Description

On December 14th, 2017, 21st Century Fox Studios (FOXA) agreed to be acquired by Walt Disney (DIS) in a stock-for-stock transaction -  concurrent with a spin-off transaction of certain FOX assets. We’re interested here in creating the SpinCo at a discount before the transaction(s) close by going long Fox and short DIS at a ratio.

FOX shareholders should receive approximately 0.2745 shares of DIS and one share of the Fox SpinCo, called “New Fox.” The SpinCo assets include FOX News, FOX Business, FX Sports Networks, half of The Big Ten Network, and the FOX TV broadcast network.

The transaction is expected by the Street to close in the second half of 2018, and will not otherwise interfere with FOX’s plan to acquire the 61% of Sky Network FOX does not already own. The DIS/FOX transaction is not contingent on the FOX/SKY transaction, but if FOX/SKY is successful, DIS will acquire all assets and liabilities of SKY as part of its purchase of FOX.

The spin-off will be taxable to FOX, not its shareholders, and so DIS will assume an estimated tax liability of about $8.5bn. That liability will be offset by a cash dividend paid to DIS by SpinCo. Immediately prior to closing, the exchange ratio may be adjusted (up or down) to reflect a final estimate of the tax liability.

However, if the final tax estimate is lower than the initial estimate, the first $2bn of the adjustment will be made by a net reduction in the amount of the cash dividend paid to DIS from the SpinCo. The amount of the tax liability will depend upon several factors, including tax rates in effect at the time of closing as well as the value of the SpinCo.

The new Trump tax cuts had not been passed at the time of the deal annoucement, they passed about a week later. The companies appear to have built-in a mechanism to allow for the benefit of a tax change to flow through the deal strucute. In a bull case, the SpinCo would carry less net debt because it would pay a smaller dividend to DIS and therefore have to borrow less money. In a bear case, the tax liability would be upsized and the exchange ratio tilted as to make the SpinCo more expensive. Why calibrate a $2bn cash boundary condition, before the exchange ratio is touched, if one has no realistic expectation of achieving improvement? Was it just randomly sized contingency planning?

Analytically, $8.5bn of tax divided by a 35% rate implies a taxable base of $24.29bn. If we instead applied the new 21% rate to the $24.29bn base, the tax bill would instead be $5.1bn, a savings of $3.4bn. In this light, their calibrating to a favorable $2bn reduction in the cash dividend paid to DIS from SpinCo has reasonable explanation.

As referenced above, to get the approximate price of the FOX SpinCo, subtract 0.2745 DIS from the FOX share price. So, FOXA - 0.2745 DIS = SpinCo price = $35.24 -  $29.83 = $5.40. Note that the SpinCo price varies a little if one substitutes FOX in place of FOXA because of the existence of a small dual class share spread between FOX/FOXA. FOXA is the more liquid of the two.

SpinCo price: $5.40

FOX shares: 1.86bn

Stub Market Cap: $10.0bn

Cash: $500mm

Debt: $8bn (w/assumption of tax liability)

Net Debt: $7.5bn

TEV: $17.5bn

2018E Revenue guidance: $10bn

2018E EBITDA guidance: $2.8bn

TEV/Revenue = 1.75x

TEV/EBITDA = 6.25x

Net Debt/EBITDA = 2.7x

If we assume the cost of debt is 7% then cash interest expense would be $560mm/yr. Capex is roughly $200mm/year and cash tax guidance is $100mm/yr. That puts free cash flow at about $2.8b - $560mm - $200mm - $100mm ~ $1.9bn. Free cash per share is a little over a buck and the Stub price is $5.40/share (~18% free cash flow yield).

A $2bn tax break that would reduce net debt lowers the implied SpinCo price by about $1.00/share and the multiples get yet more attractive in this bullish scenario (5.5x EBITDA vs the current 6.25x implied at $5.40/share).

With more traditional public media assets I have often noticed a high free cash flow yield but at the same time very high leverage that otherwise eats up all the yield equity holders would hope to gain from in some way other than the indirect benefit of slowly reducing debt. In this case, however, one acquires some valuable ‘older’ media franchises for roughly ~18% free cash flow yield - but with surprisingly reasonable net leverage (2.7x). The reason, I suspect, is that the market is pricing in some arbitrage spread and/or tax discount, and those discounts are showing up in this analysis and making these assets look attractively priced both in absolute and relative terms. Put differently, it’s cheap because there is deal risk.

From a regulatory standpoint, the President has made public remarks against the (unrelated) Time Warner deal and in favor of the FOX/DIS deal. I’m not sure it matters that DIS will now become a controlling shareholder of Hulu, or that ownership of all the Marvel franchise characters will be reunified in this deal. It’s possible some issues could arise around ownership of Sky, but I am not a regulatory expert - and the Sky deal is not a pre-requisite for the Spin-off.

In conclusion, we have a high free cash flow yielding SpinCo with a complex hard catalyst comprised of two acqusitons and a Spin-off. The SpinCo may be even cheaper if we get a favorable tax adjustment. If you can get comfortable with the deal risk it looks like some high quality, large scale, traditional media assets are on sale.

Catalyst

The catalyst is the closure of the FOX/SKY and DIS/FOX deals, respectively, and the simultaneous spin-off of the Fox SpinCo - all set for the end of 2H18. Although DIS gives 12-18 months for closing the street estimates we’ve seen use a 2H18 estimate. The gating items are regulatory approval and shareholder votes at both DIS and FOX.