While the combined AT&T Inc./Time Warner Inc. will benefit from new revenue opportunities, its heavy debt load and shrinking EBITDA across multiple business segments limit the company's financial flexibility, analysts said as the deal came to a close.
The newly merged entity has $180.4 billion in net debt, AT&T said June 14, well above the debt totals for any other major competitor in the wireless and pay TV markets. U.S. wireless leader Verizon Communications Inc., for instance, ended the first three months of 2018 with net debt of $117.13 billion, while leading cable operator Comcast Corp. ended the period with net debt of $60.69 billion.
In addition to the debt, the combination of AT&T and Time Warner will generate a massive amount of revenue and EBITDA, with the company estimating a net-debt-to-adjusted-EBITDA ratio of 2.9x at close, which is more in line with its peers. However, analysts note that both AT&T's and Time Warner's EBITDA totals have been moving in a negative direction in recent quarters as the pay TV business continues to experience a secular shift toward more over-the-top options.
MoffettNathanson analyst Craig Moffett said in a research report prior to deal close that there is no doubt the purchase of Time Warner is a positive for AT&T's income statement but a negative for the company's balance sheet.
Adding in operating leases and post-retirement obligations to the combined entity's debt load, Moffett calculated "an astounding $249B of debt." If the combined entity were a country, "It would place 32nd on the list of highest total debt burdens" between Indonesia and the United Arab Emirates, he noted.
Part of Moffett's concern is that AT&T will have to service that debt and support its overall leverage ratio at a time when its EBITDA is shrinking, both on an organic basis and with Time Warner included. AT&T recorded recurring EBITDA of $12.32 billion in the first quarter of 2018, down 1.6% from $12.52 billion in the prior-year period. Contributing to the overall decline was a year-over-year drop in EBITDA at AT&T's entertainment segment, where customers continue to move away from traditional video offerings like DIRECTV's satellite service and instead embrace lower-cost, over-the-top offerings such as DIRECTV NOW.
Moffett said that by enabling customers to switch to cheaper OTT offerings and providing bundled pricing deals, some of AT&T's EBITDA troubles are "self-inflicted." But he added, "None of the pressures on AT&T's portfolio of businesses are likely to get better."
Moody's also noted the strain the deal will put on AT&T's balance sheet. "The deal's financing costs will consume the majority of acquired free cash flow due to incremental annual dividends and interest expense on acquisition-related debt," the rating agency said June 13.
Looking forward, Moody's said AT&T's "limited excess cash after dividends" and "modest EBITDA growth potential" will limit its ability to reduce its leverage ratio after the deal, though the rating firm noted, "Asset sales could accelerate this trajectory, including segments of AT&T or Time Warner."
Elizabeth Lim, a senior analyst with the M&A data provider Mergermarket, said AT&T has one distinct advantage when it comes to the financing for its Time Warner deal — the timing.
"They set up their financing at a time when interest rates have been historically low. So they are getting this done before interest rates go up more," Lim said in an interview.
AT&T's June 12 antitrust victory came one day before the U.S. Federal Open Market Committee on June 13 set a target range for the federal funds rate of 1.75% to 2%, up 25 basis points from the previous level. The central bank also signaled it may take a faster path on rate hikes this year.
Over the long term, Lim said if rates continue to rise as expected, they could serve as a limiting factor for future M&A.
In the meantime, the media and communications sectors are seeing a flurry of deals. Comcast on June 13 made a formal $65 billion cash offer for key 21st Century Fox Inc. assets, challenging the $52.4 billion all-stock deal Fox previously struck with Walt Disney Co. for the same holdings. Comcast CFO Michael Cavanagh told analysts during a June 13 conference call, "We obviously have a very strong balance sheet and have the ability to finance the transaction. Our work on this front is well advanced. And as a result, our proposal is not subject to a financing condition."
Moreover, Sprint Corp. and T-Mobile US Inc. are in the midst of a proposed merger. The stock transaction represents a total implied enterprise value of $59 billion for Sprint and $146 billion for the combined company.
While a number of these transactions are based on stock and therefore would have a more limited impact on companies' balance sheets, Moffett said during a recent conference call that he would like to see the biggest players across the media and communications sector focus on delevering. "The balance sheets of these companies are rather precarious positions for an economic downturn," he said, pointing to the leverage ratios of the major cable and wireless operators. "These companies will have to delever ahead of the next cycle or they will be in real duress if they don't," he added.