Comcast's Offer Is A Bad Deal for AT&T
Commentary, Wall Street Journal
By Andy Kessler, a partner in Velocity Capital Management LLC, based in Palo Alto, Calif.
July 12, 2001
Comcast's unsolicited $41 billion bid for AT&T's cable systems has been billed as an instant value enhancer for AT&T's beleaguered shareholders. Comcast CEO Brian Roberts claims that Comcast has superior management, as evidenced by its 42% operating margins (income before non-cash expenses) vs. AT&T's 18%. And, he says, the deal would have strategic value because it would allow Comcast programming to be leveraged over more systems.
It's all just a smokescreen. Comcast has to buy some company or its returns will begin to falter as it starts to pay taxes. A buy-out offer motivated largely by fear that the tax man cometh? Don't be so surprised. Cable is an entire industry structured around tax avoidance.
As a highly regulated and virtually competition-free local franchise, cable TV is extremely lucrative. You put up some capital, string some cable, and the cash flows like water. So cable companies are set up to shield that cash flow from taxes. Take on high debt loads, run high depreciation and amortization expenses and under no circumstances actually show profits. No reported earnings, no taxes.
But this makes cable a game of hot potato. You put fresh (borrowed) money into new infrastructure, write it off over (say) five years, raise prices often, and then either upgrade for fresh depreciation, buy more systems so you can write them off, or try to sell what you have to someone else, tax free.
That's what John Malone, ex-honcho of Tele-Communications Inc., did. Unable to expand his network because of the Federal Communications Commission's now-discarded ownership limits, he stopped upgrading his systems years ago, increased cash flow and then sold out to AT&T at a premium price -- on a tax-free basis, of course.
Comcast, on the other hand, has accidentally paid taxes for the last several years, almost exclusively because of investment gains caused by AT&T buffoonery. In 1999, Comcast collected a $1.5 billion breakup fee from the MediaOne deal that AT&T terminated by stepping in. In 2000, Comcast recorded a $1 billion gain on the value of Excite@Home shares that AT&T agreed to buy from Comcast at a minimum price of $48 way back in 1999. (Excite@Home shares now sell for $2, barely an $800 million market cap for the whole company.) Comcast also paid taxes on gains from systems that it swapped with AT&T last year, and I think that scared the Roberts clan. They are nearing the end of a depreciation cycle, and either they act now or it's time to sell.
But of course they can't sell because then Brian Roberts would be out of a job. Brian is the son of Ralph Roberts, who founded the company in 1962. The family owns about 2% of Comcast through an investment company named Sural. But through the vagaries of various voting classes of stock, the Roberts have 87% of the votes. Brian doesn't own Comcast, he controls it.
And that's a big problem in the cable industry as a whole. The usual balance between customers, management and shareholders is gone; instead, these companies are run for the betterment of those that control them. Brian won't sell, and he can't stand still or Comcast will have to pay taxes, so he has to buy something. Buy AT&T's cable systems for $40 billion plus assuming $13 billion in debt? It's a small price to pay to keep a job.
Cable is basically a flat business. Comcast, like everyone else, has been stuck at a subscriber-to-homes-passed ratio of around 61% for the past five years. So the majority of growth has to come from passing more homes, typically via acquisition. Comcast is also good at raising prices, and even occasionally offering new services, such as digital cable or cable modems. But of Comcast's $4.1 billion in cable revenue in 2000, $3.6 billion came from analog video, the same stuff daddy originally sold almost 40 years ago.
AT&T has been rapidly spending money, $1.8 billion so far, to upgrade its neglected TCI systems, which has hurt AT&T Broadband's margins and, in effect, put the company in play. Comcast, with the help of $1 billion in cash from Microsoft in 1997, is through with its current upgrade wave, so its margins are higher. The supposed synergy of the deal is getting AT&T Broadband's current 18% operating margins up to Comcast's 42%. But neither number is absolute; it all depends on where you are in the upgrade cycle.
So the deal stinks for everyone but Brian Roberts. Current AT&T shareholders would get 51% of the equity of the new entity, but the Roberts would still run it -- more of a coup than a takeover. Comcast shareholders, meanwhile, suffered a 10% loss on the announcement, which means that the company may have to issue more shares to finance the purchase, which could drive its stock down more in a vicious cycle.
What the cable industry needs are companies where management answers to shareholders and capital spending is driven by the market, not tax laws. Slicing the industry into horizontal layers to get rid of content-and-distribution players would help, as would deregulating local franchise authority. Disallowing interest expense in tax calculations, or ditching corporate taxation altogether, would help too.
But for now, the industry is what it is. And the bottom line on this deal is this: AT&T's low margins on cable have little to do with current management but are mostly a relic of the tax-avoidance machinations of John Malone. They'll rebound. Acccordingly, there's no need to sell cheap. If I were an AT&T shareholder, I'd tell Comcast to get lost. |
