Staff Analysis

Executive Summary

This staff analysis examines the proposed AT&T/Time Warner merger by focusing on

potential operational cost synergies through combining content production and distribution to

reduce transaction costs and enhance collaboration. The strategic rationale includes addressing

challenges in AT&T's traditional revenue segments and adapting to changing consumer behavior

by acquiring Time Warner's content production expertise. The financing structure appears

manageable, constituting a short-term bridge loan, cash, and a significant portion paid in AT&T

stock. However, the discounted cash flow analysis suggests that the $108.7B purchase price may

be on the higher end of analysis, leading to concerns about overpayment and limited return on

invested capital. The sensitivity analysis reinforces these concerns, indicating vulnerability in

proposed price to changes in key variables. The analysis recommends against the investment,

advising Frank to explore alternative opportunities while considering the potential negative

impact of antitrust regulations on stock price volatility.

Discussion and Analysis

Competitive rationale for the AT&T/Time Warner merger

The competitive rationale for the merger between AT&T and Time Warner is to generate

operational cost synergies by reducing costs, fostering collaboration between content production

and distribution, and strategically addressing challenges in the evolving entertainment industry

by combining AT&T's distribution strength with Time Warner's content production expertise.

This vertical merger will create operational cost synergies for both AT&T and Time Warner. A

synergy is defined as the incremental cash flow that the merger generates on top of combining

both companies’ original streams of cash flow. Traditionally in telecommunications, there is a

transaction cost between content production companies and content distribution companies. This

means that for Time Warner to distribute their products, they must pay a portion of their profit to

AT&T and vice versa. By merging together, this will reduce incremental transaction costs for
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both companies. It will also lower other soft operational costs such as communication and

coordination costs between the two companies as both personnels can directly work together

when working on important projects.

Secondly, this merger will also create strategic expansion of both company’s comparative

advantage and produce market power. AT&T has always been a market leader in broadband and

satellite TV services. The entertainment and internet services component represents the second

largest revenue segment. generating $11,957M in EBITDA each year (AT&T and Time Warner

Merger Case, Exhibit 1). However, as the advent of the internet and accessible home streaming

services transformed consumer behavior, subscription to antiquated cable TV services decreased

across the nation. This brought challenges to AT&T’s existing strength in broadband and satellite

TV services. As such, to rapidly and effectively adapt to changing consumer behavior, AT&T

must look into acquisitions of companies with key expertise in this area. Specifically, it should

invest in a company that produces digital content so AT&T can “gain more advertising income

and subscription revenue” without cannibalizing AT&T’s existing telecom services (p. 5). On

the other hand, for Time Warner, this move represented strategic development as Time Warner’s

strength is in content production, which AT&T lacks. Its largest revenue segment, Warner Bros,

produces “movies, television, video games” and generates $2,081M in EBITDA each year (p. 4).

However, since the failed acquisition of AOL, an internet service provider, Time Warner has lost

the opportunity to expand and take market share in the internet distribution space. By merging

with AT&T, Time Warner will regain market power position with AT&T’s existing strength as

market leader in the distribution field.

I initially thought this was a good opportunity because in addition to the numerous

synergy benefits by acquiring Time Warner mentioned above, AT&T will be able to finance this

$107.8B with medium disturbance on their balance sheet. While AT&T will be taking on a short-

term bridge loan of $40B from both JPMorgan Chase & Co. and Bank of America Merrill
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Lynch. AT&T is capable of supporting this as AT&T’s total EBITDA in 2016 alone across all of

its business segments is $52B (Exhibit 1). This implies that they will be able to easily pay off

their debt or recapitalize later on. Additionally, since half of Time Warner’s price is paid in

AT&T’s stock, this will also be beneficial to AT&T’s shareholders as Time Warner’s

shareholders now participate in AT&T's equity if this merger is completed. Time Warner’s

shareholders will have a vested interest in AT&T and Time Warner’s joint performance and

would therefore be inclined to help both companies perform well. If AT&T could acquire Time

Warner, AT&T would have effectively bought a market leader that expands on its current

opportunity set while covering their weakness in content production.

Time Warner Share Price Valuation and Sensitivity Analysis

To value Time Warner’s equity price, a discounted cash flow (DCF) analysis is

employed. A DCF analysis begins by projecting Time Warner’s future free cash flow in the five-

year period using Frank’s conservative assumption of 7% future growth rate and assumptions

from Exhibit 8 for first year free cash flow (p. 6). Then, at the end of the five years, Time

Warner’s terminal value is calculated in the following three approaches: 1) Perpetuity growth, 2)

Exit Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) multiple by

combining Time Warner’s individual business divisions together, and 3) Exit EBITDA multiple

by using precedent transaction. To provide further detail analysis in the exit multiple approach,

both mean and median value is used from the comparable companies set for both of the exit

multiple approaches. Out of all the methods, the mean exit EBITDA multiple by using precedent

transaction yielded the highest present value of terminal price of $93.7B while the mean exit

EBITDA multiple by combining individual divisions together yielded the lowest present value of

terminal price of $40.1B. This is possibly because one of the precedent transactions,

Dreamworks acquisition of Comcast at 32.2x EBITDA multiple, skewed the average EBITDA

multiples for all precedent transactions (Exhibit B). If Frank is considering a conservative
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market-based valuation of Time Warner, the exit EBITDA multiple approach combining Time

Warner’s individual division provides the best valuation as it breaks down all of Time Warner’s

different segments into individual, specific rates. However, if Frank is considering the potential

AT&T is willing to pay a premium to Time Warner because it seeks strategic expansion, then

she should use the precedent transaction approach in valuing Time Warners as these are based

off of past companies who approached acquisition in a similar manner. Lastly, if Frank is

considering an intrinsic picture of Time Warner’s value uninfluenced by market factors, then the

perpetuity growth method would be the best approach.

After both the terminal value and cash flow has been projected, it is important to discount

both of this amount to the present value to determine how much Time Warner is worth today.

The discount factor is calculated by taking Time Warner’s weighted average cost of capital

(WACC) utilizing the assumptions from Exhibit 8, which yielded approximately 9.8%. This will

be used to discount Time Warner’s terminal value and future cash flow to arrive at Time

Warner’s total enterprise value today. Furthermore, since Uria Investments is an equity investor

in AT&T, it is important to calculate the precise equity value to use as comparison for the

financial analysis. Time Warner will take the total enterprise value and deduct debt, cash and

marketable securities, minority interest, and preferred stock to calculate the equity value for each

valuation approach. Then, each equity value will be divided by the 781 average basic common

shares outstanding for common shareholders to arrive at the share price (Exhibit A).

Lastly, a sensitivity analysis is conducted for the following key variables: terminal

growth rate, WACC, EBITDA multiple, and free cash flow growth rate to further analyze all the

potential output in share price. The following conclusion is derived (Exhibit D):

1. WACC - As the WACC increases, the share price decreases because the discount rate is larger,

thereby reducing the cash flow at a greater rate.

2. Terminal Growth Rate - When the terminal growth rate increases, the share price increases

because Time Warner’s free cash flow after the projection period will grow at a higher rate.

3. EBITDA Multiple - When EBITDA multiple increases, the share price increases because Time

Warner’s terminal EBITDA is multiplied by a higher rate, thereby giving a greater value.

4. Free Cash Flow Growth Rate - As the free cash flow growth rate increases, the share price

increases as well because this results in an overall higher free cash flow projection and

terminal cash flow, which is used in terminal value calculations.

Recommendation:

The $108.7B purchase price proposed by AT&T to Time Warner is not a fair price based

on my discounted cash flow analysis, it is leaning towards the higher end of all potential

purchase prices. As such, Frank should not invest in AT&T anymore and allocate funds

elsewhere to generate a higher return for her investors. From Exhibit A, AT&T’s share purchase

price of $107 is second highest only to the mean exit multiple of all precedent transactions at

$116 (Exhibit A). The other potential share purchase price is much lower than AT&T’s purchase

price by $23 - $59 per share (Exhibit A). This analysis implies that AT&T is overpaying Time

Warner by a great amount when considering the total purchase price. The sensitivity analysis

also corroborates this as any slight changes in WACC, EBITDA Multiple, terminal growth rate,

and free cash flow growth rate results in a share price that is lower than AT&T’s current price.

This would be problematic for Frank’s portfolio if reality does not meet her assumptions

perfectly.

Additionally, while AT&T/Time Warner’s purchase EBITDA multiple of 12.4x appears

to be in-line with precedent transaction for most other companies of 10.9-32.0x (Exhibit B),

AT&T has a significantly larger purchase price of $108.7B compared to other companies of

around $3.9-$4.0B (Exhibit C). Since AT&T is paying out a greater total amount today, AT&T

should be given a discount in EBITDA multiple from Time Warner in order to justify
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the.purchase. However, AT&T is still paying out an EBITDA multiple purchase in-line with

other much smaller deals that affects the acquirer’s company’s balance sheet a lot less. As such,

AT&T is paying an unfair price to Time Warner.

Lastly, according to Forbes magazine, “the return on invested capital (ROIC) would be

4.7 per cent, marginally improving AT&T’s current ROIC of 4.6%” (p. 6). This implies that the

synergy for ROIC is only 1%, which is a very meager amount of increase in ROIC considering

that the deal size is so large. This makes AT&T’s acquisition price highly unattractive to its

existing shareholders as they are getting small marginal benefits while experiencing very large

changes in AT&T’s financial structure. As an equity investor, Uria Investment should also

consider the antitrust regulations that may hinder the acquisition process. Since both AT&T and

Time Warner are national companies with market leader dominance, antitrust regulators may

view their merger negatively as a way to monopolize the entire telecommunications and

entertainment industry. This could lead to negative fluctuations and high volatility in AT&T’s

stock price in the near term, which affects Uria Investments portfolio. Uria Investment should be

cautious in its current fund allocation.

The proposed $108.7B purchase price for the AT&T/Time Warner merger is deemed

unfair based on discounted cash flow analysis, which suggests that AT&T is overpaying. This

staff analysis recommends against investment due to potential negative impacts on returns, high

acquisition cost compared to industry standards, a minimal increase in return on invested capital

(ROIC), and the risk of antitrust regulations affecting stock price volatility in Uria Investment's

portfolio.
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