Verizon (VZ) and Disney (DIS)

A short while ago, rumors began circulating on Wall Street that VZ is interested in acquiring DIS.

Yesterday, the CEO of VZ said the company has no interest.

some sense…

The rumors made a little sense, in my view, for two reasons:

–the cellphone market in the US is maturing.  The main competitors to VZ all appear to be acquiring content producers to make that the next battleground for attracting and keeping customers, and

–the Japanese firm Softbank, which controls Sprint, seems intent on disrupting the current service price structure in the same way is did years ago in its home country.

…but really?

On the other hand, it seems to me that DIS is too big a mouthful for VZ to swallow.

How so?

–DIS and VZ are both about the same size, each with total equity value of around $175 billion.  If we figure that VZ would have to offer (at least) a 20% premium to the current DIS stock price, the total bill would be north of $200 billion.

How would VZ finance a large deal like this?  VZ’s first instinct would be to use debt.  But it already has $115 billion in borrowings on the balance sheet, so an additional $200 billion might be hard to manage, even though DIS is relatively debt-free.

Equity?  …a combination of debt and equity?

An open question is whether shareholders in an entertainment company like DIS would be content to hold shares in a quasi-utility.  If not, VZ shares might come under enough pressure for both parties to want to tear up a potential agreement.

dismember DIS?

VZ might also think of selling off the pieces of DIS–like the theme parks–that it doesn’t want.  The issue here is that all the parts of DIS, except maybe ESPN, are increasingly closely interwoven through cross-promotion, theme park attractions and merchandise marketing.  So it’s not clear the company can be neatly sectioned off.

Also, as the history of DIS’s film efforts illustrates, the company is not only a repository of intellectual property.  It’s the product of the work of a cadre of highly creative entertainers.  Retaining key people after a takeover–particularly if it were an unfriendly one–would be a significant worry.

From what might be considered an office politics point of view, VZ’s top management must have to consider the possibility that after a short amount of time, they would be ushered out the door and the DIS management would take their place running the combined firm.  Would key DIS decision makers want to work for a communications utility?

my bottom line

All in all, an interesting rumor in the sense that it highlights the weakness of VZ’s competitive position, but otherwise hard to believe.

 

 

 

Verizon Wireless: who’s getting the better of the deal, Verizon (VZ) or Vodafone (VOD)?

I think it’s VZ.  The company says that even at a cost of $130 billion the buy-in of VOD’s 45% minority interest will add 10% to VZ’s earnings.  But VZ is also adding a significant amount of risk in leveraging itself financially.

a simplified history

In 1982 the federal government forced the breakup of the monopoly telephone service provider, ATT.  It separated the parts into a national long-distance provider, which retained the ATT name, and a bunch of regional local service providers, nicknamed the “Baby Bells.”  Each Baby Bell contained its area’s nascent mobile services.

Soon enough, the Baby Bells began to merge with one another, ultimately forming into a Western US group (which subsequently acquired “new” ATT and took on the ATT name) and an Eastern group, which subsequently renamed itself Verizon.  Proto-VZ wanted to keep its mobile assets.  Proto-ATT didn’t.  To keep the mobile assets out of the clutches of prot0-VZ, Airtouch, the proto-ATT mobile operation, sold itself to VOD in 2000.

VOD promptly struck a deal with VZ in which it merged Airtouch with the VZ mobile operations to form Verizon Wireless.  VZ had operating control and a 55% interest.  VOD had veto power over some decisions and held the other 45% of Verizon Wireless.

Got all that?

culture clash

VOD is a British company.  It apparently believed in the old-style colonial European way of doing business, according to which a firm with global pretensions could get more bang for a buck (or quid, in this case) of capital by taking large minority interests in important foreign  firms.  Through superior intellect/management technique, or force of will, or sheer European-ness, it would dominate the board of directors.  It would thereby get the benefits of 100% ownership without the capital outlay.   The resulting network of companies would move in lockstep with its European leader, buying the capital equipment suggested (getting discounts for all) and perhaps paying management fees to the European company for its advice.

VZ, an American firm, would have thought that no one in his right mind would accept a minority stake.  If would have figured that VOD would soon see the light and be persuaded to sell.

Or maybe that’s just how the two parties rationalized the unhappy partnership that they entered into.

what each party gets from the deal

Verizon

–when the deal closes early next year, VZ will have access to the cash flow from Verizon Wireless for the first time.  US tax law   requires that a parent have an 80% interest in a subsidiary before cash can flow tax-free from it to the parent

–VOD will no longer have an operational say in Verizon Wireless

–the very mature fixed-line telephone business will be a significantly smaller proportion of the whole

–the deal is accretive to earnings by 10%

Vodafone

–VOD extracts itself from its awkward minority position

–ir gets a big payday, even after distributing the bulk of the proceeds to shareholders, which it will presumably use for EU acquisitions

–VOD believes it can use a provision in UK tax law regarding transactions between conglomerates to pay only about $8 billion it taxes on this deal

Verizon (VZ), Vodafone (VOD) and flowback

VZ is buying the 45% of Verizon Wireless that VOD owns.

VZ, which owns 55$ of Verizon Wireless, recently agreed  to buy the other 45% from VOD for around $130 billion.

From what I can tell so far, the deal will be good for VZ.  And, at the very least, VOD gets a boatload of cash and stock.  In hindsight, VZ would have been a lot better off striking the same deal in March, before the Fed began hinting that it was thinking of ending the current post-recession period of extra-super-accommodative money policy in the US.  The interest rate VZ would have paid on newly issued bonds would have been lower.

More on this topic in future posts.

There may not be a great need to load up on VZ ( which I own) immediately, however–even if you think the deal is a spectacular coup for VZ (too enthusiastic for me).  The reason is flowback.

what flowback is

VZ is going to issue over a billion shares of new stock to VOD as part of the purchase price.  VOD has already announced it will distribute to its shareholders all of the VZ stock it receives.  That’s something like one VZ share for every 40 VOD shares held (the exact ratio isn’t important).

What is important is that VOD is a UK corporation whose stock is traded in London.  The bulk of its shares are held either by UK or Continental European institutions.  US institutions hold only about 15%.

Put another way, early next year almost everyone who owns VOD will receive shares in a foreign stock, VZ.

What will they do with it?

For index funds, the answer is clear.  If it’s not in the index, it has to be sold.

For institutional managers in the EU, the answer depends, in the first instance, on what their contracts with customers say.  They’ve presumably been hired for their expertise in EU equities.  Management agreements probably stipulate that they’re not allowed to hold non-European securities.

Even if they are permitted to hold VZ, why do it?  Why take the risk of holding a stock that’s outside your area of competence–and which will require considerable research effort to get a firm grasp on.  Selling is a much safer option.

For individuals, if form runs true, the first they’ll hear of the deal will be when their broker calls to tell them that shares of VZ have plopped into their accounts–and to urge them to get rid of this weird thing.

That’s flowback.

It happens in all cross-border deals that involve stock.  When shares of the issuing company leave the home country, some portion will be sold immediately by investors who are unable or unwilling to hold what is for them a foreign stock.

Where do these sales take place?   …ultimately in the home market of the issuer.

the VZ case

For VZ, average daily trading volume is around 10 million – 12 million shares.   Occasionally, volume can get as high as 30 million- 40 million shares without moving the stock too much.

Let’s make up a number and say that flowback will be 300 million shares.  That’s easily an entire month’s trading volume.  So this could be a serious issue for VZ’s price.

mitigating factors

There are three that I see:

–Verizon Wireless is the largest and most important asset for both VZ and for VOD.  Non-index investors in the EU must have wanted exposure to Verizon Wireless to be holding VOD shares.  Arguably, they will want to continue to have that exposure and will therefore be less inclined than normal to want to sell.  So maybe some will be able to wangle exceptions from their clients.

–trading volume in VZ over the past seven trading days (not including today) has averaged about 25 million, or–let’s say–12 million shares above normal.  If this is all merger-related short-selling, which it probably is, then this trading has already created demand for 80+ million shares of VZ when the shorts are covered.

–the stock has a current dividend yield of 4.6%.  At some point, this and other VZ fundamentals should provide price support.

my take

Worries about flowback are one reason large cross-world acquisitions involving stock aren’t that common.  This one was clearly too big for VZ to do any other way.

My guess is that anticipatory selling in advance of the acquisition will make it hard for VZ to go up for a while.  I also think, however, that downward pressure from potential flowback will abate long before the deal actually occurs.

At some point, an excellent buying opportunity for VZ will emerge from acquisition-related stock activity.  The trick is deciding exactly when.  The most prudent strategy, I think, is to establish a small position and await further developments.

 

 

Verizon (VZ) outperforming Apple (AAPL)? …what’s going on?

VZ vs. AAPL

Yes, it’s true.  Over the past three months, VZ is up 10.7% while AAPL is flat and the S&P 500 is down 4.2%.  We should toss in another 50bp to VZ’s outperformance because it has a high dividend.

Maybe there’s nothing to this.  After all, the stock market is, even at its best, a two-steps-forward, one-step-back affair.  So VZ could be having one of its forward steps while AAPL is temporarily in reverse.  The period in question is very short.  The overall market is also down over the past quarter, the kind of environment that favors more defensive stocks.  And, of course, VZ and AAPL were neck and neck through the first half of last year before AAPL rocketed ahead and left VZ in the dust.

Still, there may be something a little more substantial going on.  I don;t mean to argue that AAPL will be an underperformer.  The surprise may be that VZ continues to be an outperformer.  I may be biased here, too.  I haven’t finished my research yet, but I have recently bought some VZ.

the argument for VZ

the US cellphone market is maturing

According to Nielson, 69% of current cellphone purchasers in the US are buying smartphones.  If we break that out by age, close to 80% of new phone purchases by Americans under 55 years of age are smartphones.  About half of those 55 or older are choosing smartphones, too.

Given that there will be some–mostly 65+–users who will never adopt new technology, can it get much better than this?  I don’t think so.

strategy shift in maturing markets

In a recurring subscription business, the winning tactic in any new market is usually to stake out as much territory for yourself as possible, without much regard for profitability.   You don’t care what anyone else is doing.  You just want to get as many clients in the door as you can.

As the market matures, however, two changes occur:

–growth comes from taking customers away from competitors, not from finding people who have never used the service before.  This is typically harder work and more expensive, so firms with scale end to have an advantage.

–profitability becomes more important.  Firms try to raise prices and to cut operating costs.

I think this is where we are in the US cellphone market.

sources of profit growth for VZ

1.  lowering phone subsidies.  To use round numbers, let’s say VZ pays AAPL $600 for an iPhone 4s.  It resells the phone, linked to a two-year contract, to a customer for $200.  VZ loses $400 on the transaction.

If the company can persuade that customer to choose an Android phone that it pays, say, $450 for, it loses $250 instead.  So it’s $150 better off.  That’s all incremental profit.

Better (for VZ) still, if the customer chooses a Nokia Lumia phone, the loss may be only  $200.

In Europe, phone companies are experimenting with using INTC reference designs to make house-branded phones.  Why bother?  INTC is only interested in selling chips, so it is ceding the entire wholesale markup to the carrier.  So it may cost the carrier $350 for a phone it can resell for $200–meaning a loss of $150.

Make this sort of marketing shift for enough customers and the savings become significant, even for a company of VZ’s large isze.

2.  raising prices.  In a sign that VZ thinks its market is maturing, it is fundamentally reworking its pricing.  Starting late this month, customers will get voice for free but begin to pay for data.  No more all-the-data-you-can-use plans, either.  Interestingly, VZ is going to eliminate a $20 per month charge for the ability to make your phone a mobile “hot spot” for internet access.  So you can tether your laptop or tablet to your phone for free, just by asking VZ politely.  Why?  Videos look a lot better on a tablet.  And they’re very data intensive.

all good things end, someday

At some point, possible profit-enhancing measures will run their course.  But that’s probably several years down the road.  In the meantime, VZ’s profit performance vs.Wall Street expectations may be surprisingly good.

In a perfect world (for the holder of VZ shares), the company would be able to spin off or otherwise shed its fixed line and FIOS money pits.  For stockholders, that would be like hitting the lottery.  It’s very highly unlikely to happen, in my opinion.  But, on the other hand, there’s nothing in the stock price for the possibility.