We added AT&T (T) to Northlake’s portfolio of individual stocks.  Not all clients use individual stocks as part of their strategy, and a few that do may not have purchased T due to unique client constraints.  In most cases, the purchase was financed by cash reserves in client accounts. 

T is a low-risk, moderate-reward way to earn a solid return over the next 12-18 months which makes it especially attractive against cash reserves that most likely will continue to earn well under 1%.  The current yield from AT&T’s dividend is over 7%.  We expect this dividend to be paid three more times at 52 cents per quarter before the company closes the merger of its Warner Media segment into Discovery Communications.  The new dividend will be 29 cents per quarter.  Based on our analysis, the implied yield post the Warner Media merger is a still very healthy 5.5%.

What has Changed at AT&T?

For many years, Northlake has had a negative opinion toward T as the company made a series of acquisitions outside of its core wireless and broadband connectivity businesses.  The largest acquisitions were DirecTV and Time Warner.  The idea behind the acquisition strategy was to increase the attractiveness of wireless and broadband services by adding content that could be packaged into attractive bundles.  We disliked the acquisitions from their announcement given (1) T’s poor history of diversification, (2) the timing of the acquisitions against secular challenges to the video business, and (3) the massive debt that was issued to finance the purchases.

So, what has changed that shifted our opinion on T from sell to buy?  New management took over in April 2020 and immediately looked to sell assets and pay down debt.  DirecTV was first to go along with many smaller businesses including international and advertising.  These were good first steps, but we were still not enamored of the Time Warner acquisition (subsequently renamed Warner Media).  When T and Discovery surprised virtually everyone in May with the merger announcement, our view of T began to shift.  Time Warner had been acquired just a few years ago in a massive, company-defining acquisition.  The willingness of new T management to realize its error and act aggressively to shift course is a major feather in their cap.  We have been managing money since 1982 and can think of few strategy changes of this magnitude coming so quickly after they were initiated. 

Thoughts About the Merger

We also were intrigued by the structure of the merger of Warner Media into Discovery (Discovery’s current stock reflects the post-merger company).  We have long held a favorable view of Discovery and once owned it for several years across the Northlake client base.  The company has had a unique strategy of focusing on non-fiction programming including the Discovery Channel, TLC, Animal Planet, HGTV, and the Food Network.  Non-fiction programming has been insulated from the secular changes in TV caused by streaming.  Discovery is backed by John Malone, one of our favorite billionaire investors.  Malone has a fantastic record of creating value in cable, media, and entertainment businesses.  In the current deal, he is giving up his voting and control shares at no premium, a huge endorsement of the deal by one of the world’s best investors.

The merger should close by the middle of 2022 after a regulatory review.  At that time, T shareholders will receive 70% ownership of the newly created Warner Brothers Discovery.  Discovery’s excellent management team will be in complete control, led by long-time media executive David Zaslav.  The idea behind the merger is to create a streaming giant that can rival Netflix and Disney by combining Discovery’s non-fiction content with Warner’s  HBO, HBO Max, and Turner networks (TNT, TBS, CNN, Cartoon).  Warner also brings the world’s #2 movie studio and #1 TV studio as content creation engines.  Put together, the two companies can better soften the decline in linear television and more effectively compete in streaming television.

Success in streaming is critical for traditional media. It has become clear that global scale is required.  Warner Brothers Discovery has the global reach and broad content to be a winner.  The new company also offers significant free cash flow to pay down debt incurred in the acquisition and finance the heavy content spending required to compete against Netflix and Disney as well as Amazon, Apple, Facebook, and Google.

Initially, T and Discovery shares rose sharply on the merger announcement.  However, both stocks have drifted lower and sit 15-20% below their pre-merger levels.  Investors are concerned about initial elevated debt levels, the risks of a one-year delay due to regulatory approval in a rapidly shifting media landscape, the possibility that T shareholders will sell the Discovery shares they receive, and the cut in T’s dividend after the merger closes.  We believe all these factors are well understood and implied in the stock prices of T and Discovery.

Target Price and Sum of the Parts

T currently trades around $28.  We see upside to $36 over the next 12-18 months.  In addition, we expect T shareholders to receive $2.43 in dividends over the next six quarters.  The total return potential is 37% composed of new T shares, Warner Brothers Discovery shares, and dividends.

New T will be a pureplay on connectivity with a leading wireless business and smaller — but fast growing — broadband business.  T has shown improved performance in both these business segments over the past several quarters.  We believe execution has improved thanks to the focus management can now bring to the business post the divestitures and debt paydown.  Given its recent history of strategic errors, we believe new T will start off trading at a discount to its closest peer, Verizon.  Verizon trades at a dividend yield of about 4.5%.  We believe new T shares should start trading at 5.5% yield.  This equates to about $21 per share.  We expect several more quarters of improved execution from T will allow the stock to move closer to Verizon’s valuation.  At a 5% yield, T shares would trade at $23.  If T can ultimately achieve valuation parity with Verizon, a reasonable possibility in our opinion, T shares would trade to $25. 

Our target for Warner Brothers Discovery is $40 vs. a current Discovery price of just under $28.  We base our Warner Brothers Discovery (the current Discovery stock represents the soon to be merged company) target on the valuation of the company’s traditional media businesses and a per-subscriber value for its streaming business.  T shareholders will own 70% of Warner Brothers Discovery, which works out to about $11 per share at our target.  At Discovery’s current price, T shareholders have $7 in value.

Thus, we see a range for T from the current $28 to as much as $36 at our targets for both stocks.  The $2.43 in dividends to be paid over the next 6 quarters adds material incremental value and provides downside protection if the stock market or company fundamentals falter.  The risk-reward profile skews favorably and is the key reason T is now part of the Northlake’s individual stock portfolio.

T is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.