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Will Discovery’s Owners Buy Into Deal?

7/08/2005 8:00 PM Eastern

Liberty Media Corp. set the spinoff date for its Discovery Holdings Co. last week — but at least one Wall Street analyst believes the long-awaited separation will receive a lukewarm reception from Wall Street.

Liberty said it will distribute DHC shares on July 21, with Liberty shareholders of record on July 15 receiving 0.10 shares of DHC for every Liberty share they own. DHC will include Liberty’s 50% interest in Discovery Communications Inc. and its 100% stake in Ascent Media Group.

Discovery Holdings Co.
At a glance:
Source: Securities & Exchange Commission filings
Discovery Communications: 2004 revenue: $1.1 billion; 2004 operating cash flow: $662.7 million; 2004 free cash flow: $125 million
Ascent Media Group: 2004 revenue: $631 million; 2004 operating cash flow: $97.4 million.

While the idea of spinning out DHC was received enthusiastically by Wall Street when it was first announced in March, Fulcrum Global Partners media analyst Richard Greenfield wrote in a report last week that the separation is unlikely to excite investors because Discovery’s other stakeholders — Cox Communications Inc. and Advance/Newhouse Programming Partners own 25% each of the group of networks — would not participate in the spin, as had first been expected.

RESISTANCE SEEN

Both Cox and Advance/Newhouse have so far resisted putting their interests in DHC, a fact that Greenfield believes will widen the gap between DHC’s trading value and the sum of its assets.

Back in March, when the DHC spin was first announced, Liberty chairman John Malone appeared confident that Cox and Advance/Newhouse would participate, telling investors and analysts that if they didn’t contribute their Discovery interests, the spin could be a vehicle for Liberty to divest of its half of the networks.

“There are lots of ways this can evolve,” Malone said on the conference call. “I would put a fair amount of money on the table that Cox and Newhouse will want to merge into this vehicle. But I would say the downside isn’t so bad.”

Later, at Liberty’s Investor’s Day meeting in May, Malone didn’t appear quite as confident.

Malone said at that meeting that both Cox and Newhouse wanted Discovery’s governance at 50-50 while assuming no tax risk. That, he said at the time, would violate the Morris Trust structure of the spin, which requires the spinoff entity to retain more than 50% of the value and more than 50% of the vote.

“With the passage of time, post-spin, these Morris Trust issues go away,” Malone said. “In that fullness of time, it will be much easier for the entity to accommodate the governance and ownership ambitions of Cox and Newhouse merging in. To try and do that in the short run is really a daunting challenge for the lawyers and the tax guys.”

Key to Greenfield’s valuation is that DHC will not have access to Discovery Communications’ considerable free cash flow ($125 million in 2004) and that the current ownership structure restricts Liberty or DHC from influencing the stable of domestic and international networks.

According to a securities filing made June 27, the shareholder’s agreement between the three parties requires approval of at least 80% of Discovery’s shares for certain actions such as merging Discovery with another network, issuing additional shares of Discovery’s capital stock or even the approval of its annual business plan.

“Because we do not own a majority of the outstanding equity interests of Discovery, we do not have the right to manage the businesses or affairs of Discovery,” Liberty said in the filing.

In the event of a deadlock, DHC said Discovery chairman John Hendricks can cast the deciding vote, but he is not obligated to do so.

In addition, if Liberty elected to sell its 50% interest in Discovery, it would be required to first seek out an offer from an unaffiliated third party and then offer to sell its interest to Cox and Advance/Newhouse on substantially the same terms.

“Why will investors want to invest in a public company that has no access to the free cash flow of its primary asset, with Discovery operating management not incentivised via DHC stock, with zero visibility as to whether the situation ever changes?” Greenfield asked in his report.

When it announced plans for the spinoff, Liberty had hinted that Cox and Advance/Newhouse would come on board.

But despite some initial conversations, including those that posed swapping their interests in Discovery for shares of Liberty stock, no deal has been reached.

And it is possible that no deal will ever be reached.

“Prior to the spinoff, we elected to terminate such discussions and there are no current plans to resume such discussions,” Liberty said in the SEC filing. “We do not have the ability to require Cox Communications or Advance/Newhouse to sell their interests in Discovery to us, nor do they have the ability to require us to sell our interest to them. Accordingly, the current governance relationships affecting Discovery may continue indefinitely.”

STRATEGY QUESTIONED

The inherent problems in the DHC spin caused Greenfield to wonder about Liberty’s future strategy.

Many investors, according to Greenfield, hold Liberty stock with the belief that management would unlock value by selling or spinning off assets in the next 12 to 18 months.

While Liberty has done little to discourage that thinking, Greenfield wrote that the media giant’s actions are telling a different story.

Greenfield points to two key events in addition to the DHC spinoff. The first was Liberty’s assertion at its “Investors Day” meeting in May that it was looking for acquisitions and to lever up its balance sheet to pursue opportunities such as increasing its stake in the National Geographic channel or certain assets of IAC/InterActive Corp.

The other is the lack of a deal for Liberty’s voting shares in News Corp.

While National Geographic’s ownership structure could present a roadblock to a transaction (the National Geographic Society would have to sign off on any deal), Greenfield still believes that a move could be made to divest of News shares.

Liberty acquired an 18% voting stake in News in December, a move that prompted speculation that Malone would attempt to wrest control of the company from its chairman Rupert Murdoch.

News Corp. effectively quashed that speculation later that month, adopting a “poison pill” shareholder’s-rights program that would make it difficult for any individual to acquire more than a 15% voting interest in the media conglomerate.

Although News Corp. in June announced a two-year, $3 billion share repurchase plan — it has already bought back about $500 million of its own stock — Greenfield believes News Corp. and Liberty could engineer a tax-free split-off (placing the Liberty-owned News stock and an operating asset in a separate entity).

While News Corp. would be precluded from having majority control of that asset for at least two years, Greenfield wrote that Murdoch has more than enough financial capacity to complete the share buy back and acquire the company Liberty spins out.

“The problem is that there is no visibility on if or whether this will ever occur,” Greenfield wrote.

News Corp. is not obligated to buy Liberty’s 18% stake (it can extend its poison pill indefinitely) unless Liberty presents an attractive offer, Greenfield noted.

September