Description

Investment thesis

We are presenting a merger arbitrage opportunity that we believe offers an attractive risk-reward profile. Sky is subject to a potential takeover from 21st Century Fox for the second time since 2010. This time Fox is offering £10.75/share in cash to shareholders of Sky for the 61% it doesn’t already own. The current price is £9.95/share, which represents a potential 8% upside to the offer price. Sky expects the transaction to close by the end of 2017.

Required approvals: competition approval by the European Commission (cleared), clearance by the UK on media plurality (e.g. concentration of media ownership) and clearance by the UK on Fox being “fit and proper” owner in terms of broadcasting standards and shareholder approval.

Deal background and terms

• On 6 December Fox approached the deputy chairman of Sky with a proposal to acquire the company but the company’s independent committee rejected the bid. On December 8, Fox put in a revised bid, which was again rejected. Then the offer was increased to the current £10.75/sh
• Premium of 40% compared to the day when the proposal was received and 36% on prior day to transaction announcement. However, it is not much of a premium to where Sky used to trade during much of 2015 and early 2016
• Scheme of arrangement requires the recommendation of the independent directors of Sky. This is the case however the board has the right to change its recommendation until the formal offer documents for the EGM are published. This should take place after the regulatory approvals
• The offer has been agreed by the independent directors but certain material offer terms are under discussions
• Some analysts suggest that the target price could be revised upwards if Sky’s underlying results improve during the year. We don’t think of this as the base case
• Fox has financing lined up from GS, DB and JPM
• Break fee: £200m payable by Fox (£0.12/sh) in this deal (it was £38.5m in the previous takeover attempt)
• Dividends:
  • Sky will not pay any dividends in 2017
  • If for some reason the deal doesn’t complete by that time an additional £0.10/sh special dividend is offered to Sky shareholders

Why the opportunity exists

While we make no attempt to address the share price decline of Sky over the past year (pre-takeover bid announcement) we believe the spread exists due to the regulatory uncertainties and shareholder approval concerns.

Headlines have sowed doubt about the deal at every step of the way. The likelihood of shareholder approval has been reported on with titles such as “Major Sky shareholder to vote against Fox bid” that defines vocal top 50 shareholders as major. Juicy headlines about Fox News have led to parallels drawn with the phone hacking scandal that derailed Fox’s 2010 bid.

Fit and proper test

There has been much media noise around whether recent events at Fox News could lead to the regulator Ofcom finding Fox as not a fit and proper owner of Sky. Given that News Corp, James Murdoch and Rupert Murdoch were all cleared by this Ofcom investigation in 2012 amidst the criminal proceedings and public uproar within the UK while adding some harsh comments about James Murdoch’s oversight that failed to influence the outcome, it is highly unlikely that the settlements of civil lawsuits at Fox News (involving some behavior that could be labeled quite Presidential) could produce a different decision. Moreover, being fit and proper is an ongoing requirement to hold a media license and Murdoch is already the Sky chairman.

Media plurality test

For this test, the regulator is likely to view News Corp and Fox as a single entity as they are under common control. However, a deal was already reached in 2011 on plurality whereby Sky would spin Sky News off into a separate entity. Ofcom noted that from 2012 and 2015 the influence of papers owned by News Corp and Sky News has fallen as people spend more time online (e.g. social media) on entertainment and print media readership declined. Fox believes a deal won’t be necessary this time around but it remains a lever that could be pulled, so at worst the outcome would be similar to 2011. We believe the deal is virtually certain to clear this hurdle with or without minor concessions.

Political pressure

Murdoch withdrew the 2011 bid due to overwhelming across-the-board political pressure. This time around, there are individual critics like former opposition leader Ed Miliband, but overall reaction has been muted, leading us to believe that the political climate has changed.

Shareholder approval

The deal is structured as a scheme of arrangement, requiring approval by 75% of shareholders (in this case it would be 75% of the 61% stake they don’t own i.e. 45.8%) at an EGM vote. The vote is binding on all shareholders. However, if 25% of the shareholders vote against the deal (25% of the 61% i.e. 15.3%) they can block the deal. Even though some minority shareholders have spoken out against it, a survey of top 10 shareholders conducted by Sky concluded they were quite sanguine about the price.

Acquisition rationale

Fox’s current 39% stake is an awkward ownership percentage. By owning 100% they would eliminate double taxation, be able to consolidate Sky into Fox’s financials, allowing Sky to be included above Fox’s net income line rather than using the equity method. Benefits for Fox include diversification of revenue away from advertising. Valuation is acceptable and Sky is widely expected to grow into a much more attractive valuation in the near term. Sky currently has good momentum in revenue growth and is a bright spot in a declining British TV advertising market.

Timeline

In 2010/11 the plurality/fit and proper reviews took around six months, so we can expect a similar timeframe this time. Ofcom has until June 20, 2017 to deliver its decision to the UK government (this was extended from May due to snap UK elections). After approvals are in place Fox will need up to three months to implement the scheme of arrangement. Sky expects the transaction to close by the end of 2017.

Risks

• Deal not closing
• USD/GBP FX

Resources

https://corporate.sky.com/investors/21st-century-fox-offer#

https://www.21cf.com/investor-relations/firm-offer-sky-plc-info

Catalyst

Progress on regulatory reviews.

Closing of the transaction.