A few weeks ago, the revelation that Twenty-First Century Fox (NASDAQ: FOXA) (NASDAQ:FOX) offered to purchase Time Warner (NYSE: TWX) sent the latter's stock surging roughly 17% for the day. The stock sat around the offer price of $85 for a few weeks providing the opportunity to sell it at a solid price before the 12% drop today. The offer for the content giant is another step in the cable wars though it may not materialize into a merger now. The initial moves to consolidate the cable networks in the case of Comcast (NASDAQ:CMCSA) (CMCSK) buying Time Warner Cable (NYSE: TWC) is leading the content providers to look into ways of bulking up.
Questions should exist whether Comcast is overpaying for an asset in Time Warner Cable that had already soared. In this case, the content providers, such as Time Warner, hadn't seen the same level of gains recently, but the stock was up nearly 150% in the last two years following news of the offer. Stock gains alone aren't a reason for dumping a stock, but the investor has to wonder if the gains are sustainable if they aren't linked to revenue growth. A company can't cut costs forever.
Since Time Warner rejected the offer and now Twenty-First Century Fox has officially withdrawn it in favor of a stock buyback, what should investors do?
Rejected Offer Rescinded
A few weeks ago, the New York Times broke the news that Fox offered nearly $80 billion for the Time Warner assets that include HBO, Cinemax, TNT, TBS, and Warner Bros. According to Time Warner, the offer included 1.531 shares of Twenty-First Century Fox Class A non-voting shares and $32.42 in cash per share. Based on the previous closing price of Twenty-First Century Fox, the offer was worth nearly $86 per share. With Twenty-First Century Fox's stock declining roughly 10% after the news of the offer, the deal had dropped in value to around $80.60 per share before the company rescinded the offer.
Time Warner management claims that execution of the existing strategic plan will provide more value to investors. It also suggests that significant risk and uncertainty exists with operating an entity of the proposed size of the combined entity plus the regulatory risk. For its part, Time Warner reported a fantastic Q2 with earnings of $0.98 far surpassing the $0.84 expected by analysts.
To make the deal work, Fox reportedly suggested selling CNN in order to obtain regulatory approval. In the end, the company claims Time Warner was unwilling to negotiate, leading it to move forward with a buyback of $6 billion.
Similar to the deal for Time Warner Cable, the valuations originally offered in this deal raised considerable red flags after large stock gains for the targeted companies. In the case of Time Warner, the stock traded for nearly 19x 2015 earnings. For Fox to raise the bid, the multiple would need to creep up toward 20x forward earnings or more. Those numbers are very expensive for a company only expecting 4% revenue growth. Analysts do forecast faster earnings-per-share growth because of cost savings and net share buybacks, but the question is whether an acquirer can afford a higher bid even with significant synergies.
The below chart highlights how Time Warner stacks up with the group now that the stock has dropped.
The synergies are suggested at $1 billion annually, but a big concern for investors has to be the threat of over-the-top services like Netflix (NASDAQ:NFLX) and Hulu. Combining cable networks and content providers doesn't address the real pressing issue that younger consumers prefer consuming content on these services that in many cases block out the above cable networks and content providers. To that extent, Bloomberg reported that Fox wants the streaming services and online presence of HBO in order to better compete with Netflix.
While the media appears set that the deal is off the table for good, investors should understand the stock component of the original offer was making the deal difficult to process. The nearly 10% drop in FOXA stock prior to any counter offer made it impossible for a counter offer to provide any value to Time Warner shareholders. Any raised bid would only send FOXA down diluting any benefit to Time Warner. The proposed stock buyback actually places FOXA shares back into a better negotiation position whether that plan is ever implemented.
The head of Twenty-First Century Fox, Rupert Murdoch, isn't likely to stop without making a higher offer, and it's possible another suitor will covet HBO, especially after the solid Q2 '14 numbers. Assuming a higher offer is made, the high valuation based on earnings multiples and lack of revenue growth, along with the substantial stock gains, suggest investors should take the money and run as soon as the increased offer hits the wires.
Disclosure: The author is long TWX. 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.
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