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Business of Magic
A look at the business of Disney
|Alex Stroup, Editor|
Disney's Purchase of the Fox Family Channel, Part Two
In Part One, we looked at Disney's offer to buy the Fox Family Channel from its current owners, News Corp. and Saban Entertainment, for $3 billion in cash and $2.3 billion in assumed debt. We discussed what Disney will be getting for its $5.3 billion investment:
Today we finish up by looking at why Disney is buying Fox Family and how it is going to pay for all this and, as well as "run" some numbers to see if this deal makes financial sense.
How Will Disney Pay for This?
That's a big question, actually. Disney will be paying $3 billion in cash to News Corp. and Saban, but as of March 31, Disney only had $663 million of cash on hand. It also had investments totaling $2.137 billion. So even if Disney's management sold all of its investments (and it's unlikely that it would or even can) Disney would still fall short of the amount needed and would have no cash left for normal business or other acquisitions.
Rather than leave us to guess at how it will pay for this acquisition, the Walt Disney Company has already given us a partial answer. It submitted a filing to the U.S. Securities and Exchange Commission stating its intention to raise $7.5 billion by issuing and selling various securities. This means the company will either sell more stock, sell bonds, or do a bit of both.
Disney will most likely finance this acquisition with bonds, which is the corporate equivalent of taking out a very large loan. There are only two problems with this: First, Disney already has $9.6 billion in long- term debt. Second, the company will of course have to pay the bond issue back -- with interest. Assuming about a 6.5 percent interest rate (which is what Disney paid on its last 15-year bond issue in May), an additional $3 billion bond issue would require the company to pay $195 million per year in interest to the bondholders. Let's hope that the cash flow of $300 million a year that Mr. Staggs was talking about was after interest payments -- or else the profitability of this venture drops rapidly.
However, now is a very good time to issue bonds, as interest rates are quite low and thus the amount of interest paid will be as small as possible. Plus, there are tax benefits to bonds since interest paid is deductible against corporate profits.
The other alternative is to issue additional stock and sell it to the public. I doubt that Disney will issue much -- if any -- new stock to raise this amount. As a general rule, companies like to issue and sell more stock only when their stock price is high -- because they can raise a lot of money without creating too many new shares. Disney's stock price is rather low right now (35 percent off its 52-week high) and its total existing stock outstanding is worth $54 billion. $7.5 billion in new stock would dilute existing shareholder holdings by about 13 percent, which is most likely unacceptable.
Note that acquisitions are often paid for directly in stock -- that is, Disney could issue an additional $3 billion of Disney stock and give it directly to News Corp. and Saban Entertainment in exchange for their shares of Fox Family. This avoids all the hassle of issuing bonds and the expense of paying interest. But in this case, News Corp. and Saban apparently wanted to cash instead, probably so News Corp. could use the cash in its bid to buy Hughes Electronics from General Motors. Hughes Electronics owns the DirecTV satellite system, which News Corp. wants in order to compete with the cable system companies. Boy, the media business certainly gets complicated, doesn't it?
It May Cost Disney Less Than $5.3 Billion
A good thing about the way Disney structured this deal is that it is only paying 60% of the purchase price in cash. The rest, $2.3 billion, is debt that the Fox Family Channel has accumulated over the years. But it may not cost Disney the entire $2.3 billion to pay off these debts, as it may be able negotiate down the debt.
For example, if Disney offered to pay you $2.3 billion over several years or $1.3 billion right now, which would you take? Some companies that Fox Family owes money to may opt for a quicker, but smaller, payoff. Obviously, we have no way of knowing how much Disney might save by doing this, but let's just say that Disney is known as a tough negotiator when it comes to paying off debts.
So why does the Walt Disney Company want to spend a little over $5 billion to start another cable channel? As I mentioned in Part One, it wants access, and it wants to repurpose programs. But how does this fit into the big picture? Disney CEO Michael Eisner and President Robert Iger have pretty much spelled it out for us.
The problem is that the profitability of network television programs is being attacked from two sides. On one side, quality programs are becoming more expensive to produce. On the other side, advertising revenue for network programs are falling, due to both a shrinking audience for network TV -- as niche cable programming siphons off more and more viewers -- and an economic slump that has cut advertisers' budgets. Mr. Eisner has stated that the ability to continue creating high-quality programming under the current business model is "in jeopardy."
Disney's solution is that if it can't make enough money to pay for the programs with the ad revenue from showing them once or twice on ABC, it would more profitable to show the programs again on cable, getting additional viewers and selling additional ads. Those additional viewers would be people who, for whatever reasons, didn't see the programs on ABC the first time around. In theory, everyone wins: the viewers continue to get high-quality programs along with more chances to see them, the advertisers get more places to show their ads, and Disney gets additional revenue without the cost of creating more shows. This plan is, according to Eisner, an "insurance policy for the consumer" that will allow Disney to be able to continue creating high-quality programs.
The main assumption behind this theory is that Disney will get enough viewers for these repurposed programs to make the plan work. The idea seems natural for certain shows: Nightline or Politically Incorrect, for example, which are on too late for some viewers. For other programs, conflicts (say, viewers having to choose between Drew Carey or West Wing) or the fact that many of us lead busy lives, means we often miss TV programs that we enjoy.
Mr. Iger stated that the typical network viewer sees on average only seven episodes per year of programs they like. This, conceptually, leaves a large potential audience for showing those programs again. And in practice, it appears to have worked on a small scale: This year, NBC repeated episodes of Law and Order: Special Victims Unit on the cable-based USA Network on Sundays after the shows aired the previous week. The rebroadcasts had better- than- average ratings for USA, while NBC's ratings for the program have increased as well. In addition, for years HBO has repeated episodes of its original programs such as The Sopranos several times over the course of a week or month.
However, I see a few potential problems here. The key will be getting the viewers to show up. The overall problem, I believe, is that television viewing is currently a zero-sum game. That is, most of us watch about as much TV as we have time to. If this is true, then adding repeats of shows will not significantly increase the number of hours that people can watch. So if I decide to watch something on the ABC Family Channel, that means I have to not watch something else. And this is where I believe Disney's plan will fall apart: I suspect we only watch seven episodes of a show not because they aren't on at convenient times, but because we just don't have the time to watch everything we'd like. Personally, I would love to be able to watch Politically Incorrect at an earlier hour, but where I would find the extra two and a half hours every week? Additional reshowings won't help me find more time to see them. Therefore, I'm not convinced that reshowing programs will significantly increase the number of viewers. The audience the new channel obtains may come at the expense of the ABC's. This is what in the business world is commonly called "cannibalism," when your new product steals away customers from one of your old ones.
This leads to other issues as well. By siphoning away viewers, this plan may very well upset ABC's broadcast affiliates, who are the owners of the individual, local ABC TV stations. They want to be the only place where you can find popular shows like Dharma & Greg, because that means they'll get more viewers and higher advertising revenues. They don't want to see the ad dollars coming out of their pockets and going to Disney through the cable channel instead. These affiliates are the reason why Disney can only reshow 25% of ABC's program on the new cable channel -- the affiliates wouldn't agree to anything more. Affiliates have also been known to switch networks, so Disney must be very careful not to antagonize them.
Yet another issue is how much these multiple showings of programs will lower their value for syndication. In the past, if you didn't catch an episode of Seinfeld or X-Files when it aired first time or during its later single rerun, you had to wait eagerly until syndication. But with multiple showings, will anybody care to watch the syndicated reruns? A lot of the profit from a TV show comes from selling its syndication rights -- and the question is whether the lower syndication value will be offset by more money up front from the repurposed broadcasts.
Running the Numbers
Finally, let's do a quick Net Present Value (NPV) analysis on this deal to see if Disney is making a wise financial move with this acquisition. "Present Value" is what a future amount would be worth today. For example, $1 a year from now is worth 91 cents today if the interest rate is 10%, because you could invest that 91 cents for a year, get 9 cents interest and in a year have $1. Hence, they are basically equivalent. "Net Present Value" simply means to take the present value of each cash flow for a project. Some are cash flows into the project -- investments -- with a negative sign while others are cash flows out of the project -- profits or pay outs -- with a positive sign. The interest rate chosen is what return you could get by investing the money elsewhere.
If the sum of the present values of all the cash flows is greater than zero, then this particular project makes more money than the alternative investments and the company should therefore go for it. On the other hand, if the sum is less than zero, the company can make more by investing the money elsewhere. From what I understand, Disney management loves NPV analysis. The company undoubtedly did one for this acquisition as well, albeit a much more sophisticated one then what we'll do here.
Ours is going to be very simple. To keep it that way, let's assume:
Fortunately, I'm going to spare you most of the math and just give you the results. The present values at the time of the closing are:
Since the NPV was positive, this means that in our simple model the purchase of the Fox Family Channel is a sound financial investment -- in fact, theoretically it is better than investing that money elsewhere within Disney.
By doing some additional math, the break-even point is 14.2 percent. This means that in our simple model, as long as the ABC Family Channel's annual growth is greater than 14.2 percent, this deal makes financial sense. This means profit will have to double about every five years, which is an aggressive -- but not unachievable -- goal.
Some Final Thoughts:
Disney's purchase of the Fox Family Channel makes sense if you buy into certain assumptions. But these are some pretty big assumptions:
In other words, all these assumptions have to come true to make this a good deal for Disney and its shareholders. It's a risk with a $5 billion price tag attached to it -- remember, the expansion of the Disneyland Resort cost less than $1.5 billion, and look at the concern one part of that project (California Adventure) is causing within the company.
On the other hand, can Disney afford not to try this? In Eisner's view, having a cable channel with repurposed ABC programming is "insurance" that provides enough profit to allow it to continue producing good television programs. But I have to wonder: rather than trying to squeeze more money out of existing programs, wouldn't it be better to try to find ways to create good programs for less money?
It seems to me that a $5 billion investment into new production technologies and techniques would go a long way in improving the process. And in the future, that will be the real key to success. In a world of 500-channel digital cable systems, high- speed internet and movies- on- demand, there will need to be more and more fresh content created. The real winner will be whoever figures out how to most quickly and inexpensively create that all new programming. Not the guys who figure out the most profitable way to recycle the same old stuff.
And my last point is that the final negotiations in the Fox Family purchase were made at the annual Sun Valley, Idaho media conference hosted by investment banker Herbert Allen. Disney history buffs will recall that it was at a previous Sun Valley retreat where the final negotiations for the $20 billion ABC merger deal took place.
This begs the question: If this deal doesn't go as expected, should the shareholders take away the checkbook from Michael before next year's conference?
Next Time: Another Look at DCA