With the smaller firm trying to acquire the big one, a lot of debt will be involved in any potential deal. The significant debt position, which will exceed $60 billion in the most optimistic scenario, creates quite some leverage risk. I will discuss this in further detail later in the article.
Note that Time Warner is losing customers at a pace of over 2,200 customers per calendar day. Time Warner Cable lost 825,000 customers over the past year, as the business model for the future remains unsure with the competitive landscape continuing to change.
On Monday, Time Warner Cable's board of directors rejected a "grossly inadequate" proposal from Charter Communications. In the letter received by the board, Charter made an offer in the "low $130s". Time Warner stated that it learned from Bloomberg that the offer was pegged at $132.50 per share, consisting out of $83 per share in cash and the remainder of $49.50 in Charter's stock.
Charter has been targeting Time Warner Cable before. In June of 2013 it offered roughly $114 per share for the company, followed by a higher offer of $127 per share in October of last year.
For the entire timeline of the deal, see the following illustration:
Time Warner Continues To See Undervaluation
Rob Marcus which is CEO and Chairman of Time Warner Cable believes the latest proposal is a non-starter, undervaluing the company at roughly 7 times EBITDA. This multiple is below that being paid in other transactions in the cable sector. The quality assets, scale, synergies and growth potential should command a premium compared to other deals according to Marcus, and not a discount.
Marcus is not happy with the valuation and deal structure, with a huge portion being in the form of Charter's stock. This creates additional risks, especially given the leverage on Charter's balance sheet following the deal.
Marcus notes the board is open to a transaction with Charter if it were to offer around $160 per share. Such a deal would furthermore need to consist out of $100 per share in cash and the remainder in Charter's common stock. Such a deal would value the company at round 8 times EBITDA.
Back in December of last year, Time Warner appointed Christian Lee as Vice President for mergers & acquisitions.
Focused On Growth
Since the separation from the parent company Time Warner (TWX) in 2009, Time Warner Cable spend some $15 billion to boost growth, expand offerings and offer faster and higher quality solutions for its clients.
For the first nine months of 2013, Time Warner Cable generated revenues of $16.5 billion, which is up 4.0% on the year before. Operating income was up by a similar percentage to $3.41 billion, with adjusted earnings coming in at $4.80 per share.
Video and voice remains under pressure, while high speed data revenues are increasing. Video, which still makes up half of total revenues, saw a 3.5% decline in revenues for the period. Voice offerings make up another 10% of revenues, as revenues fell by 2.7%. The high speed data solutions, making up a quarter of total revenues, saw revenues increase by 14.6%.
At this pace, annual revenues are seen just above $22 billion with earnings seen around $2 billion. While these numbers are impressive, the company operates with roughly $25 billion in debt, while holding just roughly $1 billion in cash and equivalents.
Is Time Warner Asking Too Much?
Shares of Time Warner Cable are currently trading at $135 per share, valuing the business at $39 billion. Including the net debt position of $24 billion, the business is valued at $63 billion.
This is quite a high valuation for the business. Note that shares of the business have seen very strong returns, increasing from levels around $30 in 2009 to current highs in their $130s. Shares of Charter Communications have seen similar returns, as investors have not penalized the firm for trying to acquire Time Warner Cable.
The Small Company Is Hunting Big
Charter Communications with some 4.2 million customers, is targeting to acquire 12 million video customers and assets in major cities. The new combination would have some 16 million customers, making it the third largest provider of cable in the US behind Comcast (CMCSA), among others. As such, Time Warner Cable is much greater, yet Charter boosts that it is more productive. Charter is growing its customer base while Time Warner Cable saw 825,000 customer defections in 2013.
Combined, both companies are on track to report annual revenues of around $30 billion, while reporting adjusted EBITDA of around $11 billion. Charter expects some $750 million in annual synergies following the deal, while it anticipates greater revenues from Time Warner Cable compared to letting the business run as a stand-alone business.
Charter aims to boost revenue growth for the troubled Time Warner Cable making offerings all-digital, and allowing more bandwidth to achieve greater internet speeds. Furthermore, Charter would eliminate the "nickel and dime" charges for various services which Time Warner Cable is charging, while upgrading inferior internet and TV packages.
The proposed deal involves roughly $24 billion in debt on top of dilution in shares of Charter. Including $24 billion debt held by Time Warner Cable and nearly $13 billion in debt held by Charter at the moment, this results in a very steep $61 billion net debt position.
This significant net debt position is the result of the net debt position of both firms before a possible deal. On top of this comes the cash component of the proposed deal. Note that if the price tag would surpass $132.50 per share, leverage will increase further.
These high interest payments are "useful" given Charter's large tax assets. There will be significant dilution in terms of Charter's outstanding share base, seen increasing by 80%. Following the proposed deal by Charter, its shareholders will hold 55% of the equity in the newly created company.
The potential new company will have a market capitalization of roughly $25 billion, but will be saddled with more than $60 billion in debt. Besides the financial leverage the new combination will still have a lot of operational and strategic challenges ahead. This comes from internet competitors like Netflix (NFLX), or competing offerings.
This is a very dangerous cocktail in my opinion, operating with a lot of debt combined with a troubled business model amidst customer defections. Such a deal would only become more dangerous if executed at higher levels than the proposed $132.50 offer. Note that Time Warner asked $160 per share, so a deal around $145 per share might be among the possibilities.
I remain on the sidelines with a negative stance if a deal is being executed.