Latepost Comcast Bids For Fourth Dimension Warner Cable: Synergy, Contrary Synergy Or Ego Trip?

In Dec 2012, I did a series of posts on acquisitions that reflected my dyspeptic sentiment of their impact on value. In maybe a attempt of my cynicism almost the M&A process, Comcast final calendar week announced that it was making an offering to purchase the equity inwards Time Warner Cable for $45.2 billion. As the 2 largest players inwards the marketplace contemplated consolidating their cable operations, “synergy” reared its caput in i lawsuit again every bit a potential rationale for the premium existence paid yesteryear Comcast for TWC's shares, only every bit consumer groups together with anti-trust regulators warily eyed monopoly power. While the market's initial reaction to the proclamation was non favorable to Comcast, it does render a attempt instance of how synergy affects value together with what acquirers should pay for it.

The condition quo: Comcast together with TWC

The get-go measuring inwards assessing the merger is to become dorsum together with expression at the nation of play at the 2 companies, run independently, prior to the acquisition bid. Using the 2013 fiscal statements that are available for both firms, that is where I started the analysis.

Financial Mix & Cost of Capital

Both firms job debt widely to fund their uppercase needs, though Time Warner is a heavier user, inwards proportional terms:

To compute the cost of capital, I incorporated 2 additional inputs. The get-go was a beta(s) for the business(es) that these companies were in, which inwards conjunction amongst estimated values for each business, yielded concern (asset) betas of 0.896 for Comcast (because it derives a pregnant portion of its revenues from broadcasting, through its ownership of NBC) together with 0.71 for TWC.

The minute were the bond ratings for the 2 firms: Moody's gave Comcast a bond rating of A3 (with a default spread of 1.30% associated amongst it) together with TWC a bond rating of Baa2 (with a default spread of 2.25% over the risk gratuitous rate).

Operating Cash flows & Expected Growth

To guess the cash flows generated yesteryear the 2 firms, I worked amongst the 2013 fiscal statements that were released lately yesteryear both companies. The values are summarized below:

Note that the numbers are adjusted for the capitalizing of leases. Both firms generated salubrious cash flows inwards 2013.

 Rather than brand the expected growth my estimate, I tied it to how much the companies were reinvesting together with how good they were going so, captured inwards the reinvestment charge per unit of measurement (the proportion of the after-tax operating income existence set dorsum inwards the business) together with the render on invested uppercase inwards 2013:

Based on the 2013 numbers, Comcast is investing a salubrious portion of its after-tax operating income dorsum into the society (perhaps inwards NBC Universal) together with tin hold upwards expected to grow 5.10% a year. TWC seems to hold upwards only maintaining its uppercase base of operations (with a reinvestment charge per unit of measurement of only 5.88%) together with its expected growth is minimal (0.61% a year).

Valuation

To consummate the valuation, I convey these inputs together, giving both companies a 5 twelvemonth transition menstruum period, earlier putting them inwards stable growth. The growth charge per unit of measurement during the stable growth menstruum is gear upwards to 2.75% together with both firms are assumed to generate a 9% render on uppercase inwards perpetuity. The valuations of the 2 companies every bit stand upwards lonely companies is presented below:

Based on my estimates, it looks similar Comcast was over valued yesteryear almost 7.1% prior to this bargain together with Time Warner was undervalued yesteryear almost 12.6%.

These stand upwards lonely valuations every bit good render us amongst a mensurate of what the combined firm's operating assets would hold upwards worth, if at that spot were no synergy, since values are additive. 

Combined firm's operating property value (no synergy) = $176,574 + $72,827 = $249,409 million

This is the base of operations value that nosotros tin compare the value of the combined firm, amongst whatever foreseen synergy.

Synergy Potential

Is at that spot potential for synergy inwards this merger? There is ever inwards unopen to potential inwards almost every merger, peculiarly if y'all sort your cyberspace broad to include both fiscal together with operating synergies. With

Financial synergy

With fiscal synergies, y'all are looking at the possibilities of recapitalizing the combined theater to generate a cost of uppercase that would hold upwards lower than the i y'all would become far at yesteryear only aggregating the existing uppercase mixes of the 2 firms.. Looking at the combined firm, at that spot seems to picayune potential for pregnant changes inwards value from altering financing mix. Both companies job salubrious amounts of debt, amongst Time Warner maybe a picayune over levered together with Comcast a picayune nether levered. At best, the combined theater may hold upwards able to generate marginal savings on its cost of debt together with maybe a slightly higher debt ratio than 30.3%, which is the combined firms aggregated statistic.

Operating synergy

With operating synergies, y'all tin roam wider together with expression for the potential for added value yesteryear either operating income inwards the close term, increasing expected growth or both.

I. Operating income

1. Increased revenues: On the cable part of the business, this would hateful increasing cable or broadband bills at a charge per unit of measurement higher than they would have, if they remained independent firms. While at that spot has been unopen to speak (from analysts) of this happening, the combined theater volition hold upwards stymied yesteryear 2 factors. The get-go is that the regulatory government volition hold upwards reviewing the effects on contest of this merger together with it is rattling probable that increasing bills correct afterward a merger volition hold upwards viewed every bit a monopolistic act. The minute is that piece at that spot is unopen to speak almost the absence of competition, it is worth noting that ___ of Americans nether the historic menstruum of thirty no longer receive got cable together with are increasing getting their amusement from Hulu, Netflix together with other providers though they are nevertheless subject on broadband. Increasing cable rates volition only accelerate that flight. We volition assume that at that spot volition hold upwards no close term increment inwards the combined firm's base of operations revenues.
2. Higher operating margins: For the combined theater to hold upwards able to increment margins, it has to hold upwards able to cutting costs. To the grade that they receive got overlapping costs, that is for certain viable but large portions of their businesses practice non overlap together with cost cuts are probable to hold upwards difficult. In addition, both firms are reporting salubrious operating margins, inwards excess of manufacture averages, removing the tardily cost cuts that may receive got existed, if i or both firms had bloated cost structures. We volition assume that the combined firm's pre-tax operating margin volition increment slightly from 21.50% to 21.75%.
3. Lower effective revenue enhancement rates: Both firms pay 32-33% of their income inwards taxes, much higher than the average effective revenue enhancement charge per unit of measurement across all US companies (closer to 28%). However, i argue that they pay these higher taxes (and may hold upwards unable to alter easily) is that they generate the mass of their income inwards the United States. We volition assume that at that spot is no potential for revenue enhancement savings at the combined firm.

II. Expected Growth

The framework for estimating growth that nosotros used for the standalone valuations was based upon how much the firms were reinvesting (the reinvestment rate) together with the render that they generated on that invested capital. To the extent that the combined theater is able to reinvest to a greater extent than or reinvest better, it may hold upwards able to deliver synergy from growth.

1. Reinvestment rate: The aggregated reinvestment charge per unit of measurement for the combined theater is 41.45%, weighed downward yesteryear the depression reinvestment at Time Warner Cable. While nosotros receive got no Earth for the contention, it is possible that the depression reinvestment at TWC may hold upwards driven yesteryear uppercase constraints together with that Comcast may hold upwards able to reinvest more, though the nature of the cable concern volition confine how much. We volition assume that the reinvestment charge per unit of measurement for the combined theater volition hold upwards 45%, upwards from 41.45%.
2. Return on capital: The aggregated render on uppercase for the combined theater is 9.68%. While at that spot may hold upwards unopen to marginal benefits from the merger, nosotros volition assume that the increased reinvestment volition human activity every bit a counter weight. We volition larn out the render on uppercase unchanged at 9.68% for the combined firm.

Valuing Synergy

            With the marginal alter inwards uppercase construction together with a slight increment inwards pre-tax operating margins, nosotros re-estimated the value for Comcast/TWC, relative to the condition quo value:

The proficient intelligence is that fifty-fifty little changes inwards operating margin or tweaks inwards the cost of uppercase interpret into large changes inwards combined value. With the changes I assumed, the increment inwards value at the combined theater is $4.82 billion, an increment of 1.9% over the condition quo (no synergy) combined value. The bad intelligence is that fifty-fifty these little changes volition receive got endeavour together with time. The quondam volition require commitment on the part of Comcast’s administration (and accountability) together with the latter volition trim back the value of the synergy (by the fourth dimension value factor). In the graph below, I summarize the value of synergy every bit a purpose of the improvement inwards operating margin together with the set out of years spent waiting for synergy to present up.

I am non a Comcast stockholder, but if I were, this analysis would larn out me feeling a picayune to a greater extent than comfortable amongst the acquisition than I would receive got been a few days ago. The nether valuation of Time Warner (at to the lowest degree based on my estimates) inwards conjunction amongst fifty-fifty little improvements inwards operating margins render plenty surplus to comprehend the premium. In fact, the nether valuation of TWC prior to the merger (at to the lowest degree based on my estimates) provides unopen to buffer for Comcast. In fact, the numbers tin every bit good hold upwards used to brand a judgment on whether Comcast's stockholders are get down sick served yesteryear the proposed telephone substitution ratio on this deal. 

Intrinsic value per portion (Comcast) = $130,303/ 2606.5 = $49.99/share

Intrinsic value per portion (TWC) = $47,585/ 277.9 = $171.23/share

Intrinsic telephone substitution ratio = $171.23/ $49.99 = 3.43 Comcast shares/ TWC share

At the proposed telephone substitution ratio of 2.875 Comcast shares/TWC share, the bargain is tilted inwards favor of Comcast shareholders, at to the lowest degree based on my estimates.

The bottom draw is that piece this is a high-priced bargain together with at that spot is plenty that tin become incorrect (from a regulatory together with concern standpoint) inwards the future, it does non bang me every bit a value destructive bargain together with may, inwards fact, create value for Comcast stockholders. As always, delight practice experience gratuitous to download the spreadsheet that I used to value the synergy, tweak it or modify it together with come upwards up amongst your ain assessments that y'all tin set into this shared Google spreadsheet.

The market’s view

When large acquisitions are announced, it is natural to focus attending on the target society together with shareholders inwards that society are mostly celebrants. This acquisition was no exception, every bit TWC’s marketplace capitalization increased yesteryear $2,779 meg on the proclamation of the merger, an increment of 7.4% over the pre-merger value, but good below Comcast's offering of $45.2 billion. To me the to a greater extent than interesting side of the activity is on the acquiring firm, since stockholders  inwards the theater larn a risk to overstep judgment on  whether they meet themselves every bit winners or losers, from the deal. In this merger, Comcast’s marketplace cap dropped yesteryear $4,509 million, a refuse of 3.13% inwards value. In sum, if y'all combine the marketplace capitalizations of the 2 companies, at that spot was a refuse inwards $1,730 meg inwards value afterward the announcement. 

I don't know whether this reflects pessimism on whether the regulators volition let the merger to become through or synergy benefits, but it does seem similar the reaction is non warranted yesteryear the facts.

Bottom line
I boot the bucket on to believe that growing yesteryear acquiring publicly traded companies at a premium is a hard game to win. However, I every bit good believe that unopen to acquisitions tin create value, if y'all tin target nether valued firms together with generate unopen to synergy benefits inwards the process.

1. Spreadsheet to value Comcast/TWC merger synergies
2. My newspaper on valuing synergy
3. Google shared spreadsheet on synergy value

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