NEW YORK (The Deal) -- Starz Entertainment (STRZA) Chief Executive Chris Albrecht last week found himself in the increasingly familiar position of addressing M&A reports. "Press speculation, what a shocker!" he quipped at Goldman Sachs' (GS - Get Report) annual media conference in New York.
Starz was linked in talks to AMC Networks (AMCX - Get Report) Tuesday afternoon, about 24 hours before Albrecht's presentation. Last December, on the eve of the UBS (UBS - Get Report) media confab, it was Lions Gate Entertainment (LGF). While Allbrecht did not explicitly confirm or deny negotiations with AMC Chairman James Dolan, he conceded that the heads of the cable networks talk "all the time."
Cable network bosses have plenty to discuss lately. Second-quarter earnings reports sparked an investor freak-out that preceded the mid-August drop in the broader markets. Even ESPN, Walt Disney's (DIS - Get Report) cash machine, faces questions about its ability to retain subscribers. Investors are sweating evolving advertising paradigms and questioning the tens of billions of dollars that cable networks have spent in recent years to buy back stock, which is worth significantly less than it was in mid-Summer.
That cash might have built or bought technology platforms to compete with online streaming services from Netflix (NFLX - Get Report), Amazon.com (AMZN - Get Report) and Hulu. Just a few weeks before the end of the third quarter, there is the gnawing concern that the future arrived ahead of schedule and caught the networks off guard.
With Altice's (ATCEY) $17.7 billion acquisition of Cablevision (CVC), consolidation of cable TV distributors continues. AT&T (T - Get Report) closed its purchase of DirecTV (DTV - Get Report) for $67 billion, including debt, and Charter Communications (CHTR - Get Report) is working to complete its purchase of Time Warner Cable (TWC).
Since Rupert Murdoch abandoned Twenty-First Century Fox's (FOXA) $80 billion offer to acquire Time Warner (TWX), cable networks have not pursued consolidation. Albrecht's non-denial of talks suggests that the mid-sized cable networks such as Starz, AMC and Lions Gate could seek greater scale and other benefits from deals.
The second quarter earnings for Disney, Time Warner and the other network owners was "one of the worst earnings seasons we have ever had outside of the Great Recession," Marci Ryvicker of Wells Fargo Securities wrote in a recent report.
Among the many low points was Disney CEO Bob Iger's statement that ESPN had lost subscribers in the quarter and that the company would lower guidance. Sports has been a safe haven for the networks. Signs of weakness at ESPN caused investors to recalibrate expectations across the sector.
Since Aug. 4, or "the Day before Disney," Time Warner has dropped more than 19% and Fox is down 21%. Viacom (VIA - Get Report) has surrendered more than 16% of its value, and at the close of Aug. 24 was down 28% from the day before Disney cast gloom on the sector. CBS (CBS - Get Report) has dropped by nearly 18%.
Time Warner is well below the $85 per share that Rupert Murdoch offered last year. Fox shares have also fallen, and generally the stock that media groups could use to make acquisitions has also fallen. James Murdoch supplanted Rupert as CEO over the summer, and does not have his father's record of M&A. Empire-building deals have fallen out of vogue in the sector.
"Slapping companies together just because they are under pressure doesn't really add up strategically," Moody's Investors Service analyst Neil Begley about media M&A. "In a time when you're worried about subscribers declining, why spend 10 or 12 times Ebitda to buy one of these business if your own stock is trading at 9 times?"
Network CEOs have favored shareholder friendly actions like stock buybacks and dividends over acquisitions. Fox, Time Warner, CBS, Viacom, Scripps (SNI) and Discovery (DISCA - Get Report) have high leverage relative to their target ranges, Begley said.
"They really don't have any more bullets in their belt to accelerate share purchases," he added. "I'm sure some of them regret doing that so they could buy more of their shares now."
From 2012 to 2014, New York investment bank LionTree notes, AMC, Lions Gate, Scripps, CBS, Discovery, Viacom, Starz, Fox, Time Warner, Tribune and Disney collectively returned $72 billion to shareholders. Stock buybacks accounted for $62 billion, exceeding the companies' $51 billion in cumulative free cash flow.
In a podcast about the media meltdown, Rich Greenfield of BTIG suggested that media boards should change their capital allocation strategies.
"The whole sector should realize they have no idea how to forecast their business," Greenfield said. "The last thing you should be doing is buying back your stock if you're not convinced its cheap and undervalued. I don't think anybody can know that right now."
Companies could make dividend payments, he suggested, and should invest in content and innovation. "Maybe that takes more scale and companies like Fox and Time Warner should merge," he said.
Fox CFO John Nallen said the company is focused on smaller deals at a Bank of America Merill Lynch conference in September. "I have nothing on my desk back in New York of some major acquisition that we're looking at," Nallen said.
"Is it crazy to believe that Disney buys SnapChat tomorrow?" Greenfield asked. "Is that a $25 [billion] or $30 [billion] or far bigger acquisition? Maybe but if you're looking to figure out where consumers are in the future maybe you have to be there."
Disney typically devotes about 20% of its capital to M&A, 60% in to investing in its businesses and returns 20% to shareholders. An acquisition on the scale of SnapChat would dwarf recent deals, such as the acquisitions of Lucasfilm Ltd. for $4.05 billion and and Marvel Entertainment Inc. for $4.3 billion. While the largest purchases were for intellectual property, Disney has acquired technological platforms like gaming company Playdom Inc. and online video group Maker Studios, each for less than $1 billion.
Disney, Fox and Time Warner declined to comment.
Lions Gate may be in the best position to roll up its peers, according to Macquarie Capital analyst Amy Yong. The company's corporate structure is relatively simple compared to conglomerates like Fox and Time Warner. Moreover, the company has ties to John Malone and his global network of media investment and contacts.
Malone and Lions Gate announced in May that they would exchange equity holdings. Lions Gate will give Malone 3.43% of its stock and a seat on its board. Malone provided Lions Gate with Starz A and B shares representing 4.51% of Starz's outstanding stock and 14.5% of the vote.
Yong suggested Lions Gate or another network owner could justify paying $55 per share for Starz, or about 12 times Ebitda, because of the benefits from a deal. The stock currently trades around $40 per share.
Albrecht discussed some of the ways that Lions Gate and Starz complement each other. The companies have a film library deal. Both companies are trying to reach second-generation bilingual Hispanic viewers.
If there were a deal, he said, it would not necessarily be the "final step," suggesting that there could be a more complex consolidation.
Stifel, Nicolaus analyst Benjamin Mogil suggested in a research note that buzz of a deal with AMC could push Starz and Lions Gate closer together. "We view an AMC/Starz deal as more complex as both entities have voting control blocks which may not want to cede power and there is the possibility that an acceleration of this deal track was to accelerate the conversations with Lions Gate," he wrote.
AMC and Lions Gate declined to discuss the outlook for deals.
Taking a page out of Netflix's playbook, Time Warner has launched HBO GO, an online app that provides programs to consumers without cable boxes.
CEO Jeff Bewkes said at the Goldman conference that the company introduced the offering because the market of broadband subscribers without cable TV service has reached a large enough market to support the service. Time Warner's Turner Broadcasting System that acquired a majority stake in video streaming company iStreamPlanet, to boost its ability to provide video online. Bewkes added that the second quarter numbers did not indicate that the network model is broken. "We don't see a tipping point," Bewkes said of the second quarter results.
Iger said that Disney could also offer its content direct to consumers. Crossing the line into a Netflix-esque online video offering carries daunting implications for some networks. HBO is an a la carte channel, but ESPN and other networks that are part of the basic cable bundle would have to gain massive numbers of online customers in short order to account for losses of cable subscriptions. Netflix has spent heavily to develop a large-scale streaming video interface, something that the cable networks have not done.
Moody's analyst Begley said that investing in intellectual property, programming and technological innovation is paramount, especially for companies with networks that have declining viewer ratings.
When it comes to M&A, Begley suggested, the media business has a herd mentality.
"When companies start to make acquisitions and they are rewarded for that in their share price others follow," he said. "When they are avoiding that, and stocks got punished for making acquisitions, its also a herd mentality."
Starz CEO Albrecht said that when considering a deal, media executives should ask themselves if they would want to hold the stock of the combined companies in five years.
"We've seen value destruction in M&A, and we've seen value creation in M&A," Albrecht said.
The failed merger of Time Warner and AOL serves as a cautionary example more than a decade after its close.
"Jeff Bewkes has created a lot of value by just shedding things that were sitting side by side rather than working together," Albrecht reminded investors at the Goldman conference.