Discovery deal announcement ends AT&T’s designs on a vertically integrated media and distribution empire. It unravels years of deal-making under the leadership of former CEO Randall Stephenson less than a year after his retirement. This deal follows the $16 billion spin-off in February of AT&T’s video distribution assets, including DirecTV, U-Verse video, and streaming service AT&T TV. These deals mark a return to the company’s historical focus on connectivity at a time when the current 5G capex cycle is ramping up.
Under the terms of the deal, AT&T will spin off its WarnerMedia division, including HBO, Warner Brothers Studios, and the Turner Networks (including TBS, TNT, and CNN), and combine them with Discovery in a deal that will allow AT&T to recover $43 billion in cash and debt.
ATT’s Cash Quandary
AT&T found itself capital-constrained after multiple investment initiatives during the Randall Stephenson era, particularly in the areas of content and distribution. On the content side, WarnerMedia is engaged in an arms race against Disney, which is expected to ramp its spending to $14-16 billion by 2024, and Netflix, which expects to spend more than $17 billion in 2021 alone. On the distribution side, AT&T has committed billions of dollars in several recent FCC spectrum auctions, including $27.4 billion early in 2021 to acquire 3.7 GHz mid-band spectrum. The result: a balance sheet that swelled to make AT&T the world’s most indebted industrial company with over $209 billion of debt and net leverage of 3.6x. AT&T’s balance sheet asset growth is shown in Figure 1 below.
Figure 1: AT&T Assets
Recently, the market has soured on the prospects for the company’s substantial $15 billion dividend payment, and, voting with their feet; investors sold the stock down to yield above 7% (~5% more than treasuries) for much of this year.
AT&T Remains Spectrum Constrained Despite Heavy Spending
Despite spending $27.4 billion in Auction 105, the C-band auction of 3.7 GHz spectrum licenses, AT&T remains disadvantaged relative to peers with much larger mid-band portfolios crucial for developing 5G networks. As shown in Figure 2 below, post-Auction 105, AT&T has 195 MHz of sub 6 GHz spectrum, significantly less than the 342 MHz and 326 MHz held by T-Mobile and Verizon, respectively.
Figure 2: Sub-6 GHz Spectrum holdings before and after Auction 105
Auction 107, another mid-band spectrum auction scheduled for later this year, provides a partial opportunity for AT&T to close its spectrum gap. Should the prices established for mid-band spectrum in this year’s C-band auction prove durable, the 100 MHz of 3.45 GHz available in Auction 107 could cost the wireless industry another $34 billion.
5G Transition is Expensive
In addition to acquiring additional spectrum, constructing a 5G network will require carriers to significantly densify their networks (more radios in more locations) as well as add lots of connecting fiber. In concert with today’s Discovery announcement, AT&T committed to incremental capital investment to cover 200 million people with their newly acquired C-band spectrum by year-end 2023. AT&T also announced an expansion of its fiber network to cover an additional 30 million households by 2025. Post-spin, management expects AT&T’s annual capex to swell to $24 billion from a pre-spin 3-year average rate of $18 billion.
Growth in total wireless capex (network and spectrum) is not surprising. New spectrum acquisitions allow a wireless carrier to avoid some of the network capex that the carrier would otherwise have spent densifying the network. The surprisingly high prices paid for mid-band spectrum in the recent CBRS and C-band auctions more than offset network capex savings based on historic costs and are, in part, an indication of the growing cost to construct denser 5G networks than prior generations of wireless networks.
The Discovery deal provided AT&T with cover to cut the dividend to $8.0-8.6 billion, paying out approximately 40% of free cash despite the upsized investment in its network. Management guided net leverage to decline over time to below 2.5x net debt to adjusted EBITDA, at which time the board will consider share repurchases. Future sales of other non-core assets (e.g., LatAm DBS video service Vrio) are possible in the future.
AT&T’s Renewed Focus on Core Connectivity Frees Resources
Today’s spin-off and merger announcement give Discovery improved scale and diversity of content that compares more favorably to its global streaming competitors. Simultaneously, the announcement liberates AT&T from its looming capital constraints. This new focus on AT&T’s core connectivity business is a welcome development, particularly for the wireless business that is investing in a developing 5G cycle that is shaping up to be more competitive than in years past.
 See: https://about.att.com/story/2021/warnermedia_discovery.html
 Excluding OPEB liabilities of $15 billion
 Including spectrum clearing costs.