This Stock is a “Buy First” in My Premium Newsletter

At long last, the merger between AT&T (NYSE: T) and Time Warner (NYSE: TWX) has closed.

This act was completed on June 14. The telecom giant didn’t waste any time in taking control (after all, it had already waited as long as 20 months after the acquisition plan was announced on October 22, 2016).

As you remember, on June 12, just two days before the acquisition closed, a federal judge ruled in AT&T’s favor, clearing the way (with no conditions imposed) for this mega-merger.

And yes, it is indeed a mega-merger: AT&T’s cost to purchase the entertainment company was more than $100 billion (equity cost plus an assumption of debt).

There are only a few companies in the United States that could finance such an acquisition from their cash reserves. AT&T is not one of them.

The business of providing customers with telecommunication services is costly, and while it’s one of the best in generating free cash flow, AT&T’s generous dividend policy (the stock yields 6.4%) together with its capital spending leave the company with little cash on hand. For instance, at year-end 2016, just after AT&T moved to acquire Time Warner, it had about $5.7 billion of cash and equivalents on the balance sheet (a little higher than the $5.1 billion at year-end 2015, but less than the $8.6 billion it had at year-end 2014).

So, AT&T had to borrow. And the total amount of this borrowing, along with the inevitable uncertainties of the net effect of combining two different businesses, has already led to a credit rating downgrade.

On a Friday immediately following the antitrust decision, both Standard & Poor’s and Moody’s cut credit ratings on AT&T bonds to a level only two notches above the junk-debt category. All said, not counting other liabilities (such as leases and retirement obligations, estimated to be worth $50 billion), AT&T will owe about $180 billion.

On a side note, even tech giants — ones that do have massive amounts of cash on their balance sheet, such as Microsoft (Nasdaq: MSFT) or Apple (Nasdaq: AAPL) — have borrowed (sold bonds) to take advantage of the recent record-low interest rates. But I digress.

Or maybe not so much. While AT&T has had to borrow to finance the acquisition (and, essentially, its future growth), it did so at a still-low average interest rate. AT&T now has $176 billion in debt, with an average maturity of just over 12 years and an average coupon of 4.27%.

While the total amount of all this debt is a cause for at least some concern (hence the recent debt downgrade), the 4.3% average coupon — thanks to the still-low-rate environment — is not too scary.

Think about it this way: for all this debt to be helpful, not hurtful, to AT&T’s future, it has to grow its profits at a bigger than 4.3% rate.

I’m oversimplifying, of course, but it’s worth repeating: long-term revenue and profit growth are key to any company’s future. If a company is growing, it can pay back its debts, operate profitably and prosper.

And if a company is not growing — or, worse, when its business is in decline — it’s often excessive borrowing that leads to its downfall.

Let’s take as examples AT&T’s peers, smaller rural telecoms Windstream (NYSE: WIN) and Frontier Communications (NYSE: FTR). Both Windstream, which suspended its dividend in August 2017, and Frontier, have not been able to handle their snowballing debt.

Over the past decade or so, with the advent of mobile, the situation changed dramatically for rural telecoms/wireline companies. After cutting its dividend by about two-thirds, Frontier threw in the towel this February, discontinuing the dividend altogether.

But here’s the difference: both Windstream and Frontier are rural telecoms whose landline businesses suffered mightily from the advances made in the availability — and the cost to the consumer — of mobile communications.

And even when Frontier, for instance, in 2014 acquired The Southern New England Telephone Co and TNET from no other than AT&T, the more than $2 billion purchase saddled it with more debt than FTR could handle for one fundamental reason: the business that it acquired was not growing. The landline business was, after all, Frontier’s specialty.

But there’s more!

This was not the end of FTR’s landline purchases.

In a deal announced in February 2015 and completed in April 2016, FTR bought $10 billion worth of landline business from our other telecom, Verizon (NYSE: VZ). At that time, this was VZ’s largest asset sale.

And it didn’t take long from there for FTR’s overall business model to unravel: with not enough revenue and with the need to both service the debt and to pay shareholders, the dividends clearly could not be sustained.

FTR first announced a 66% dividend cut (about a year ago, in May 2017), and then, less than nine months after that, the rural telco had to stop paying dividends altogether, having announced that its dividends had been discontinued.

I don’t think this is what is likely to happen with AT&T.

Most important, the business it’s buying is a growing one.

Second, its own core, while burdened by the deteriorating landline business, is poised better than either FTR or WIN: AT&T is a major provider of mobile services, and, because it also owns DirecTV, it can compete with cable companies in the business of delivering content.

And, finally, the cost of debt is much lower than what FTR, for one, had to pay. With a much shorter maturity (of about seven years as of today), FTR’s average coupon exceeds 9%. This cost is high for nearly any economic environment.

Bottom line: has delivered a 79% gain for my subscribers and I since adding it to our Daily Paycheck portfolio — with the vast majority coming in the form of dividends. Today, it yields over 6%, and I think AT&T investors can sleep well owning it.

It’s good news for the company and its shareholders that the Time Warner acquisition has happened. For that reason, I still have it rated as a “buy first” in my premium newsletter. Whether it’s a good thing for consumers, though, is another question. We’ll know the answer soon enough.

— Genia Turanova

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Source: Street Authority