Description

Yes, you read the title correctly, this is a pitch for of all companies: Comcast.  Like you, I have avoided this stock like the PLAGUE for all of my investment career, but it seems there is a great risk-adjusted opportunity to buy Comcast right now (or at a minimum short Verizon against it if you really hate the telecom/cable industry).  Given what the market has done recently and how little value is actually left out there, I think this is attractive both on an absolute and relative basis.

What makes Comcast interesting right now?

When I saw the NBC Universal deal rumors Wednesday night, like everyone else I cringed and assumed it was an awful deal for Comcast shareholders and more Roberts family empire building. However, what I found most interesting was how surprised shareholders and sellside seemed to be that they were doing a deal. I thought it was widely understood that they were going to do something big and stupid and thus was discounted in the stock.  Comcast management tried to buy Disney a few years back and for the past several months have been going from conference to conference talking about the virtues of owning content.  On top of this, they have been delevering more than all other cable companies and holding cash all year.  This has led to Comcast's current valuation of 5x EBITDA and 4.5xish at the bottom of the market.  If they had levered up like shareholders wanted and bought in a ton of stock this year, it would never have traded so cheaply.  Since leaks of the deal have begun, shareholders and sellside who have stood up for Brian Roberts and Steve Burke for the past several years have unanimously turned on him and voted against the deal taking the stock down 12% from $16.5 to $14.5. 

Is everyone wrong?

No.  Of course Comcast could have pulled the John Malone playbook, levered the stock up at $12 a share, bought in 75% of the company and had much better equity returns in the short term for shareholders.  However, this was never going to happen.  Comcast made it clear what their priorities were and shareholders could have switched to TimeWarnerCable if they wanted a levered cable pure play.  I am uncertain what the multichannel video business will look like out ten years so I do not think it is crazy that Comcast wanted to hedge by owning content so that they could help shape the future distribution of content over the internet.  The question then comes down to what is the price of doing that.

Enter Michael Aneglakis, the new CFO of Comcast as of March 2007.  Up until this point, Comcast was controlled exclusively by Brian Roberts (son of Comcast's founder) and Steve Burke (son of Dan Burke), so there was real question as to the financial credibility of management.  Angelakis is the first extremely high quality outside person that they brought in.  He was formerly a managing director at Providence Equity Partners and is extraordinarily well liked among investors and clearly a great financial mind.  I have been skeptical that he could make any real difference in a company controlled by Brian Roberts, so I discounted all of the talk.  Consequently, my first inclination when I saw the deal chatter was to just assume this was Roberts continuing to put his family legacy ahead of shareholders.  That said, after analyzing the deal, it actually looks like the deal is a pretty good deal for Comcast shareholders and so the stock which already discounted bad management decisions and then dropped another 12% way overreacted without people actually going through the numbers.

Here are the leaked deal details (which are obviously subject to change):

-The NBCU assets include the NBC Network, cable networks (USA, Bravo, Sci Fi, CNBC, MSNBC, Weather Channel), Universal Studios, television stations, weather.com, ivillage.com, etc.  The value people are putting on it is $24-30B.  This is about 7.5-9.5x EBITDA and 9-10.5x EBIT, not so cheap and at a slight premium to comps and discount to Discovery and Scripps. 

-Comcast will contribute its low profile cable networks including E, Style, regional sports networks, The Golf Channel, Versus for roughly $5-6B or 10-11x EBITDA into a separate standalone company w/ the NBCU assets.

-So, the total complex will have say a $28B value roughly from NBCU and a $6B value from Comcast properties making it a $34B enterprise value.  It is also being said GE is contributing $10-12B of debt so call the equity value $23B.  Comcast wants to take 51% control so they need to put up $11.5B in equity; given they are putting up $6B in the cable networks that is only $5.5B in cash.

-Why is the deal happening now?  Vivendi owns 20% of NBCU and has the right as of November to force GE to buy their stake (which GE doesn't have the capital for) or to do an IPO.  So, Comcast is entering the mix.

Looking at the proposed deal terms, I have to say that I think Comcast has actually structured a pretty attractive deal.  Once again, the relevant question is not how high they could have gotten the stock price if they levered up and bought in their own stock, it is looking at the deal as it stands vs. the current valuation.  Comcast is effectively using funny money for most of this transaction as they are contributing low value cable networks for half of their equity purchase price.  The rest of the purchase is being financed by GE since they are contributing $10-12B of debt to the deal.  In other words, this is basically a private equity deal that Comcast has structured and it is extremely accretive.  So, Comcast is getting 51% control of a giant complex of great media assets for $5.5B cash.

Here is a summary Comcast model that I took sellside numbers and discounted for the next few years for the core business to show the accretion of the deal.  I assumed the core EBITDA would grow slightly under 3% and then just had Comcast keeping a constant debt level (although delivering organically through growth) and buying in stock as they now have no need for excess capital (we can debate this later).  The point of this is to show what the deal looks like next year and what could be over the next few years if it plays out that Angelakis has an impact.

The deal is over 10% accretive to free cash flow per share next year  ($.17 on a base of $1.60) which seems at odds with the stock going down 12%.

Taking a step back, people (including myself) have perpetually assumed the worst about Comcast; is it possible they are financially savvy?  The deal takes their pro forma leverage up a bit to 2.5x but provides the Roberts family and Comcast the hedge they have been seeking.  I am extraordinarily skeptical about the value of integrating content and distribution (as evidenced by no synergy between Time Warner Cable and Time Warner Networks and DirecTV and NewsCorp), but I do not think it is crazy for a wealthy billionaire family to vertically integrate in order to have a seat at the table regarding the future of television.  In acquiring NBCU, Comcast would now be in control of 20% of the viewing hours in the country and have some very powerful brands in addition to a stake in Hulu.  NewsCorp owns another 20% of viewing hours so between the two companies 40% will be controlled by large worldwide video distributors (NewsCorp doesn't have distribution in the US anymore but I don't think they will ruin the business model in the US as it would repeat across the world).

I think the key to the deal is that there is little cash being paid and the cash they are using is already sitting on Comcast's balance sheet earning 1%.  Also, they are trading network assets that the market is valuing at no premium to cable operators to get a value for them.  Finally, it is clearly better to own 51% of a large complex of network assets than 100% of a few small, subscale assets as it gets them more influence in the space.  So, the deal structure appears intelligent.  They could have bought the whole thing and I am sure GE would have preferred that, but it appears that Comcast has SOME discipline at least.  Also, I had always assumed they would buy a group of assets at some premium multiple to the market, but since the alternative for GE would have been an IPO the valuation is not a takeout multiple but somewhere a bit over what the stock would have been traded at publicly but much less than a takeout premium.

With Regard to Valuation:

*The stock at $14.5 is trading at a 12% levered free cash flow yield on 2010 pro forma numbers adjusted for the deal and the company is only moderately levered at 2.5x debt/ebitda.  So, the stock dropped 12% yet the deal is 10% accretive, the FCF per share growth rate is higher because of the leverage and higher growth content assets, the stock was already trading at a discount because of acquisition risk, and the deal ended up being a pretty intelligently structured deal.

What is it Worth?

This is the tougher question.  I think by and large cable will be a 0-1% unit growth business when the economy normalizes with some pricing so a 3-4% EBITDA grower.  This will be a mix of cable having a high-speed data monopoly in the 50% of the country where FIOS and UVerse aren't (because reinvestment doesn't make sense for the RBOCS) combined with a very competitive video business in areas where all the distributors compete and then VOIP plateaus and degrades over time.  My view of cable is that it is utility-like long term and I think a 12-13x FCF multiple is a reasonable multiple on the business.  If it does $1.75ish in FCF next year, that gets you a $22 stock or a 50% move as of today.  A lot of people would put a higher multiple than 12-13x as well, but where the stock will really do well is if it doesn't pop immediately (which sure seems likely) and Comcast now starts returning cash to shareholders and buying in stock.  It should be noted that they bought in $2.3B of stock in 2006, $3.1B in 2007, and $2.8B in 2008 so they have been returning most of their FCF to shareholders. 

In the model I put above, I put a reasonable scenario of them continuing to shrink the equity at a 12x free cash flow multiple and you can see by 2013 you could see close to $2.75 in free cash flow per share.  If the stock stays cheap for a bit and they are able to buy in stock at $15 a share, this could be much higher.  I am not assuming Comcast keeps relevering to 2.5x debt/ebitda which would make the returns even higher but I am also not assuming that they make another stupid acquisition so this is a wash.  I should also mention that my numbers are discounted from sellside; I am assuming under 3% EBITDA growth into the future which may prove pretty conservative as some have them earning $1.80 next year in FCF before this acquisition so there could be upside. 

If they don't shrink the equity, I think the 12-13x multiple is fair; if they do shrink it the value goes up.  I think it is fairly likely they shrink the equity fairly aggressively as I think they have been holding cash waiting for a large content acquisition as they didn't know what they would need to spend.  They have said publicly a focus is returning cash to shareholders, so I am hopeful (though not sure) that from this point forward they would do so.  In other words, I think they can finally focus on optimizing returns.  And, although this is a long shot, Brian Roberts might at some point care about his legacy in the business; Comcast stock has done nothing for 15 years and is down 10% in the 8 years he has been CEO.  With the stock cheap and him having acquired the assets he has coveted, this may be a one-time shot to really help equity holders.  Also, if I look back at what they have done in the past 7 years their record is not so bad:

-They almost bought Disney at a great valuation using overpriced Comcast stock, which would have been a great deal

-They refused to lever up and buy in stock at a very high price like shareholders wanted

-They said they viewed content as strategic and wouldn't overpay and seem to have structured a shareholder friendly deal

-They have returned most of FCF to shareholders while not levering up before the crash

-They hired a CFO who had a great private equity career ahead of him and presumably he wouldn't have moved to Comcast to be a puppet and wants to make money on his options; the obvious way to do this is shrink equity at 8x free cash flow

Other points/risks:

-I think this gets rid of a bit of tail risk to the cable disintermediation fears.  Presumably with content ownership consolidated and a seat at the table with Hulu ownership, Comcast will be a large factor in the future role of internet distribution.

-This should satisfy their content hunger and at a minimum will prevent them from making any other large acquisitions as the FCC likely wouldn't allow it

-Comcast now becomes analyzable as their future options are limited so the discount in the stock should disappear

-There is some chance (albeit small) that Comcast does something intelligent with the NBCU assets.  Some ideas are putting all the content on demand immediately to help their core business and grow their advertising revenues by getting more viewership.

-Using NBCU's advertising prowess to grow Comcast's advertising revenues.

-Morphing NBC from a broadcast to a cable network; people value the NBC broadcast network at $2B yet The Weather Channel just sold for $3.5B so if NBC were on cable surely it would be worth in the high-single digit billions plus the value of the stations/spectrum.

-Risks:  The two biggest risks are that they get bad terms on the deal-i.e. the leaks are wrong, they pay a higher valuation or use more cash (I assign this a low probability) with the greater risk being that they have plans to go to 100% ownership over the next few years so they hold an incremental $10B of cash to buy out GE.  I don't think Comcast owning over 51% of the NBCU complex helps them at all but there is clearly risk Roberts is an empire builder.  Angelakis will not be able to pencil this out on a DCF so I am not sure how that conversation evolves and if they wanted 100% they could do it today.  The other major risk is that they keep making acquisitions, but I would think this large of a deal limits their future ability to get a deal approved by the FCC.

*Importantly, the deal could fall apart easily because there are 3 parties involved and getting Vivendi to agree might complicate things.  That said, given all parties are discussing this publicly, it seems that they are pretty far down the road.  Also, Comcast's stock move presupposes the deal gets done.  The stock would go up if the deal falls apart as Comcast won't make this "allegedly stupid" acquisition and they will have showed discipline in their purchase price.  In this scenario, you get some pop in the stock but I would exit as the bad capital allocator discount will remain in the stock in perpetuity until they make their content acquisition.

Price Objective:

-Upside Case:  15x $1.75 2010 FCF or $26 (+80%)

-Base Case:  12.5x $1.75 2010 FCF or $22 (+50%)

-Bear Case:  10x no-deal $1.50 FCF or $14.5 (+3.5%)

Analysts are a bit higher than $1.50 in FCF for 2010 and you could argue for higher multiples given the earnings mix is a much higher quality after the NBCU deal, but I feel these are fair multiples.  At a minimum, the stock seems extremely risk asymmetric given the valuation.

Quickly on the hedge w/ Verizon:

-If you hate Comcast, you should really hate Verizon.  Despite better growth, better margin characteristics, better competitive positioning, better businesses, and better capital allocation, Comcast trades at a discount to Verizon.  Verizon's revenue adjusted for the Vodafone stake in Verizon wireless is dropping close to 1% and EBITDA is decreasing approximately 3%.  This is clearly secular, not cyclical.

Verizon's businesses are local wireline, wireless, and enterprise.  Wireline is a disaster.  Revenue and EBITDA are down double digits.  Enterprise is a smaller business but is a zero to low growth business.  And, VZ Wireless has a great competitive position but they don't own the entire business and the industry looks to be getting increasingly competitive.  The wireless business is starting to become nasty and industry ARPU is declining.  Sprint, T-Mobile, Leap, and Metro are declining and dropping price so the business will go ex-growth very soon (look at Japan or Korea for hints of how bad the wireless business can get quickly).  Still, VZ has weaker competitors so will likely be a share gainer for time to come and has some growth in wireless data. 

Verizon is trading at 5.5x EBITDA and at 12xish cash earnings.  Although VZ does have a sizable dividend yield they are also reinvesting capital into FIOS at an abysmal return.  Paying $1500 to wire a home with a 25% penetration costs $6k per added home which is ridiculous when you could buy the cable companies at $3k per sub. 

In summary, Comcast is growing, has a better mix of assets and competitive positioning, is cheaper, and has better management so VZ is a good hedge against a Comcast purchase.

Catalyst

The deal closes, sell-side adjusts their estimates for 2010, people can all of a sudden model the future of Comcast without applying a huge discount for an unknown huge acquisition, Comcast starts buying in stock again because they don't need to hold cash for acquisitions.  Given the stock's move because of this deal, I would not be shocked if they announced a continuation of the share buyback if/when the deal is announced.  If the deal falls apart, the stock pops a bit, you exit and get a good IRR.