Mar 10, 2022
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Despite an entrenched position in its industry, telecom behemoth AT&T hasn’t exactly been a market favorite. Over the past 12 months, shares have fallen 21% — a sharp contrast to the S&P 500’s 10% gain over the same period.
But according to Morgan Stanley analyst Simon Flannery, a rebound could be on the horizon due to the company’s upcoming spinoff of WarnerMedia.
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“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.
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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.
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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.
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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%.
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The downside
In the least bullish scenario, Flannery sees investors underwhelmed by the transaction and doubtful about whether AT&T can achieve its targets on deleveraging and free cash flow. Increasingly intense competition in the wireless space would also weigh on investor sentiment.
In such a scenario — Flannery gives it a 30% likelihood of happening — he sees the post-spinoff AT&T fetching a price of $16.25 per share, implying a downside of 2%.
The bottom line
Morgan Stanley isn’t the only firm with a bullish outlook on AT&T.
Barclays has maintained an overweight rating on the shares with a price target of $28 — the same as Morgan Stanley’s. UBS has a buy rating on AT&T and a price target of $32, roughly 32% above current levels.
Of course, the overall stock market is having difficulty finding upward momentum at the moment. Both the S&P 500 and the Nasdaq are in correction territory, down 12% and 18%, respectively, in 2022.
Proceed with caution.
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Jing is an investment reporter for MoneyWise. He is an avid advocate of investing for passive income. Despite the ups and downs he’s been through with the markets, Jing believes that you can generate a steadily increasing income stream by investing in high quality companies.
