Description

Recommendation: Buy AT&T (T), Short pro-rata ownership of Discovery (DISCA/K) which is 0.2360 shares of DISC for each share of T, optional short of Verizon (VZ) as a hedge. Example trade construction would be buy $100 of T, short ~$25 of DISCA, optional short of $75 of VZ.

Thesis: The T-Stub (T less DISC) is a long as the complexity of the pending spin-merge into DISC has resulted in T-Stub trading at an extremely cheap price of 5.5x EBITDA, 7x FCF, and a 6.3% dividend yield. The T-Stub or the AT&T RemainCo is a pure-play US telecom company that is 70% wireless and 30% wireline that will grow revenue LSD and EBITDA LSD/MSD. The merger is expected to be completed in the coming weeks. Over the coming months as all market participants have the opportunity to buy the T-Stub, we expect the T-stub to rerate closer to Verizon’s (VZ) valuation of 7.3x EBITDA, 11x FCF, and a 4.9% dividend yield.

Price Target: Based on historical trading multiples and accounting for a slightly higher mix of business wireline which has secular headwinds, we expect the T-Stub to rerate to a 0.5x turn discount to VZ on EBITDA and a 50 bps premium on dividend yield resulting in a target price of $22 for the T-Stub, plus $6 for the DISC shares you own results in a target price for T today of $28 or 20% upside on T, or 28% upside on the T-Stub. At the $22 target price for T-Stub it would trade at 9x FCF which for a business that doesn’t shrink seems conservative. Note that our 2023 FCF estimate is $18 b which is less than the $20 b guidance given at the time of merger announcement in May 2021.

Situation Overview: T is unwinding their 2018 acquisition of Time Warner (TWX) by spinning off the asset and merging it into Discovery (DISC). The new company will be called Warner Bros Discovery (WBD) and T shareholders will receive 0.236 shares of WBD for each 1 share of T they own. AT&T has been active in divesting other non-wireless assets (DTV, Xander, etc) in a “back to basics” or “shrink to grow” playbook centered around their US wireless business and overbuilding their wireline network with fiber. We believe the RemainCo is a stable business that can grow modestly.

Why the opportunity exists:

·       Most market participants won’t create the T-stub by shorting DISC and many market participants don’t want to own DISC so will wait until the deal closes and then buy the T RemainCo.

·       The T-stub inflicted massive P&L pain on investors in February when T management surprised the market with how the mechanics of the merger would be executed (market expected an exchange offer, instead we got a spin-off) which created technical selling pressure from non-fundamental investors that had a risk-arb trade on to play the exchange offer. Note that the T-Stub is down 10% YTD vs. VZ up 2% YTD.

Risks:

·       The US wireless industry has a large profit pool and new entrants (Cable, DISH) that could be disruptive. If competitive intensity increases and pricing (ARPU) inflects to negative the entire space is a short. This risk is mitigated by hedging with VZ.

·       T has perennially disappointed the market on growth and quality of earnings. It could trade at a cheap price for longer than we think. This risk is mitigated by the 1) all-time wide discount to VZ of 1.7x turns of EBITDA and 150 bps premium on dividend yield and 2) current 6.3% dividend yield.

Catalyst

Closing of the merger expected in April.