AT&T, Time Warner Tie The Knot, For Better Or Worse

AT&T’s (NYSE:T) acquisition of Time Warner (NYSE:TWX) , first announced in 2016 and held up by a Department of Justice antitrust lawsuit, finally saw light of day this week.

The court’s ruling was decisively and unconditionally in favor of the merger and based on the DoJ’s inability to prove resultant harm to consumers. It also included a statement to the DoJ asking it not to stay the order as it would be unjust.

Just hours after the DoJ said it wouldn’t stay the order while reserving the right to appeal, the companies announced that the deal had closed. Time Warner shareholders then became eligible to receive 1.4 shares of AT&T common stock and $53.75 in cash for each TWX share held, netting a total purchase price of $85.4 billion.

Time Warner, which will soon be renamed, saw its shares soar after the announcement, while AT&T shares swooned (before recovering some of the losses).

As far as Time Warner is concerned-

The company operates through three segments: Turner, which creates branded news, entertainment, sports and kids multi-platform content and operates 175 TV channels globally; Home Box Office (HBO), which owns and operates the HBO and Cinemax multichannel premium pay TV services; and the Warner Bros. studio, in charge of production, distribution and licensing of TV programming and feature films.

So it’s a content juggernaut with a lot of focus on TV programming, demand for which is declining, according to just about anyone crunching the data. Analysts at MoffettNathanson Research say, for example, that the total number of pay TV subscribers dropped 3.4% in the fourth quarter of 2017, which is an accelerated rate compared with 2016, when subs dropped 2% and also compared with 2015, when they dropped 1%.

Moreover, it’s estimated that approximately 13.5 million households do not pay for traditional forms of TV service currently (this includes cord-cutters and cord-nevers). Online pay TV services like Dish’s (DISH) Sling TV, AT&T’s DirecTV Now, Alphabet’s (NASDAQ:GOOGL) YouTube TV, Hulu’s live TV package and Sony’s PlayStation Vue are partly to blame, picking up 2.6 million of the total 3.3 million people that cancelled their pay TV subscriptions in 2017. Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN) constitute the more dangerous competition, as they are spending billions on content.

Time Warner is still growing, but the business is clearly on extra time, so this is a very good time to cash out.

AT&T Has BIG Problems

As the following infographic from Statista shows, AT&T saw its pay TV subscribers drop sharply in 2017.

The company is betting that it can do more with more content, but it could simply be throwing good money after bad. The main problem with pay TV is the model, which forces customers to pay for programming they don’t need as a strategy to get paid for the content that isn’t in demand. Until the Internet (as it is today), there was no competition for these companies, so customers were forced to pay. But for many people, it doesn’t make sense any more.

If AT&T is to profit from the deal, it needs to raise prices. This could be by making TWX content exclusive to its own service and charging more for it (barring HBO, which is already distributed through HBO Go and which AT&T has promoted hugely over the past year), or by charging competing networks exorbitantly for licensing the content.

Another benefit from the acquisition could be the ability to establish a connection between the consumer and the content creator, thereby helping to generate the kind of content that customers want. This has to be a relatively longer-term objective requiring AT&T to shoulder not just the huge debt that TWX is bringing, but also requiring it to continue investing in content, at least on par with the Amazons and Netflixes of today.

The court’s unconditional approval looks intended to allow the company to raise prices in the near term if required, as it gathers the data and builds the systems and tools to compete effectively with Internet players. Google and Facebook (NASDAQ:FB) for example have powerful advertising tools that allow them to dominate the market. As the competitive landscape matures, prices will automatically be competitive.

AT&T will operate Time Warner as a separate unit for now, possibly because the case can still be appealed. And this way, it can be split off easier if required.

AT&T's Advantage

The abolition of net neutrality rules has positive implications for AT&T.

In 2014, the company started offering a program called “sponsored content,” which basically means that a content provider is allowed to pay for the data the consumer is charged, thus effectively lowering the cost of the service to the consumer. But this naturally disadvantaged competitors who didn’t want to do the same.

The net neutrality rules from 2015 specifically provided that “sponsored content,” which it referred to as zero rating was not prohibited by the rules because it lowered cost for consumers. However, there was also a “general conduct” rule that prohibited "unreasonable interference," "disadvantaging" competitors.

The FCC later found that AT&T’s DirecTV Now service was priced too aggressively but Ajit Pai dismissed the case soon after taking office.

Last Word

The industry consolidation has only just started. 21^st Century Fox could go to Walt Disney (NYSE:DIS) if it can outbid Comcast (NASDAQ:CMCSA) , which already outbid Fox for a majority share of Sky. Viacom and CBS could finally follow suit. And then there will be many others. This case has opened the floodgate.

Recommendation

Both AT&T and Time Warner carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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