In December 2012, I did a series of posts on acquisitions that reflected my dyspeptic view of their impact on value. In perhaps a test of my cynicism about the M&A process, Comcast (CMCSA) last week announced that it was making an offer to buy the equity in Time Warner Cable (TWC) for $45.2 billion. As the two largest players in the market contemplated consolidating their cable operations, "synergy" reared its head again as a potential rationale for the premium being paid by Comcast for TWC's shares, just as consumer groups and anti-trust regulators warily eyed monopoly power. While the market's initial reaction to the announcement was not favorable to Comcast, it does provide a test case of how synergy affects value and what acquirers should pay for it.
The status quo: Comcast and TWC
The first step in assessing the merger is to go back and look at the state of play at the two companies, run independently, prior to the acquisition bid. Using the 2013 financial statements that are available for both firms, that is where I started the analysis.
Financial Mix & Cost of Capital
Both firms use debt widely to fund their capital needs, though Time Warner is a heavier user, in proportional terms:
To compute the cost of capital, I incorporated two additional inputs. The first was a beta(s) for the business(es) that these companies were in, which in conjunction with estimated values for each business, yielded business (asset) betas of 0.896 for Comcast (because it derives a significant portion of its revenues from broadcasting, through its ownership of NBC) and 0.71 for TWC.
The second were the bond ratings for the two firms: Moody's gave Comcast a bond rating of A3 (with a default spread of 1.30% associated with it) and TWC a bond rating of Baa2 (with a default spread of 2.25% over the risk free rate).
Operating Cash flows & Expected Growth
To estimate the cash flows generated by the two firms, I worked with the 2013 financial statements that were released recently by both companies. The values are summarized below:
Note that the numbers are adjusted for the capitalizing of leases. Both firms generated healthy cash flows in 2013.
Rather than make the expected growth my estimate, I tied it to how much the companies were reinvesting and how well they were going so, captured in the reinvestment rate (the proportion of the after-tax operating income being put back in the business) and the return on invested capital in 2013:
Based on the 2013 numbers, Comcast is investing a healthy portion of its after-tax operating income back into the company (perhaps in NBC Universal) and can be expected to grow 5.10% a year. TWC seems to be just maintaining its capital base (with a reinvestment rate of only 5.88%) and its expected growth is minimal (0.61% a year).
To complete the valuation, I bring these inputs together, giving both companies a five year transition period period, before putting them in stable growth. The growth rate during the stable growth period is set to 2.75% and both firms are assumed to generate a 9% return on capital in perpetuity. The valuations of the two companies as stand alone companies is presented below:
Based on my estimates, it looks like Comcast was over valued by about 7.1% prior to this deal and Time Warner was undervalued by about 12.6%.
These stand alone valuations also provide us with a measure of what the combined firm's operating assets would be worth, if there were no synergy, since values are additive.
Combined firm's operating asset value (no synergy) = $176,574 + $72,827 = $249,409 million
This is the base value that we can compare the value of the combined firm, with any foreseen synergy.
Is there potential for synergy in this merger? There is always in some potential in almost every merger, especially if you cast your net wide to include both financial and operating synergies.
With financial synergies, you are looking at the possibilities of recapitalizing the combined firm to generate a cost of capital that would be lower than the one you would arrive at by just aggregating the existing capital mixes of the two firms.. Looking at the combined firm, there seems to little potential for significant changes in value from altering financing mix. Both companies use healthy amounts of debt, with Time Warner perhaps a little over levered and Comcast a little under levered. At best, the combined firm may be able to generate marginal savings on its cost of debt and perhaps a slightly higher debt ratio than 30.3%, which is the combined firms aggregated statistic.
With operating synergies, you can roam wider and look for the potential for added value by either operating income in the near term, increasing expected growth or both.
I. Operating income
- Increased revenues: On the cable part of the business, this would mean increasing cable or broadband bills at a rate higher than they would have, if they remained independent firms. While there has been some talk (from analysts) of this happening, the combined firm will be stymied by two factors. The first is that the regulatory authorities will be reviewing the effects on competition of this merger and it is very likely that increasing bills right after a merger will be viewed as a monopolistic act. The second is that while there is some talk about the absence of competition, it is worth noting that ___ of Americans under the age of 30 no longer have cable and are increasing getting their entertainment from Hulu, Netflix (NFLX) and other providers, though they are still dependent on broadband. Increasing cable rates will only accelerate that flight. We will assume that there will be no near term increase in the combined firm's base revenues.
- Higher operating margins: For the combined firm to be able to increase margins, it has to be able to cut costs. To the degree that they have overlapping costs, that is certainly feasible but large portions of their businesses do not overlap and cost cuts are likely to be difficult. In addition, both firms are reporting healthy operating margins, in excess of industry averages, removing the easy cost cuts that may have existed, if one or both firms had bloated cost structures. We will assume that the combined firm's pre-tax operating margin will increase slightly from 21.50% to 21.75%.
- Lower effective tax rates: Both firms pay 32-33% of their income in taxes, much higher than the average effective tax rate across all US companies (closer to 28%). However, one reason that they pay these higher taxes (and may be unable to change easily) is that they generate the bulk of their income in the United States. We will assume that there is no potential for tax savings at the combined firm.
II. Expected Growth
The framework for estimating growth that we used for the standalone valuations was based upon how much the firms were reinvesting (the reinvestment rate) and the return that they generated on that invested capital. To the extent that the combined firm is able to reinvest more or reinvest better, it may be able to deliver synergy from growth
- Reinvestment rate: The aggregated reinvestment rate for the combined firm is 41.45%, weighed down by the low reinvestment at Time Warner Cable. While we have no basis for the contention, it is possible that the low reinvestment at TWC may be driven by capital constraints and that Comcast may be able to reinvest more, though the nature of the cable business will restrict how much. We will assume that the reinvestment rate for the combined firm will be 45%, up from 41.45%.
- Return on capital: The aggregated return on capital for the combined firm is 9.68%. While there may be some marginal benefits from the merger, we will assume that the increased reinvestment will act as a counter weight. We will leave the return on capital unchanged at 9.68% for the combined firm.
With the marginal change in capital structure and a slight increase in pre-tax operating margins, we re-estimated the value for Comcast/TWC, relative to the status quo value:
The good news is that even small changes in operating margin or tweaks in the csot of capital translate into large changes in combined value. With the changes I assumed, the increase in value at the combined firm is $4.82 billion, an increase of 1.9% over the status quo (no synergy) combined value. The bad news is that even these small changes will take effort and time. The former will require commitment on the part of Comcast's management (and accountability) and the latter will reduce the value of the synergy (by the time value factor). In the graph below, I summarize the value of synergy as a function of the improvement in operating margin and the number of years spent waiting for synergy to show up.
I am not a Comcast stockholder, but if I were, this analysis would leave me feeling a little more comfortable with the acquisition than I would have been a few days ago. The under valuation of Time Warner (at least based on my estimates) in conjunction with even small improvements in operating margins provide enough surplus to cover the premium. In fact, the under valuation of TWC prior to the merger (at least based on my estimates) provides some buffer for Comcast. In fact, the numbers can also be used to make a judgment on whether Comcast's stockholders are begin ill served by the proposed exchange ratio on this deal.
Intrinsic value per share (Comcast) = $130,303/ 2606.5 = $49.99/share
Intrinsic value per share (TWC) = $47,585/ 277.9 = $171.23/share
Intrinsic exchange ratio = $171.23/ $49.99 = 3.43 Comcast shares/ TWC share
At the proposed exchange ratio of 2.875 Comcast shares/TWC share, the deal is tilted in favor of Comcast shareholders, at least based on my estimates.
The bottom line is that while this is a high-priced deal and there is plenty that can go wrong (from a regulatory and business standpoint) in the future, it does not strike me as a value destructive deal and may, in fact, create value for Comcast stockholders. As always, please do feel free to download the spreadsheet that I used to value the synergy, tweak it or modify it and come up with your own assessments that you can put into this shared Google spreadsheet.
The market's view
When large acquisitions are announced, it is natural to focus attention on the target company and shareholders in that company are generally celebrants. This acquisition was no exception, as TWC's market capitalization increased by $2,779 million on the announcement of the merger, an increase of 7.4% over the pre-merger value, but well below Comcast's offer of $45.2 billion. To me the more interesting side of the action is on the acquiring firm, since stockholders in the firm get a chance to pass judgment on whether they see themselves as winners or losers, from the deal. In this merger, Comcast's market cap dropped by $4,509 million, a decline of 3.13% in value. In sum, if you combine the market capitalizations of the two companies, there was a decline in $1,730 million in value after the announcement.
I don't know whether this reflects pessimism on whether the regulators will allow the merger to go through or synergy benefits, but it does seem like the reaction is not warranted by the facts.
I continue to believe that growing by acquiring publicly traded companies at a premium is a difficult game to win. However, I also believe that some acquisitions can create value, if you can target under valued firms and generate some synergy benefits in the process.