AT&T Elects Spin-off Structure for Media Separation, Reveals Post-Close Dividend in Line With Expectations

On Tuesday, AT&T provided an update on its plan to separate and combine WarnerMedia with Discovery.

Most notably, AT&T elected to structure the separation as a spin-off rather than a so-called exchange offer. This surprised some investors since management seemed to be leaning towards an exchange offer up until last week.

An exchange offer would have allowed AT&T holders to swap some, all, or none of their AT&T shares for shares of the new media company. This would provide more flexibility for investors and eliminate a meaningful portion of AT&T's beaten-down shares, but it involves additional complexity to execute.

A spin-off is more straightforward: all AT&T investors will receive a 0.24 share of the new media company – Warner Bros. Discovery (WBD) – for each AT&T share once the deal closes, expected in the second quarter of 2022.

Using a simple example, if you hold 100 shares of AT&T, you will continue to own 100 AT&T shares but also receive 24 shares of Warner Bros. Discovery when the transaction closes.

Management expects AT&T's post-close annual dividend per share to be $1.11, down 47% from the current payout of $2.08 per share but roughly in line with what we had estimated in May 2021, when the separation was first announced.

AT&T's rebased dividend, which reflects both the loss of WarnerMedia's cash flow and AT&T's need to deleverage and invest more in 5G and fiber internet, will go into effect once the transaction closes.

AT&T has historically declared its second quarter dividend at the end of March. Depending on the spin-off's timing, this could be the final $0.52 per share quarterly dividend investors receive, or management could look to implement the lower dividend amount at that time.

Based on AT&T's dividend guidance, we expect shares to yield around 6% after the spin-off executes. Our estimate accounts for the $6 to $7 decline we expect in AT&T's share price to reflect the distribution of Warner Bros. Discovery shares. (We estimate a 0.24 share of WBD will be valued at $6 to $7.)

This is a similar phenomenon to how a stock's price is expected to drop by the amount of its dividend on the ex-dividend date since new shareholders are not entitled to that payment.

Once the dust settles and the rebased dividend is in place, we anticipate upgrading AT&T's Dividend Safe Score to a Safe rating.

However, the extent of our score upgrade will depend in part on the additional financial expectations management provides for AT&T's communications business at a conference on March 11. The biggest factor we are monitoring is the company's expected pace of debt reduction.

As we discussed in May 2021, this spin-off transaction will strengthen AT&T's balance sheet by effectively shoving nearly 30% of the firm's net debt onto Warner Bros. Discovery, adding support for AT&T's BBB credit rating. 
 
With the reduced dividend consuming only 40% of AT&T's projected free cash flow, the firm will have more flexibility to reduce debt and increase network spending. Having completely exited the entertainment and streaming business, AT&T will hopefully benefit from a more focused management team, too. 

With AT&T's valuation appearing to provide a healthy margin of safety – on a post-close basis, we estimate the stock trades for less than 7x free cash flow and will sport a secure 6% dividend yield – we plan to continue holding our 1% position in AT&T in our Conservative Retirees portfolio.
 
But investors must also decide what to do with the shares of Warner Bros. Discovery they will receive as soon as next quarter. 
 
We do not expect Warner Bros. Discovery to pay a dividend – much less a meaningful dividend – for the foreseeable future.

Not only will this media giant be saddled with debt, but the fierce battle for streaming subscribers worldwide shows no signs of moderating. Remaining competitive will require substantial investment in content and global distribution for years to come.

While the combination of streaming services HBO Max and Discovery+ make Warner Bros. Discovery a very formidable rival to Netflix and Disney, this type of growth-oriented investment is not aligned with our portfolio's objectives of safe dividend income and capital preservation. 
 
If we had to guess, we will likely sell our shares of Warner Bros. Discovery and use the proceeds to buy more shares of AT&T. As always, we will send out an email prior to taking any actions, which are likely months away given the expected close date.

Overall, AT&T is nearing the finish line to painfully undo some of its major capital allocation decisions that have destroyed significant shareholder value over the past decade. 

Management has a long ways to go to restore credibility with investors, who have not responded enthusiastically to the media separation either with AT&T shares slumping over 10% since the transaction was announced last year.

However, AT&T's remaining business will be driven by wireless and internet services, which fulfill essential needs and maintain high barriers to entry due to their capital intensity. 

With a large subscriber base in place, a strengthening balance sheet, and more cash flow flexibility with a right-sized dividend, AT&T seems likely to remain relevant for many years, albeit with a slow but defensive growth profile.

We will continue monitoring the media spin-off and provide updates as needed.

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