AT&T Broadband-Comcast Merger Gets Wary Outlook from Analyst
On April 18, 2002, Scott Cleland, a well-respected Wall Street analyst, issued a warning (reprinted below) about the proposed AT&T Broadband-Comcast merger. Cleland believes that there are a number of factors weighing against the merger of the two companies. He sites concerns by labor organizations and the Securities and Exchange Commission.
Cable Valuations & Comcast-AT&T Deal on Wrong Side of Change
By Scott C. Cleland, April 18, 2002
Summary: Further analysis of the recent negative developments in the cable industry (highlighted in our 4/3/02 "Cautionary Cable Outlook" report) leads us to advise investors to underweight cable because cable is on the wrong side of multilevel external market changes and because the Comcast-AT&T Broadband deal faces increasing risk.
The "post-Adelphia" scrutiny on cable's financial practices combined with the increasing Comcast-AT&T Broadband merger risk could be catalysts for re-valuing cable.
I. Cable On Wrong Side of External Change:
(A) Macro trends: Cable's high relative valuations depend on the continued perception of forward growth; however, slower industry growth plus rising cost of capital is a vise that squeezes life out of cable's traditional growth tools: cheap financing, and rollup M&A. Cable's M&A-dependent growth model faces a hostile M&A environment.
(B) Financial trends: Cable needs to borrow and spend freely to maintain growth initiatives; at the same time credit agencies are tightening ratings market-wide. Cable is the ultimate "pro-forma" financial model. During the bubble, equity and credit analysis were disconnected – equity analysts viewed heavy debt as an endorsement of high equity values, while credit analysts took high equity values as an endorsement of heavy debt. Post-Enron, heavy "junk debt" is increasingly a proxy for "junk equity."
(C) Post-Enron government scrutiny: The SEC investigation of Adelphia spotlights questionable cable accounting practices at a time when SEC enforcers are aggressively re-establishing accounting integrity, disclosure and transparency market-wide. Adelphia's troublesome accounting practices are not unique -- at least AOL and Cablevision have significant off-balance sheet debt. And Adelphia and other cable companies may capitalize broadband customer acquisition costs. That practice was considered misleading accounting when the SEC fined AOL $3.5m for inappropriately capitalizing 1996 narrowband customer acquisition costs.
(D) Post-Enron shareholder scrutiny: Five of the seven largest publicly-traded cable companies are majority-controlled by family or individuals (Comcast, Cox, Cablevision, Charter, and Adelphia), which effectively gives public shareholders second class voting rights and little ultimate recourse or deterrent to protect their ownership interests. (E) Expectations of profitability: To the extent the post-Enron market increases focus on profitability over growth, cable valuations could be under pressure. Cable has long been a "gerbil wheel" for investors, lots of motion but no progress toward sustainable profitability. Cable is a profit paradox; becoming profitable could hurt growth and create tax liability, and growth and tax avoidance expectations help prop up future cable valuations. Cable has a history of "perpetual cap-ex creep," meaning that cable has already mortgaged its future profits.
(F) Searching for post-EBITDA valuation metric: The "pixie dust" of EBITDA assumes away real non-operational costs that limit GAAP earnings. It is grossly misleading for a competitive and debt-laden cable industry facing rising interest rates to downplay interest and depreciation expenses in pro forma reporting. Precursor suspects the post-Enron market could be less accepting of EBITDA pro forma accounting.
II. Comcast-AT&T Deal -- Weak Cable Valuation Prop:
(A) More deal risk than market appreciates: (1) Comcast warned it may have to draw on its $4.5 billion "liquidity cushion" to complete the deal. If Comcast effectively maxes-out its credit card, it pressures its equity, which makes its debt more risky and costly. (2) This deal's Achilles' heel may be Comcast's plan to subjugate AT&T shareholder voting rights to management's effective control of the combined entity with only about 1% of the economic interest. Comcast wants to bundle approval of the AT&T Broadband merger with several anti-shareholder protection provisions: preventing removal of management for eight years, no combined board meeting until 2005, and limits of 10% stock ownership without board approval. The AFL-CIO and the City of New York, among others, are urging the SEC to enforce its own 1992 rules that prohibit the bundling of key shareholder votes like Comcast-AT&T proposes to do. In this post-Enron market, precursor doubts the SEC will allow Comcast-AT&T management to enrich itself at the expense of AT&T shareholders in such a public vote. (3) The merger is also vulnerable due to the critical $5 billion in financing supplied by Microsoft. Microsoft's financing is contingent on provisions granting Microsoft leverage over competitors for set-top box software, middleware, and ISP access; Precursor expects the FCC and DOJ to have significant antitrust concerns about those commitments.
(B) Deal price hanging precariously on bubble valuations: A key valuation support peg for cable is Comcast's original bid of roughly $4500 per sub for AT&T Broadband. $4500 per sub represents over 90% of the 1999 peak valuation for cable during the bubble. However, the key factors that levitated these valuations to their peak are gone. (1) In an historical Telecom Act anomaly, AT&T was uniquely desperate and financially capable to bid up the value of cable during an extremely friendly M&A and growth environment. (2) The dual rationale AT&T used to justify peak cable valuations did not pan out anywhere near what they presented. The Internet-monopoly growth play of @Home's exclusive closed broadband model cratered; and AT&T's national cable telephony “uber-strategy” to conquer the Bells fizzled. Comcast is not proposing more growth than the "bet-the-farm" strategy of AT&T; its rationale is that it can improve AT&T's margins. (3) Even if one uses cable's flawed EBITDA valuation metric, cable's multiples today are nearly 50% higher than pre-bubble multiples.
