In the letter we wrote to our investors in December, one of the key themes we discussed for 2014 was consolidation in the cable industry and the complicated regulatory hurdles these deals would face. In the letter, we highlighted Time Warner Cable (TWC) as the prime candidate to begin this process, and we predicted that Charter Communications (CHTR) and Comcast (CMCSA) would work together to acquire the company.
After Charter's offer was declined by Time Warner's board, Comcast decided to try to go it alone and announced its deal to acquire Time Warner Cable on February 13th for about $45 billion or $158 per share in an all-stock deal. This transaction would create the largest cable company in history and give Comcast unprecedented control of both content and distribution in the market. Serious questions remain outstanding about how the regulators will respond, and if they will even allow the deal to go through in any form.
The spread between the price of TWC stock today and the deal price remains wide, which leaves a lot of room for investors to potentially profit from the deal if it eventually goes through. This is a multi-bidder situation with two CEOs who know how to work with the regulators and know how to consolidate this industry. We think they will find a way to get the deal done, and there are several factors at play which limit the downside to investors.
The Key Risk is Regulatory
In its offer, Comcast met Time Warner's asking price so there is little doubt that Time Warner and Comcast shareholders will move forward with the deal. The key variable is how the FCC and DOJ will respond.
At this point, Comcast's CEO, Brian Roberts, has acknowledged the difficulty regulators will face, and has already offered some initial divestitures to get the combined company's cable market share below the FCC's 30% threshold. Regulators will almost certainly ask for the company to go further than that if they allow the deal to go through. Roberts has done $65 billion in deals in the past 10 years, he knows how to work with the regulators, and we think he is capable of finding a solution. That being said, even Roberts has hedged his bets in this transaction. Typically, a buyer pays a reverse break-up fee to the seller if the deal fails to go through. In this deal, there is no such clause, which leads us to believe that Roberts is wary of the regulators and the pushback he'll receive.
What makes the current regulatory environment particularly interesting is that under this administration, regulators appear much more willing to work with companies in order to accomplish their agenda in various industries. Take the DOJ's case against the American Airlines (AAL)/US Air. The DOJ had a strong antitrust case against this merger, and yet they allowed it to go through. Why? The deal gave them a means to sculpt the airline industry a little more closely to their liking, particularly the price competition between a few key cities (incidentally, for anyone watching, the few key cities most frequently visited by DoJ antitrust enforcers).
The cable industry has been a problem for regulators for some time. Competition is limited by the infrastructure, and prices have durably increased more than twice the rate of inflation over the last 17 years. The cable industry blames the content providers for raising prices, while others blame the cable industry's lack of competition in individual geographies.
A deal of this size will give the regulators the tools necessary to take steps to reshape the industry and increase pricing pressure and competition. This is not going to be an easy task. This deal will shape the new regulatory landscape for the cable industry going forward. But we believe this is important for Comcast and will meet the demands of the regulators and they can get this deal approved by January 2015.
Wide Spreads and Mispricing in Mega-Cap Transactions
As of the end of 2013, BarclayHedge estimates that the total assets under management of merger arbitrage and event-driven hedge funds are about $256 billion. If we assume the average position size for these funds is between 3-5%, then about $7-13 billion would be allocated to a given deal if all funds were invested. In a deal worth $45 billion, the arbitrage industry may not be large enough to narrow the spread. So is it possible for the market to misprice mega-cap deals when "everybody" is looking at it? Yes.
An Auction Limits Downside
When one bidder makes an offer on a company, there are a multitude of risks associated with the likely completion of the deal and the downside on the particular transaction is based on pre-deal trading prices and the underlying fundamental value of the target business. The risk dynamic changes when a second bidder comes to the table.
Charter Communications, backed by billionaire cable consolidator John Malone, has already made a bid on Time Warner Cable worth $132.50 per share. Time Warner's Board rejected the bid as too low. Before Charter could go through with its threat to replace the TWC Board, Comcast came in with a higher offer.
The problem for Comcast is that it is the largest cable company in the industry and Time Warner is the second largest. A merger of the two, as we have already discussed, is problematic from a regulatory standpoint. Charter will be one of the natural recipients of the number of the divestitures that Comcast is forced to make if the deal goes through.
If, however, the deal does end up in jeopardy for regulatory reasons or other unforeseen reasons (i.e. a decline in the price of Comcast stock), Charter could very well still serve as a backstop for the price of Time Warner Cable.
All stock deals can be a challenge when the time horizon is as long as this is likely to be. A lot can happen in a year, and the share price of Comcast will fluctuate. If Comcast shares fall, this deal could lose some luster for TWC shareholders. There may be more opportunity to negotiate down the road if this is the case, or Charter could come back with an offer that puts pressure on Comcast to increase the payout to account for a reduction in share price.
It's clear that Charter wants to compete with Comcast, and the Time Warner deal would have made Charter the second-largest cable company in the industry. If Comcast completes this deal, its scale would dwarf Charter. If the current deal runs into trouble and is less attractive to TWC shareholders, we believe John Malone and Charter would very likely come back to the table with a new offer. Its offer of $132.50 was a starting point for serious negotiations with Time Warner, and we think Charter would be willing to raise its bid to win this if the opportunity presented itself. Like any negotiation, both sides offer a price at low and high side of their range. Had the process been allowed to play out, we would have likely seen Charter raise its price and Time Warner lower its ask, reminiscent of the Dell and Icahn battle last summer. Before that negotiation could play out, Comcast circumvented the process and met Time Warner's asking price. If divestures and regulatory demands prove too burdensome to the new Comcast/TWC shareholders, an offer from Charter could appear much more attractive to Time Warner's shareholders.
This multiple-bidder dynamic provides significant downside protection in the event the current deal falls apart. The upside for TWC holders is about $158 per share, plus any stock buybacks Comcast makes post-transaction (as have already been discussed by the two CEOs). The downside is at least $132.50, but probably closer to $140 per share if Charter and Time Warner resume negotiations. These are CEOs who believe that consolidation in the cable industry is a winning strategy, compete with one another, want to win, and have worked with the regulators in the past to do big deals. At the current market price, we think this deal still offers a wide spread with an asymmetric risk/return profile.