If Fox Wins It Loses

Jul.29.14 | About: Twenty-First Century (FOXA)


Fox-Time Warner merger costs likely exceed prospective benefits.

The more likely the deal, the more aggressively Fox shares ought to be sold.

Wrong deal, wrong reasons, at wrong time.

If Fox Wins it Loses

Conventional wisdom has it that Fox (NASDAQ:FOXA) and other major media companies must bulk up for the purpose of gaining more bargaining leverage with distributors. In my view this is the first and primary assumption that is to be questioned. The second is that the media and entertainment businesses will continue along their merry way in a linear extrapolation of what's been the trend of the last five years. This too is a questionable assumption.

Fox is already in its current form, a major production and distribution entity and it might very well be that any further bargaining leverage to be gained through merger with Time Warner (NYSE:TWX) will be of marginal consequence. Even in its current form, no producer or distributor will at this stage ever ignore Fox or dare to stiff it with onerous terms. Fact is that Fox doesn't badly need TWX, at least for such leveraging purposes.

But let's for the moment theorize that it does. No one in the general media coverage of this event or in the professional analyst community seems to have examined the costs of gaining any such marginal leverage. In any transaction, proper analysis calls for a weighing of the benefits versus the costs. I'm suggesting that the costs will be abnormally high in more ways than one.

Begin first with the financial structure. Mr. Murdoch, once chastened by over-borrowing in 1990 -- an episode in which he held onto then News Corp. by no more than a lucky thread -- has apparently been afflicted with financial amnesia. He doesn't want to have Fox debt downgraded by the agencies, but seems eager to go as close to the red line as possible.

Yes, now that he's sold Sky Italia and Deutschland for around $7 billion combined to brother company BSKYB (basically moving money from one pocket to the other) he's now got some extra maneuvering room on Fox's balance sheet. Throw in another $6 billion or more for potential and likely sale of CNN in the event of a merger, and he can now raise the offer for TWX by another $15 a share to around $100 as (to make the math simple) TWX has close to 1 billion shares outstanding.

So now Fox can bump up the offered cash portion to maybe 50% of $100 a share ($50 billion cash and $50 stock) and thus probably win TWX while giving no Fox voting shares away. The institutional holders of TWX, the investment bankers and lawyers, and perhaps those top TWX managers with generous change of control exit parachutes, will not object too much. Institutions have a fiduciary responsibility to take the largest amount of money offered. They exist for that very purpose, and they couldn't care less about the consequences post-merger unless they also own Fox (which reportedly 70% do).

However, if the merger occurs and these institutions continue to hold Fox, in my opinion, they ought to reconsider their intent to do so. By winning TWX -- on what some might label as a Murdoch ego trip -- they are ignoring the costs of the presumed benefits.

The first cost will be the impaired balance sheet of Fox, which will be stretched to the limit in terms of agency credit ratings. Money will cost more, even without the Fed's raising of interest rates. That's because, if it wins, Fox will have paid out $50 billion (of which maybe half will be new borrowings) for assets and earnings which aren't growing much faster (or at all ) than what they've got right now. The chief prize, in my opinion, is the sports rights that TWX controls through its cable nets, but Fox could bid for these separately, pay a premium, and not do nearly as much damage as they will likely do in buying all of TWX.

That's because Hollywood in particular, and media companies in general, are reliant on smooth and long-lasting interpersonal relationships. As in any business, talent and other business partners want to know with whom they are dealing, not only for the next three months but for the next three to five years -- the amount of time over which programming, production, and distribution deals will normally play out. Part of the reason TWX has done so well of late is that it has settled down into a well functioning machine with reliable operating/divisional management that has mostly put to rest the furious internecine battles that extended back to the late 1990s.

If you know anything about the way mergers of this type work -- with the exception of the Murdochs and perhaps a handful of top lieutenants -- there won't be a single executive at Fox or TWX who will not be looking over their shoulders, looking for another job, or working hard to grab someone else's. When this happens, it extends over a long time, and productivity suffers greatly.

To use the baseball (and comedic) phrase, no one will know who's on first. Which executive at a hypothetically merged Fox-TWX do you or should you call for a deal? Who will have the authority, tenure, reliability, and gravitas to make a deal that sticks? If you're a talent agent, you probably now take your best prospects to other studios first and place a merged Fox-TWX last on your call list. At both companies, at the least, productivity has already plunged while counter-party risks and paranoia have risen.

In my opinion, the costs of a Fox win will be extraordinarily high relative to the presumptive benefits to be gained. If Fox wins TWX, Fox earnings will likely be under pressure for a long time, and that's even with the supposed "cost savings" estimated for now to be $1 billion (which is peanuts for a deal of this size but is greatly disruptive to the organization and the people involved).

Analysts, bankers, the companies involved, and the media, also tend to implicitly assume that the economy and the stock and bond markets will continue to press ahead with nary a cloud in the sky. Linear extrapolation is what most people do because it doesn't require much effort to best-guess that tomorrow's returns will be a lot like today's.

If your investment outlook is bullish for the next few years, then perhaps the deal looks OK. Fox will then be able to handle a potentially weakened balance sheet and growth of media earnings will continue apace even as the TWX acquisition is gradually assimilated.

My take, however, is totally opposite as I believe there are many bearish things to consider. Although Mr. Murdoch is to be admired and respected for assembling such a marvelous set of assets and creating great wealth for others who joined along for the 50-year ride, he has also had an uncanny knack of making expensive acquisitions at the top of markets (Chris Craft in 2000, Dow-Jones in 2007). He seems to call the tops rather well.

Other companies in other industries are also presently in a merger frenzy. This always happens at or near bull market tops. It's all part of the cheap money policies of the world's major central banks. (see "In Hotel QE, You Can Check in But You Can't Check Out"). You will rarely see this rate of activity at bear market bottoms.

Broadcasting and media companies are especially vulnerable to slower ad spending, and after the 2014 midterm election political advertising balloon, 2015 may turn out to be a comparative soft patch (with no World Cup or Olympic events). A shortfall in ad spending immediately and directly comes out of media company earnings. The movie industry too is not what it used to be in terms of admissions and even cable industry network margins appear to have peaked.

Look around the world and prospects for 2015 are also not exactly encouraging. Europe's economies have, for the most part, yet barely climbed out of a slump. And China is a major uncertainty for 2015 as the official economic data appears to be unreliable (some would say totally fabricated).

I could go on about record high margin debt for US stocks, subprime loans appearing again this time in automobile financing and student debt, yield chasing in bonds, extremely bullish investor sentiment, and about many more items. While none of these pertain directly to a Fox-TWX merger, any earnings and productivity slowing and balance sheet impairment at a new Fox-TWX combo will then have a magnified downside impact on Fox shares.

As for Time Warner, its top management has for a variety of historical reasons been largely competent but complacent and almost caretaker-like -- seemingly content with share buybacks, dividend increases, and divestitures while marking time until stock options and retirement pensions vest. The "vision" gene, though, appears to have gone missing. Instead of complaining about Netflix a few years ago, TWX should have then bought it.

In my opinion, for Fox, Time Warner, and the industry at large, this is the wrong deal at the wrong time and done for the wrong reasons. If Fox wins, it loses. And the more likely the merger completion prospect becomes, the more aggressively Fox shares ought to be sold.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.