Morgan Stanley says AT&T is an ‘attractive risk/reward’ tradeoff right now and could see a quick 20% pop — here's why

“We expect the early 2Q22 spinoff of shares in New Discovery (WarnerMedia & Discovery) will help unlock value for the remaining AT&T Communications business,” Flannery wrote last week in a note to investors. “We see an attractive risk/reward skew at current levels.”

Flannery has an overweight rating on AT&T shares and a pre-spinoff price target of $28 — about 20% worth of upside from current levels.

Let’s take a closer look at this call.

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The spinoff

In February, AT&T announced that it would spin off WarnerMedia in a $43 billion deal to merge its media assets with Discovery (DISCA).

AT&T shareholders would own 71% of the new Warner-Discovery company, receiving 0.24 Warner-Discovery shares for every AT&T share they own.

Management also said that it would pay a post-close annual dividend of $1.11 per share, down from the $2.08 per share it currently distributes.

Flannery points out that the new Warner-Discovery shares are currently worth about $6.75 per AT&T share, implying that the remaining AT&T business is valued at $16.78 per share at the moment. So the new dividend payout — while lower than before — will lead to a pro-forma yield of 6.6%, making the remaining AT&T company one of the highest yielders in the S&P 500.

The transaction is expected to close in Q2 of 2022.

Flannery sees the stock reacting to this transaction in three possible ways.

The upside

In the upside scenario, investors quickly gain confidence in the sustainability of AT&T’s revenue growth and free cash flow/leverage outlook, propelling the stock higher on a positive “re-rating.”

Morgan Stanley assigns a 20% possibility to this outcome, where the remaining AT&T business would command a stock price of $20 (post-spinoff), implying upside of about 14%.

The midline

Flannery’s second scenario focuses on the removal of reluctance.

Some investors might be unsure about buying AT&T shares today because they don’t want to own the new Warner-Discovery company. Income-seeking investors, for example, may only want exposure to the remaining fat-dividend-paying AT&T.

But once the transaction is complete — and management updates their outlook — we could see incremental buying from investors who were previously standing on the sidelines.

Flannery thinks the post-spinoff AT&T would trade at $18.50 per share in this midline scenario, implying roughly 7% worth of upside. He pegs this possibility at 50%.