2013) but have continued to hold their ground for the most part – at least for now. However, investors remain skeptical and have kept Comcast’s stock flat since mid-2015 despite steady results and growth (see my thesis on Comcast here).

AT&T’s bid to acquire Time Warner, a content company, is further recognition that evolving consumer preferences could pose a legitimate threat to core pay TV markets over the next decade (remember that AT&T has the world’s largest pay TV subscriber base).

In theory, as the number of consumption outlets (e.g. online streaming services) for content increases, the more valuable it becomes. AT&T is betting on the continued convergence of the media and communications industries.

Here’s what AT&T’s CEO Randall Stephenson said about the deal:

“Premium content always wins. It has been true on the big screen, the TV screen and now it’s proving true on the mobile screen. We’ll have the world’s best premium content with the networks to deliver it to every screen. A big customer pain point is paying for content once but not being able to access it on any device, anywhere. Our goal is to solve that.  We intend to give customers unmatched choice, quality, value and experiences that will define the future of media and communications.

With great content, you can build truly differentiated video services, whether it’s traditional TV, OTT or mobile. Our TV, mobile and broadband distribution and direct customer relationships provide unique insights from which we can offer addressable advertising and better tailor content. It’s an integrated approach and we believe it’s the model that wins over time.”

Over 100 million customers subscribe to AT&T’s TV, mobile, and broadband services, which allows the company to offer bundled subscription packages that can hopefully be even further differentiated with the increased content flexibility provided by Time Warner.

AT&T expects $1 billion in annual cost synergies to be achieved within three years of the deal closing. Corporate and procurement expenses will be the main source of savings. Revenue synergies (e.g. bundled sales; new advertising options; launch of streaming services) are also anticipated but are not quantifiable at this time.

Essentially, AT&T hopes to become a stronger alternative to pure-play cable TV providers with Time Warner under its wings. In my opinion, AT&T primarily chased this deal because of the growth challenges it is facing in its legacy wireless and video businesses.

Regardless, this is a bold move that will impact AT&T’s long-term fate for better or worse. It could redefine the future playbook for traditional cable companies (i.e. vertically integrate with content creators for more control over content costs and distribution), or it could reveal the challenges of trying to do two very different things well at once (i.e. produce great content and maintain relevant distribution networks).

Comcast’s acquisition of NBCUniversal in 2011 remains controversial, and it will likely take a number of years to see if these content chess moves pay off in the fast-changing media world.

Let’s take a look at the potential impact of AT&T’s acquisition of Time Warner on the company’s dividend safety and growth.

How AT&T’s Time Warner Acquisition will Impact the Dividend

Using our Dividend Safety Scores, AT&T’s dividend ranked among the safest in the market prior to the Time Warner acquisition announcement.

AT&T’s non-discretionary services, excellent free cash flow generation, and reasonable free cash flow payout ratio (67% over the trailing 12 months) all supported the company’s ability to continue paying down its high debt load while continuing to make dividend payments.

Time Warner also scored well for Dividend Safety. The company’s free cash flow payout ratio (35%) is even lower than AT&T’s, and the business is also a free cash flow machine.

The biggest risk of combining the two companies, in my view, is AT&T’s increased debt burden. The company’s total debt could further balloon from $120 billion to $170 billion, and AT&T’s credit rating from S&P was the third-lowest investment grade prior to the deal.

Adding more debt raises AT&T’s annual interest expense, could result in a credit rating downgrade (raising its cost of capital), increases refinancing risk, and leaves less margin for error if industry conditions change faster than expected.

Here’s what Moody’s noted:

“The deal’s financing costs will consume the majority of acquired free cash flow due to an incremental $2.3 billion in annual dividends and $1.3 billion in additional after-tax annual interest expense.

Moody’s believes that given AT&T’s limited excess cash after dividends and modest

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