AT&T has 120 billion reasons to approach Time Warner cautiously

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AT&T may be interested in a deal with media giant Time Warner, but the phone carrier’s ambitions are constrained by its hefty $120 billion debt load and its desire to keep an investment-grade credit rating.

Senior executives of AT&T and Time Warner have met in recent weeks to discuss various business strategies, including a possible merger, people familiar with the situation told Bloomberg Thursday. Time Warner shares surged 4.7 percent on the news, valuing the company at $64.5 billion.

If talks progress to a deal, the combination would remake the Dallas-based phone giant into a media colossus. But investors would be asked to swallow another heap of debt, and probably a diluted equity stake, just a year after the company borrowed to acquire DirecTV for $48.5 billion. AT&T, with the third-lowest investment-grade rating, could make a deal work without getting downgraded to junk — but it would be tough.

“AT&T generates a great deal of free cash flow, and it definitely has the capacity in the debt market,” said Dave Novosel, an analyst with Gimme Credit. “If it was done with a combination of equity and debt there’s a pretty good chance they could stay investment-grade,” based on a premium valuing Time Warner at about $70 billion, he said.

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Fletcher Cook, an AT&T spokesman, declined to comment.

The phone company, which has $7.2 billion of cash on hand, has said it will generate more than $16 billion in cash from operations this year. AT&T, which has a Baa1 credit rating from Moody’s Investors Service and a BBB+ rating from S&P Global Ratings, has said it wants to reduce its debt and return to a single-A credit rating.

Even a single-notch downgrade would raise the company’s borrowing costs and go against the company’s interests in keeping “strong market access,” said Mark Stodden, a senior credit officer at Moody’s.

“They’ve been fairly consistent in their message that they were targeting lower leverage, so we did not anticipate another megadeal,” Stodden said. “On the other hand, the company has a very low growth profile so I understand the strategic rationale.”

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A deal with a media company like Time Warner — the owner of HBO, CNN and the Warner Bros. movie studio — would help AT&T shift its business toward ownership of programming, instead of being reliant solely on video distribution. AT&T Chief Executive Officer Randall Stephenson is focusing on buying businesses to expand into media and entertainment, people familiar with the plans said earlier this month. Targets have included companies worth $2 billion to $50 billion, the people said.

For a Gadfly take on AT&T’s media ambitions, click here

The informal talks with Time Warner executives have been aimed at building relations between the companies rather than establishing the terms of a specific transaction, the people familiar with those discussions said, asking not to be identified as the deliberations are private.

Time Warner CEO Jeff Bewkes is a willing seller if he gets an offer he thinks is fair, said one of the people. Bewkes and his board rejected an $85-a-share approach in 2014 from Rupert Murdoch’s 21st Century Fox Inc., which valued Time Warner at more than $75 billion.

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Beyond financing, a deal with New York-based Time Warner has a number of other challenges.

The companies would face scrutiny from regulators in trying to combine distribution and content, Mike McCormack, an analyst with Jefferies Group LLC, said in an interview Thursday. AT&T hasn’t yet completed its integration of DirecTV, he said. And maintaining AT&T’s 5 percent dividend yield could be tough, he said.

“They’d have a couple choices with the dividend — either they bulk up the payout or they cut the dividend and explain that they are trying to become a different kind of company,” McCormack said. “The caveat there is a lot of their investors are looking for their dividends.”

“If AB InBev could get financing to acquire SABMiller, I think AT&T could get this done,” Novosel said, referring to the recent beer merger.

“Look, it would take 12 months to close the deal,” he said of AT&T and Time Warner. “That’s plenty of time to pre-fund it, raise money and put it in escrow. They are probably thinking, ‘With these interest rates, why wait?'”