The old fox learns a new trick - Murdoch walks away from Time Warner

Having seen the outrageous premium Murdoch paid for the WSJ, markets must have been salivating over how much he might now stump up for Time Warner. Surely, the $86ps ($80bn) offer was a mere opening shot and that the old boy could be bounced into perhaps three figures, or so the narrative went. Not to be lads! The 'old-boy' has done a runner and left the spivs holding their longs in TWX and without another putative bidder in sight, the bid premium could evaporate.

Perhaps this a cunning ploy to lower expectations and soften up the TWX management ahead of a future return for TWX? If it is, it would be a remarkably long term strategy for an 83 year old. Instead, one should follow the money. Having arranged a $7.5/$8bn cash release from selling Fox's European pay TV assets to BSkyB, initially to part fund the TWX offer, Murdoch is now proposing to spend the bulk of this ($6bn) on a share buy-back at Fox. If Murdoch was getting investor push-back on the prospective tidal wave of 'A' non-voting Fox shares that he would have to issue, even with the Sky cash, then a return for TWX, without the cash seems even less probable. As per my previous blogs on the subject, the Murdoch strategy is centered around retaining control while raising funds using cascading shareholdings and restricted voting shares.  Yes, he could always offer to issue voting shares, but is this really probable that he would risk his legacy to his children at this stage? No, he'd rather walk away. Perhaps an old fox can learn new tricks after all!



A reminder on TWX from the WYT Growth rater service

BSkyB & the rising cost of growth

BSkyB:  OK, so what’s the narrative to be?  21st Century Fox (Murdoch) parks some low yielding European payTV assets into a 39% owned subsidiary to raise at least £4.6bn of cash to help fund its (Murdoch’s) $80m Time Warner bid? As long as the market thinks that he will be back for the lot at a later point, with another full bid for BSkyB, once the phone hacking ruckus has died down, then he gets the cash, keeps control and supports the shares; which could always be re-hypothecated for some more funding. 

What about the core business? Last year’s stalled profits can in part be explained by the heavy step up costs for the new Premier League contract and bulls can point to the still healthy advance in revenues of +7% and the prospective rebound in profitability in the coming  year as programming costs stabilise.  The uplift from the revised Premier League contract however was a symptom of the changing distribution landscape and was not the only source of cost inflation to the group. To support all those new services came at a price, with Direct Network costs (+15%), Transmission & Technology (+11%) and Depreciation (+12%) all running well ahead of the +7% revenue growth.  If the above is the problem then, is the decision to buy Sky Italia and at least 57.4% of Sky Deutschland the solution?

Both Sky Deutschland and Sky Italia could be said to offer potential, but this could also be said of them many times over the past decade, while neither of them are particularly cheap on their current trading trajectories. Sky-D subscriber numbers and revenues have been flat-lining for years while the purchase price of €6.75ps values these subscribers  within 10% of BSkyB's on a per subscriber basis, yet with under half the revenue per subscriber generated. For Sky Italia, the growth record is better and the take-out price less onerous, although still struggling to generate much of a return.  Even with the £200m pa of projected savings by end FY17, these would represent less than 1.5% of combined sales and less than an additional 3pps return on the combined gross purchase price. With limited scope for joint rights purchase efficiencies or revenue synergies it seems investors will have to make a leap of faith here.   Having already had access to the best pay TV managers in town (including from BSkyB), it is also unclear what special sauce BSkyB will bring re-invigorate these two assets.

Trading – FY14: Revenues YoY +7% including retail subscriptions +5.1% (o/w ARPU +1.2%/+£7 and  TV subs +2.5%), Wholesale subscriptions +6.6%, Advertising +7.3%, Installation & Hardware -2.3% and Other +7.8% (incl Sky Bet at +18%).  Total paid-for subscriptions increased by +9.9% YoY to 34.775m, including TV at +264k/+2.5% YoY (o/w HD +456k YoY) and Broadband at +341k/+7.0% YoY. Q4 FY14 churn rates edged down slightly (by 20bps QoQ & YoY) to a still modest 10.9% while paid-for products per customer increased to 3.0 (vs 2.8) and with Triple-play now representing 37% of the retail subscription base (flat QoQ and +2pts YoY). FY14 adj EBITDA meanwhile declined by -£25m/-1% to £1,667m; a function of supporting new service introductions (SkyGo, Now etc) as well as higher programming costs (+7%/+£175m), including +£217m YoY increase from the step-up from the new Premier League 3 year contract. Including the benefit from a reduction in share base, the YoY decline in adj EPS was held at the previous year’s 60.0p while the FY 14 DPS was raised by +7% to 32.0p.

The ‘deal’. Excluding associated loan stock buyouts, BSkyB’s  proposed purchase commitments are between £4.97bn and £7.1bn, dependent on the proportion of Sky Deutschland that is tendered; from Fox’s 57.4% to a full 100% that is also being tendered for under German listing rules. To fund this, BSkyB is raising approx. £1.37bn via a placing of 156.1m new BSkyB ordinary shares (9.99% of the enlarged issued capital), with £382m funded from selling Fox BSkyB’s 21% stake in National Geographic and with the remainder funded by debt (possibly up to a max 2.9x debt/EBITDA). To maintain its 39.1% holding in BSkyB meanwhile, Fox will be taking up its entitlement. From Fox’s perspective, the disposal is worth approx. £5.35bn gross (£2.9bn for its 57.4% of Sky Deutschland and £2.45bn for the 100% of Sky Italia. As £382m will be part paid for by BSkyB’s 21% stake in National Geographic and Fox’s share of the placing will cost it around £730m, the net cash receipt for Fox should be approx. £4.24bn.

Murdoch and the art of using other people's money

So you've seen the headlines. First Fox's proposals to consolidate its interests in Sky Italia and Sky Deutschland into BSkyB, described by many as a "tidying up" exercise. Now we are treated to something more substantial to explain the earlier moves; an $80bn (c.$86 ps) plus offer for Time Warner.  The newswires are of course buzzing with analysis of the commercial logic and potential regulatory pitfalls of the proposed deal, along with the inevitable speculation about how much more can be squeezed out of Fox. There is another issue at play here however, that investors need to heed; the growing disconnect between voting control and equity risk.

There is nothing new about cascading shareholding and voting structures being used to exert control over companies.  While these companies perform to their potential, then shareholders usually turn a blind eye to the asymmetric relationship between risk and control. An enlightened despot however may be followed by a less capable one and that unfortunately is when the disenfranchised sheep learn about the equity risk premium.

21st Century Fox has two classes of equity, 2.23bn of the 'A' non-voting ordinaries with a market value of approximately $73.6bn and 0.712bn of the voting 'B' shares currently worth around $24bn.  The Murdoch family controls this c.$98bn of market value with a 39.4% stake of the 'B' voters; in other  words, with under 10% of the risk equity (39.4% x $24bn =$9.5 /$98bn = 9.6%).

This disconnect between risk and control however is not just limited to this top layer of ownership, but cascades down via a series of subsidiary layers which effectively leverage this disparity further with each step down. Take for example Fox's European broadcast interests; 100% of Sky Italia, 57% of Sky Deutschland and 39% of BSkyB. The Murdoch family control all of these assets, although with an effective equity risk exposure of only 9.4% for Sky Italia, 5.4% for Sky Deutschland and 3.7% for BSkyB. But the fun doesn't stop here though. Earlier this year, Fox proposed to fold its stakes in Sky Deutschland and Sky Italia into BSkyB - the purported 'tidying up' exercise. Regardless of the inherent risk that Fox would extract a 'control' premium from BSkyB for these assets, such a move would have further transferred equity risk on these assets to external investors while maintaining control by Murdoch. The effective share of Murdoch's equity risk for his stakes in both Sky Italia and Sky Deutscheland would have dropped to a mere 1.4%. For Fox, this deal would also have released around $11bn of cash with no effective reduction in control on these assets. Even were Fox to consolidate its share of BSkyB's increased debt, this would still add almost $7bn to Fox's funding headroom.

So back again to this Time Warner offer. 40% is in cash with the remainder in shares; not the 'B' voters however, but the 'A' non-voters. If Murdoch senior aims to leave management control to Murdoch juniors, he cannot afford to relinquish control at the top of this chain otherwise it will be game over. If this is his wish, and there is nothing to suggest otherwise, then speculation that he will sweeten the pot for Time Warner with an issue of voting shares seems wide of the mark.