Does Size Really Matter?

Liberty, Wall Street Push Consolidation, But Economies Of Scales May Not Add Up

In the next several weeks, what has long been a universal truth in the cable industry will be put to the ultimate test: Does scale really matter?

Charter Communications’ pursuit of Time Warner Cable has entered what some consider to be the home stretch — Stamford, Conn.-based Charter is reportedly close to lining up bank financing for a deal, which some believe could result in a formal offer in the coming weeks.

In the meantime, TWC shares continue to soar purely on speculation — they rose 14% between Nov. 20 and Nov. 26 as Charter shares increased 7.2% in the same period — and Liberty Media chairman John Malone continues to extol the virtues of consolidation and scale economics.

Since Malone’s Liberty Media, which owns a 27% interest in Charter, first broached the subject of a Time Warner Cable-Charter union in June — and was rebuffed by the larger cable operator — the industry has grappled with the scale question. Can simply being larger help solve the most pressing problems in the industry, such as rising programming costs, competition from over-the-top competitors and a dwindling customer base? Or will the more organic approach — focusing on selling more products to existing customers and exploring new customer avenues, like commercial services and home security — prevail?

Time Warner Cable chairman and CEO Glenn Britt has been squarely seated on the organic growth side, although he has said he would always be open to a deal at the right price that benefitted his company’s shareholders.


On a conference call with analysts to discuss third-quarter results earlier this month, Britt addressed the consolidation issue.

“Consolidation can be a good thing, but the terms really matter,” Britt said on the call, adding that succesful deals are done for several reasons: family-run businesses in which the children don’t want to participate anymore, or smaller companies being acquired by larger firms with better scale economics. In other instances, companies have sold out because they amassed too much debt and couldn’t finance the next capital cycle, or they were overly aggressive in the acquisitions market.

Britt harkened back to the split-off of Time Warner Cable from Time Warner Inc. in 2009, a period when many in the investment community expected the pure-play cable operator to go on an acquisitions spree. While TWC has done some deals — it acquired Insight Communications in 2011 for $3 billion — a spree never materialized.

“And why is that?” Britt said on the call. “Well, we certainly believe there are benefi ts to consolidation. However, we also believe that those benefits are pretty finite and easily knowable.”

It’s a basic law of economics that the biggest company in any business sector enjoys financial benefits from lower costs for supplies and equipment, and greater efficiencies in introducing new products and services. And in the past, it was those kinds of scale economics that helped drive consolidation in the industry.

Back in the late 1990s, the industry consolidated from dozens of fragmented independent operators to a handful of tightly clustered MSOs. Comcast, Time Warner Cable, Charter and Cox Communications all swallowed up larger and smaller systems to consolidate their bases, which helped keep down costs for network upgrades, programming and equipment. Tighter clusters and more customers meant that operators could also roll out new products more efficiently, market them more effectively and maintain them more expertly.

But as with all maturing industries, a point comes when getting bigger doesn’t tip the scale that much in your favor. Some say even a rumored union of Comcast and Time Warner Cable, which would create a 34 millionsubscriber behemoth that would have extreme difficulty passing regulatory muster, wouldn’t tip the programming cost scales dramatically.

Part of the reason is that as distributors have bulked up, so have programmers. In a research report last week, Sanford Bernstein media analyst Todd Juenger noted that nine companies — Discovery Communications, Viacom, The Walt Disney Co., Twenty-First Century Fox, Scripps Networks, Time Warner Inc., CBS, AMC Networks and Comcast’s NBCUniversal — control 90% of the professionally produced content in the U.S. And no distributor, according to Juenger, has ever been successful for a sustainable period without carrying all nine.


Distributor consolidation would most benefit the smaller operator, as their programming costs would likely revert to the larger operators’ costs in the event of a merger, according to Juenger. But that would even out over time.

Juenger noted that cable operators don’t overlap geographically and that consumers generally have at least four distribution options for programming — one cable operator, two satellite providers and a telco or overbuilder — which limits negotiating power even for a large cable company.

“Cable consolidation by definition does not change the number of choices of pay TV providers for (almost) any household in this country, and therefore doesn’t change the balance of negotiating power between distributors and content owners,” Juenger wrote.

Moff ettNathanson principal and senior analyst Craig Moffett worked out the programming cost numbers for a Time Warner Cable-Charter deal in a September note to clients and reached the same conclusion. In his report, Moffett noted that Charter’s average programming cost per customer, per month was about $40.66, while TWC spent about $32.36 per subscriber per month on programming.

A combined TWC-Charter would pay about $33 per customer per month for programming, Moff ett estimated — a savings of $7 per month ($337 million per year) for Charter, but pretty much status quo for Time Warner Cable.

Even Charter CEO Tom Rutledge, considered by many to be one of the most talented operational executives in cable, doesn’t seem certain on the programming-cost benefi ts of scale. Moffett said in his report that Rutledge bases his hypothetical M&A decisions partly on whether he can run a targeted business better.

“If you get to a certain scale, you have a different form of leverage in programming negotiations and you could argue about where that is,” Rutledge said on Charter’s second-quarter conference call with analysts in August. “And it’s not just scale, it’s also willingness to use that scale to affect your outcome, and how much you need or how big you need to be is a difficult question to answer.”

Others believe that Charter has a better chance in partnering with a larger operator like Comcast on a bid. People familiar with the matter have said Time Warner Cable has reached out to Comcast in the past several months, and the nation’s largest cable operator is contemplating either teaming up with Charter on a joint bid for TWC or formulating a standalone bid for the operator.

Most analysts believe a solo Comcast bid for TWC would be tough to get past regulators — the combined company would control 60% of the cable footprint and 33% of total TV households.

Wells Fargo media analyst Marci Ryvicker, in a research report last week, mapped out her scenario for a joint Charter-Comcast bid for TWC that would literally split the company down the geographic middle. In a joint bid, Comcast would receive 7.4 million TWC customers on the East Coast, including New York, Cleveland and Louisville, Ky; while Charter would get 4.5 million TWC customers in the West, including Los Angeles and Dallas, according to Ryvicker’s report.

While Charter would get a smaller slice of the pie, which could leave the operator’s need for scale unsatisfied, Ryvicker wrote, “Our view here is that 4.5 million TWC subs are better than no TWC subs at all — plus it does double the company.”

Programming-cost reductions wouldn’t motivate Comcast to do a TWC deal — it already gets the best rates in the country — so bulking up to nearly 30 million customers would be the main benefit from a union. Juenger argued that the programming costs could even be worse for Comcast in a deal.

As part of the concessions it made to the federal government to approve its acquisition of NBCUniversal, Comcast agreed not to favor its own networks over any other. That effectively removes Comcast’s ability to drop another network.

“If Comcast doesn’t have a credible ability to drop networks, it has no real teeth to push back on price,” Juenger wrote.

While scale economics don’t seem to favor consolidation, plain old business economics could throw a wrench into a Charter-TWC union.

Moffett argued that to handle the additional leverage needed to get the deal done — he estimated that the combined company would have about $64 billion in longterm debt, or 6 times cash flow — it would have to improve TWC’s operations significantly.


Moffett estimated that to service the debt, Charter would have to increase TWC’s cash-flow generation by about 19%. The second-largest MSO has averaged about 6.3% cash-flow growth for the past three years.

“Rutledge is the best operating executive in the cable industry,” Moffett wrote. “But achieving such benefi ts may prove challenging even for someone with his level of talent.”

Not everyone shares that view. Pivotal Research Group principal and senior media & communications analyst Jeff Wlodarczak estimated that a combined Charter-TWC would be levered at about 5 times cash flow, a level he said he considers extremely manageable.

The debt markets are still attractive enough that the combined company could strike deals that mature at longer terms at relatively attractive rates, Wlodarczak said, adding that TWC generates a large amount of free cash flow, which could be used to pay down debt, and Charter has a substantial amount of net operating loss carryforwards (more than $8 billion), which could be used to off set taxes.

“TWC generates sizable free cash flow and operates a very defensible business,” Wlodarczak said.

Despite the presence or lack of synergies, the structure of the deal would also play a huge role in whether it got accepted. At $150 to $160 per share, an offer for TWC would consist of at least $90 per share in cash — a minimum requirement by some TWC investors — with the rest consisting of stock and possible equity investment from third parties, according to reports. The stock component is a crucial element, some observers have said, because shares of both companies have risen more than 30% in the past six months solely on the hopes a deal would be done.

“There is a huge challenge that the TWC board would have to get comfortable with in terms of the capital structure and the currency they will be taking back,” said a former investment banker familiar with both companies who asked not to be named.

“What they are saying to their shareholders is, ‘Here’s a piece of paper that is three times levered and is growing fairly well versus a piece of paper that is 5.5 times levered in exchange for that,’  ” the banker said. “Yes, it’s going to grow a little faster, but the only reason it’s growing a little faster is because all of the markets that they just acquired were: one, markets they passed on before and, two, are underpenetrated because they weren’t run well. That’s a hard thing for a board to say they should be jumping up and down for.”


A combined Charter-Time Warner Cable may not create the economies of scale that deal proponents are pushing for.