Time Warner: Merger Arb With 15-20% Upside

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About: Time Warner Inc. (TWX), Includes: T
by: Uncorrelated Returns
Summary

Time Warner is an attractive merger arbitrage situation, offering a 16% return if the deal closes in the next 6 months.

The DOJ has sued to block the deal, but its arguments appear without substance and precedent; the odds of a favourable ruling for shareholders appear to be better than even.

Even if the deal breaks, shareholders should be rewarded. Since the deal was announced, peers have rerated materially; the standalone value of TWX is closer to $110 (20% upside).

Time Warner Inc. (TWX) is a merger arbitrage situation with an unusually positive risk-reward skew. The stock is trading at a steep discount to the $107.50 offer price (16% upside from current market levels) because the DOJ has sued to block the deal. However, the DOJ case is weak and the transaction remains more likely than not to close, in my view. More importantly, the standalone value of TWX has risen materially since the deal was announced 14 months ago, and could be 20% higher than the current market price. Investors stand to gain handsomely should the deal close within the next 6 months, but should also be rewarded if the deal doesn’t close. Heads I win, tails I also win.

Background and context

TWX is a large-cap media and entertainment business providing content under a variety of brands including TBS, TNT, HBO, CNN, Cinemax, Warner Bros. and other. Its Turner and HBO divisions create and program branded multi-platform content, earning revenue from affiliates who pay to carry TWX channels, advertising, direct subscription and content sales. Its Warner Bros. segment is a leader in the feature film industry and includes film titles based on the DC comic book universe.

In October 2016, TWX agreed to be acquired by AT&T Inc. (T) (a provider of fixed and mobile telecommunications services and video content distributor) in a cash and stock deal worth $85bn. In November 2017, after a lengthy review and against all expectations, the DOJ filed suit to block the deal. Not to be deterred, T and TWX agreed to extend the deadline for the transaction to June 21st and will vigorously defend the merits of the deal in a trial starting on March 19th.

How strong is the government’s case?

I am not a lawyer and much has already been written about the merits of the DOJ’s arguments, so I’ll keep it brief. In short, the DOJ asserts that if the deal goes through, T would use its control over TWX to force rivals to pay “hundreds of millions of dollars more per year” and use its increased power to reduce innovation and raise costs to consumers.

In my view, DOJ will have a high burden of proof to substantiate these arguments; it is telling that none of the State Attorneys General approached by the DOJ to join the suit elected to do so. Firstly, there is little precedent for vertical mergers (i.e., consolidation along the value chain) being blocked (and indeed Comcast-NBC-Universal sets precedent for the defense) and the DOJ would have to clear a much higher bar than in the case of a horizontal merger. Secondly, the argument that T is likely to withhold content from competitors and raise prices is theoretical at best, assumes customers (e.g., Comcast (NASDAQ:CMCSA)) have no bargaining power of their own, and can be managed through behavioral remedies if necessary.

The opening sentence of the DOJ filing reads: "American consumers have few options for traditional subscription television." The key word in the sentence is “traditional.” With the rise of Netflix (NASDAQ:NFLX), Amazon Prime (NASDAQ:AMZN) and other new over-the-top (OTT) services, the pricing dynamic in the industry has changed. The traditional cable bundle is already being disintermediated. I believe AT&T can easily show that they (or any other player in the market) will have little incremental pricing power as a consequence of the deal, since the DOJ’s definition of the pay-TV market is naïve and outdated.

I might be a cynic, but it seems to me that the deal has been singled out for petty political reasons, and that the government’s legal arguments are weak. Ultimately, I believe there is a better than even chance of the deal going through, possibly with minor divestitures or behavioral conditions imposed.

TWX is worth $110 even if the deal fails

Of far greater significance to the thesis, I believe the downside risk to TWX in the event that the deal fails is negligible.

First a dose of reality - the media industry is undergoing change on multiple fronts, fueled by technological change and the emergence of Netflix and other OTT services. Cord-cutting and downgrading to skinny bundles are placing pressure on subscriber numbers, and while pricing for core properties (e.g., HBO or Disney’s ESPN) has remained strong enough to offset the churn, the outlook for traditional video models is uncertain. Similarly, declining cinema numbers and shortening windows of exclusivity are changing the feature film market. In response, investment in high quality scripted content has increased, and market consolidation has accelerated (e.g., Disney-Fox, Discovery-Scripps).

Against this backdrop, TWX remains a formidable player, with a strong portfolio of properties, healthy margins, robust free cash generation and a strong balance sheet, and hence well-positioned to remain relevant in the future. Tellingly, over the past 12 months, consensus earnings forecasts for TWX have risen (FY18 EPS from $6.50 to $6.60) as the company continued to execute well. By contrast, estimates for DIS & FOX reduced over the course of the past year.

TWX’s current share price of $92 is 15% higher than the unaffected price of $80 in October 2016. By comparison, DIS and FOX have gained 22% and 46%, respectively, over the same timeframe. Had TWX merely kept pace with DIS (remember, in October 2016 few observers expected a Republican in the White House would be signing a tax reform bill the next year, and TWX earnings were being upgraded while DIS was being downgraded), the stock would be $98 today.

Price as at…

Oct 2016

Jan 2018

Increase

DIS

92

112

22%

FOX

25

36

46%

TWX

80

92

15%

Source: Bloomberg data

The table below highlights a few select metrics for TWX and its closest peers. Margins, return profile and leverage are broadly comparable across the group. Capital intensity is much lower than for DIS, given the latter’s exposure to theme parks. Tellingly, the peers all trade at around 20x FCF; TWX sticks out like a sore thumb at less than 16x.

I see little compelling reason why TWX should trade at a meaningful discount to these peers over time, were it to remain a standalone company. Therefore, I would regard a range between $99 and $123 as the appropriate zone (11x EV/EBITDA and 20x P/FCF, based on Bloomberg’s consensus earnings forecasts). Using the mid-point of $110 (12x EV/EBITDA, 18x FCF) upside would be 20%. At this level, TWX would still trade at a discount to peers on a FCF multiple, and a slight premium on a EBITDA multiple (explained by superior cash conversion and lower capex requirements).

TWX

DIS

FOX

CBS

Revenue

31,027

58,671

29,993

13,508

EBITDA

8,872

18,114

7,399

3,083

Net Income

4,934

9,682

3,680

1,726

Free cash flow

4,810

8,983

3,622

1,282

EBITDA Margin

28.6

30.9

24.7

22.8

ROE

18.8

23.4

21.3

49.6

Capex / Sales

1.5

6.6

1.3

1.5

Net debt to EBITDA

2.4

1.3

1.8

3.4

EV/EBITDA

10.4

10.8

11.2

10.7

P/E

14.8

17.4

18.3

13.8

P/FCF

15.6

20.0

21.5

20.7

Source: Bloomberg data

Collar creates complexity

The offer price of $107.50 is comprised of $53.75 in cash and $53.75 in T stock; the exact number of T shares received will be determined by the price of T on closing. However, the stock component is subject to a collar – if T trades below $37.41, the number of shares remain fixed at 1.437 and the value of the stock component declines; a similar mechanism caps the upside to 1.3 shares above $41.35. At current market prices, the offer is worth $106.70. Owners of TWX are effectively short 1.437 put options on T with a strike price of $37.41 and long 1.3 call options at a strike price of $41.35. Arbitrageurs who do not want exposure to the risk of T declining further need to hedge this exposure by buying the puts and selling the calls (which I estimate reduces the spread by around $2). A fully hedged position therefore would return 14% should the deal close by June ($107.5 offer/$92 TWX price + $2 cost of T hedge).

With T close to the lower band of the collar, another six months to run to the termination date, and the standalone upside potential on TWX, I’m comfortable being unhedged at this stage.

As always, do your own work, form your own conclusions, and size appropriately.

Disclosure: I am/we are long TWX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.