There are 44 stocks in the S&P 500 currently yielding 4% or more; AT&T Inc. (NYSE:T) is one of those stocks.
While currently in the middle of trying to buy Time Warner Inc (NYSE:TWX) for $85 billion — a deal that I recently said makes AT&T stock a ticking time bomb — many, including InvestorPlace contributor Lawrence Meyers, view its 4.8% dividend yield as the major selling point for owning it.
Meyers’ argument is simple: AT&T generated $16.9 billion in free cash flow in 2016, but only paid out $11.8 billion in dividends, for an FCF payout ratio of just 69.7%. In 2017, management expects free cash flow to be approximately $18 billion. So, even if you add 1.1 billion shares of AT&T stock that will be issued to TWX shareholders, it will pay out no more than $14 billion in dividends over the next year, leaving it with $4 billion in free cash flow (not including the $3.9 billion in free cash flow Time Warner brings to the table).
If you’re an income investor, it’s hard to argue against owning T stock. However, if you’re looking for bigger returns, ask yourself if AT&T’s 4.8% dividend yield is reason enough to own AT&T stock.
I don’t think so. Here’s why.
Excessive Multiple for Time Warner
AT&T stock currently has an enterprise value of $369.8 billion or 21.9 times free cash flow; it’s looking to acquire Time Warner for 27.6 times free cash flow (enterprise value of $107.5 billion divided by $3.9 billion in free cash flow).
AT&T believes it can cut $1 billion in expenses annually with the combination, while most analysts have that pegged at only $500 million. Even if these cost savings can be achieved, it would only bring the deal multiple for Time Warner down to 21.9 times free cash flow, and that’s assuming the entire savings are tacked on to Time Warner’s free cash flow (which is unlikely to happen).
Now, consider CBS Corporation (NYSE:CBS), one of Time Warner’s peers. It currently is experiencing a very strong year, with revenue and operating profit growth in Q3 2016 across all four of its business segments. In the first nine months of 2016, its free cash flow increased 116.1% to $1.2 billion, the same amount it generated in all of 2015.
If we assume that CBS hits $2 billion in free cash flow in fiscal 2016, that would be a current multiple of 18.3 times its enterprise value of $36.6 billion, or one-third cheaper than what AT&T is offering for Time Warner.
Is Time Warner better-run than CBS? Not by a long shot.
CBS CEO Leslie Moonves is considered one of the best executives in media, and although TWX stock has done much better than CBS in recent years — a 22.5% annualized total return over the past five years, 460 basis points greater than CBS — any effort to reunite CBS with Viacom, Inc. (NASDAQ:VIA), although unlikely at this point, would come at a major premium to CBS shareholders.
AT&T Needs Content
Some investors have focused on the fact AT&T has failed miserably in its efforts to benefit from the acquisition of DIRECTV. Indications are that T overpaid for the pay-TV business and has been losing video subscribers over the past 15 months.
With AT&T needing content for its DirecTV business, it’s going after TWX at a time when video content is going for premium prices. If it doesn’t secure the $1 billion in annual savings from the merger, CEO Randall Stephenson will be sitting on some expensive assets whose future value could easily become a noose around the company’s neck.
Bottom Line on AT&T Stock
There’s a lot that can go wrong with the Time Warner acquisition. At this point, the downside potential for T stock is greater than the upside, so unless you really need the $1.96 in annual dividends, I would suggest that AT&T’s great dividend isn’t quite enough to justify owning AT&T stock at the moment.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
