Updated from 7:03 a.m. EST
The ghost of the disastrous AOL-
. A deeper look at the securities and businesses involved in the proposed transaction suggests that while the deal features a far better blend of assets, those assets are currently no bargain, and they may not get more valuable simply by being combined.
There are a number of obvious similarities between the Comcast deal --
which Disney's board rejected late Monday -- and the one AOL pulled off during the waning days of the dot-com era. In both cases, management touted the marriage of content and distribution and inherent synergies that will take years to implement. Both saw share prices and price-to-earnings ratios increase after the deal was announced, giving rise to fears that an overvalued stock was being used to acquire a much more tangible asset.
Comcast's stock is indeed pricey, by traditional metrics. Its A shares rose 40% last year and currently fetch 107 times 2004 earnings estimates -- not cheap, using ordinary valuation standards. Disney investors wondering whether to tender their shares might think twice about whether the value implied by Comcast's exchange offer is reliable, or is apt to evaporate, AOL-style, and dilute their equity, which trades at a more palatable multiple of earnings.
To believe that it won't, one must rely, in part, on the valuation arguments behind Comcast's current share price. For better or worse, Wall Street doesn't value cable companies like Comcast on a P/E basis, on grounds that the companies' huge depreciation burden takes a much bigger bite out of profits than it does at other companies. Instead, analysts focus on free cash flow, and on that basis, Comcast's share price isn't nearly as expensive: about 11.5 times.
"Comcast has had a higher cash flow multiple than other companies, but at the same time, their growth rate is higher than other companies, because they're seeing a margin recovery," said Todd Mitchell, analyst at Blaylock and Partners. "I believe cash flow was up 44% this year. That's higher than the rest of the industry. Frankly, I think if you look at two companies, Comcast was relatively undervalued while Disney was fully valued."
According to CSFB estimates, Disney's free cash flow will outpace Comcast's in 2004, but in the years that follow, Comcast will have an edge. In 2004, CSFB estimates that Disney's free cash flow will be $100 million more than Comcast's, but starting in 2005, Comcast will have a $300 million advantage -- which it will retain through 2007.
It's also hard to argue that by offering 0.78 of its shares for one of Disney Comcast is being profligate. On the basis of Friday's close, the deal values Disney at $23.32 a share, below Disney's closing price of $26.92 and way short of the $32 per share that Disney is estimated by some analysts to be worth on the private market.
Disney climbed more Tuesday morning, recently fetching $27.37 in Instinet premarket trading.
CSFB estimates that the deal would dilute earnings by 2% in 2004. By 2007, with supposed synergies and new products in place, the brokerage estimates the deal will be 2.7% accretive, producing combined EBITDA per share of $4.16, more than a dollar higher than the 2004 estimate.
One definition of a perfect stock merger might be that no existing value is destroyed, which is to say, the combined market capitalization should be no less than the separate companies' value put together.
"Ideally, synergy would provide extra value, reduce costs elsewhere and capitalize on opportunities from the combined operations that would enhance values than would not have been possible on an independent basis," said Gordon Kaiser, head of corporate practice at Squire Sanders & Dempsey, a law firm specializing in mergers and acquisitions. "The number on a postdeal company should look equal to or better than the combination of the two entities."
In this case, on the basis of Tuesday's closing prices, that would imply a value greater than $136 billion. Currently, CSFB thinks a combined Comcast/Disney will probably be worth about $124 billion, if and when it comes to be. The reason is primarily the lower combined earnings in the deal's first years, mentioned above.
Such dilution would be painful for short-term owners. But while the first year of the merged company will create an entity that earns less and could easily slip in value, for Comcast, the deal is not about next year: it's about the next decade. By taking a few steps back early, Comcast would probably argue, the combined company will be able to make strides with new, innovative product offerings that will make it a juggernaut down the road.
Operationally, a Comcast-Disney hookup makes far more sense than did AOL-Time Warner. While the latter was a combination of offline content and online distribution, Comcast-Disney is a merger of cable content and cable distribution. Such an approach has been used successfully by John Malone's Liberty Media (L) - Get Loews Corporation Report, which owns stakes in the Discovery Channel, USA Interactive, QVC, Encore and Starz!, and has interests in video distribution businesses and a small stake in News Corp (NWS) - Get News Corporation Class B Report.
Comcast plans to leverage Disney's properties across its cable network, packaging them as video on demand, subscription services and high-definition TV offerings. And adding new cable stations will be a snap, with Disney able to reach Comcast's 21 million subscribers without paying for the privilege.
"If the Comcast-Disney combination is consummated, we firmly believe that the business of television and filmed entertainment would be radically altered," said Jessica Reif Cohen, analyst at Merrill Lynch. "Comcast is likely to use television and movie production to drive penetration of television's new array of digital products."
Also, with News Corp.'s
as an outlet for its satellite programming, Comcast's move can be viewed not so much AOL's aggressive leap of faith as a cable company's defensive act.
Nonetheless, not everyone on Wall Street thought the deal's synergies outweighed the potential for value destruction.
"While there could be some merits in combining content with distribution, we do not believe these are overwhelming, as we have seen with a company such as Time Warner, which has yet to really show the inherent benefit of marrying content and distribution," said Jill Krutick, an analyst at Citigroup Smith Barney.
And because both companies do different things, with less overlap between operations, cost savings could be light.
While Comcast said savings could come to between $800 million and $1.2 billion, given the state of the Magic Kingdom, analysts say up to two-thirds of the savings stems from a Disney turnaround -- not synergies. Only a third will come from cutting overlapping management and consolidating operations.
"At first pass, we do not see material operational benefits from the actual combination of the two companies," said Daniel Zito, analyst at Legg Mason.
Still, Comcast has one thing that AOL never did: a solid track record. Unlike AOL, Comcast has been able to acquire companies and meld them into operations, as with its recent purchase and turnaround of AT&T Broadband. Having Steve Burke, once heir to the Disney throne, helming Comcast's cable operations doesn't hurt either.
"Comcast is a company with a striking strategic ambition, as well as striking skill in acquisitions. Comcast's long history of deal execution has been extraordinary in terms of shareholder value creation," said Cohen. "We regard Comcast and Disney as logical merger partners."