Thursday, May 19 2022

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The time to consider investing in large companies is when everyone is so angry at the company that they race each other into dumping the dog. AT&T (T) is in that situation right now because they announced a dividend cut. That announcement caps a few years of perceived underperformance. So the cries of “dog” and “barking” are heard from a lot of disgruntled investors. That means it is time for a contrarian investing research project.

Whether or not investors should have seen it coming is “water over the dam”. The way to make money is to incorporate past behavior into the future. For me, all the reasons (including the dividend cut and the deal with Discovery) for disgruntled shareholders are part of the forward story only as it gives the company more money to repay debt after the proposed deal with Discovery (DISCB).

I am a firm believer in diversification because like everyone else, things happen to my portfolio I sometimes do not expect. In this case I expect a successful deal close and that dividend to be back one way or another from the two pieces I will own after the deal closes. In the meantime, I was not so dependent upon the dividend that a cut was going to cause me major financial pain. That is really the key to investing. You need to protect yourself from the unexpected by either watching your investments very closely (AND) or by diversifying to the point where the unexpected will not materially affect your financial position.

The post spinoff dividend of $1.11 is a starting point. Between AT&T and Discovery, there will be enough debt progress made that the two parts combined should exceed the total return of AT&T prior to the Discovery deal close. Spinoffs tend to have a very good post-deal history. There is no reason why this particular spinoff should be an exception.

AT&T stock price history and key valuation measures.

AT&T common stock price history and key valuation measures. (Seeking Alpha Website February 11, 2022)

The key idea would be that somehow Mr. Market figures that a rearrangement that puts subsidiaries with companies that know what to do with those subsidiaries has now made the company worth significantly less in the eyes of the market. The question really should be about management’s ability to right the ship after several years of market disappointing results as shown by the stock price action above.

Most likely it is the rush to the exit of income dependent investors that is currently depressing the stock price because this stock no longer fits the income story. With a large company like AT&T, that rush out the door could take a while. Like anything else the market does, the rush to sell usually proceeds with such haste that it gets overdone (just like the euphoria when certain ill-advised acquisitions are made). Fortunately, when the large shareholders sell, they often come back because many large funds have a limited universe of choices. Large funds often cannot invest in smaller companies because there is not enough of those smaller companies to make a material difference.

Meanwhile, a company like AT&T usually has enough staying power to more than survive any perceived mistakes. The company has a lot of assets to draw upon. As long as management firmly focuses on shaping up the remaining businesses, then investors who happened to hang around until now have a very good chance to recoup their losses and probably more. It is part of the expectations of the debt ratings that this company has at the current time.

AT&T Post Transaction Focus

AT&T Post Transaction Focus (Discovery and AT&T Merger Presentation May 2021.)

Many times, there is a market reaction that the company treated the investor badly, so “why should I believe them now?” The main reason is that managements are not infallible so investors should definitely do their own independent research. But one error that really hurts is not a reason for management to continuously go wrong forever into the future. Instead, it is very likely that management is under pressure to be accurate and produce results after something as traumatic as a dividend cut to income investors.

The other thing is that large companies tend to move very slowly due to the sheer logistics of change. Mr. Market, on the other hand, wants results “yesterday”. Therefore, Mr. Market is likely to be very frustrated over the last several years first because of a perceived mistake or two followed by years of frustrating results. The good news for contrarian investors is that the stock usually ends up in the doghouse just before better results are about to be reported.

AT&T Fourth Quarter Free Cash Flow Schedule February 2022.

AT&T Fourth Quarter Free Cash Flow Schedule February 2022. (AT&T Supplemental Schedules Of Operations Results Fourth Quarter 2021.)

One of the signs that management is already at work improving the situation is the fourth quarter growth of both cash flow and free cash flow. Despite some spinoffs and other moves to refocus the company, it appears the basic operations are growing to the point where they are beginning to overcome negative comparisons.

This analysis may get a little complicated after the completion of the deal with Discovery. But the move of the appropriate subsidiaries to Discovery appears to place those businesses with a management that knows “what to do with them” while generating some cash for AT&T. The following spinoff should allow management to concentrate on what it knows best.

Summary Of Discovery Financial Strategy After The Merger With Warner Media

Summary Of Discovery Financial Strategy After The Merger With Warner Media (AT&T and Discovery Joint Presentation May 2021.)

In the meantime, Discovery is looking to rapidly deleverage. Some ambitious savings are presented as a benefit of this combination along with an expected financial position over the next few years. There is always a risk with larger combinations like this one because the combination logistics can be challenging. Then again, management usually presents a conservative picture so that they have a decent chance of exceeding the original goals given to the public while minimizing the chances of underperformance.

Of course, all of this changes the investment strategy from income to a recovery story where new investors receive appreciation from that anticipated recovery. In return for the announced dividend cut, both of the companies will be focusing upon growth (debt repayment as well) and hence greater future profitability. Investors now have two chances after the deal closes for increased income and appreciation. At some point, Discovery is likely to initiate a dividend.

In the meantime, AT&T will likely continue the history of increasing the dividend on a regular basis. But this time those increases will be with far more relative (hopefully safer) cash flow backing up the increases. The days of mega acquisitions for AT&T appear to be over. Instead, there appears to be a return to the safety conscience management that marked this company in years past.

Mr. Market will of course demand a track record from both companies in the form they will be after the deal closes. But neither management (Discovery nor AT&T) appears to have to do anything extraordinary to restore the confidence of the market. Both pieces are likely to do very well in the future for a combined return that probably exceeds a decade of AT&T returns.

What happens after the recovery period will depend upon each management. Discovery will be the smaller company. Therefore, that part of the closed deal will likely offer more opportunities for significant future growth. Whereas AT&T will remain a very large company after the deal closes. So AT&T is likely to return to an income play at some point in the future with growth remaining in the low single digits.

Clearly the current situation will carry more risk and less income than income investors are used to. However, the additional risk is not all that great because the financial strength of both is very reasonable. The chance for some relatively lower risk capital gains from these two companies is alluring for investors willing to shoulder some risk. The financial risk in both companies appears to decline rapidly. But any projection is just that, a projection. Results can vary materially and that is the risk. I tend not to get angry with managements that make a mistake because the post mistake period is often a chance for outsized profits. That appears to be the case this time around.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.


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