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Why Discovery Is a Better Buy Than AT&T After the Blockbuster Merger

By Billy Duberstein - May 18, 2021 at 8:30AM

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The new tie-up is intriguing for Discovery, but disappointing for AT&T.

The streaming media and telecom worlds were shaken Monday, when AT&T (T 1.27%) announced it would be spinning off its WarnerMedia division and combining it with Discovery (DISCA) (DISCK). The new streaming behemoth will have a huge library of 200,000-plus hours of content, from Warner Bros. Studios, HBO and MBO Max, The Turner channels (TNT, TBS, CNN), as well as Discovery's comprehensive portfolio of unscripted content. And it will be available in 220 countries and 50 languages.

AT&T's shares were down 2.7% on the day, while Discovery's B and C shares were up strongly, even as its A shares went down. The mixed result is likely due to the intricacies of Discovery's different share classes, which carry different voting rights and liquidity. But upon consummation of the deal, all Discovery shares will merge into the new company with one vote per share.

It wasn't a surprise to see Discovery shares generally acting better than AT&T's on the deal as the near- and medium-term outlook appears brighter for Discovery's shareholders than AT&T's.

A globe divided into rectangular TV screens each with a different picture on them emanating light.

Image source: Getty Images.

Discovery gets the scale it desired

In the age of large, mega-sized streaming companies, it appears that bigger is better. Without the ability to invest billions in content to compete with the likes of Netflix, legacy cable companies were likely to get left behind, or at least become niche offerings without much growth. Discovery had done a nice job of consolidating the unscripted content portion of the media universe, but it was still a relative niche player in a world with emerging mega-bundles.

The new company, of which Discovery shareholders will own about 29%, should become more of a force in global streaming. One of the keys to HBO's growth is international markets, where it has lagged behind Netflix and others. However, Discovery is an expert in international content, with a presence across 220 markets, and expertise adapting its unscripted content to many other languages.

Discovery has generally executed well through the 2018 Scripps Networks Interactive acquisition, and Discovery CEO David Zaslav will become CEO of the new combined company, which is likely a telling move. After all, there has been a more chaotic revolving door over in the HBO C-suite since the merger with AT&T, with lots of turnover and restructuring.

With the steady hand of Zaslav now in command of more world-class media assets he can now deploy internationally, Discovery has gone from a small unscripted player to a scaled global behemoth across scripted, unscripted, and news content. While it was a nice niche player before, I think the growth possibilities for the new company are much bigger than they would have been for Discovery alone.

AT&T admits defeat and cuts its dividend

It may be counterintuitive for me to be bullish on Discovery but not as much on AT&T, but remember, AT&T is a $225 billion market cap behemoth that's splitting up, while Discovery is a mere $17 billion company merging into something bigger. In addition, Discovery didn't have a dividend prior to this announcement, while AT&T was a former Dividend Aristocrat that will cut its dividend in half in the wake of the deal.  

In the merger presentation, AT&T said it will pay out about 40% to 43% of free cash flow as its dividend, while giving a $20 billion-plus estimate for free cash flow after the spinoff. On 7.14 billion current shares, that's about $1.18 per share, just a little more than half the $2.18 payout today.

Closeup on a handshake between businessmen.

Image source: Getty Images.

The spinoff and dividend cut is probably the right long-term move for AT&T, as it will offload some $43 billion in debt to the new WarnerMedia company. That, plus the lower dividend, will allow AT&T to focus on building out its 5G network and its fiber footprint over the next few years. These are high-margin services that AT&T needs to get right, and where it's up against stiff competition in the telecom space. With the 5G transition in full swing, the company can't afford to be distracted with the streaming media wars, paying down debt, and maintaining the dividend all at once.

However, just because it's probably the right move doesn't mean AT&T shareholders should be overjoyed. After all, the spinoff is tantamount to an admission of error on the hugely expensive 2018 acquisition of Time Warner, which was the signature move of prior management. AT&T is also still behind competitors in 5G deployment, and is up against stiff competition in the fiber broadband space. Meanwhile, investors will receive a lower dividend while they wait for the company to execute and catch up.

How to play the transaction

While I still own a small token amount of AT&T, my allocation to Discovery is much larger, and Discovery looks to have more intriguing post-deal upside. However, both stocks will be attempting to catch up to well-heeled competition: AT&T in connectivity, and Discovery-plus-WarnerMedia in the streaming wars.

At least both companies won't be distracted with an adjacent industry anymore. That will simplify things a whole lot, both for the companies and their investors.

Billy Duberstein owns shares of AT&T, Discovery (C shares), and Netflix. His clients may own shares of the companies mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool recommends Discovery (C shares). The Motley Fool has a disclosure policy.

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