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JCPenney's Ron Johnson: 'Customers Don't Get Our Pricing Strategy'A few weeks ago I suggested that private equity investors might be able to generate better returns for Time Warner shareholders than the current management. A reader commented that I should do the math. When I followed that suggestion, I calculated that a leveraged buyout (LBO) of Time Warner would cost $113 billion -- 2.6 times bigger than 1989's record $31.4 billion RJR Nabisco deal -- and could generate average annual return for the private equity investors of 28% between 2006 and 2010.
Before getting into the details of this proposed deal, I'd like to point out that I got a lot of help in this analysis. First, I have to acknowledge Jerome Kohlberg, one of the key inventors of the LBO, about whom I wrote for the Swarthmore College Bulletin a couple of years ago. Although he had nothing to do with this particular analysis, his innovations made it possible. My brother Bill, a former investment banker and author of a forthcoming book on Lazard, The Last Tycoons, was the reader who suggested that I should do the math and he explained how to do it as well. The valuations and financial forecasts came from the Lazard Report which was prepared for Carl Icahn's recent effort to break up Time Warner. I take full responsibility for any mistakes.
In an LBO, private equity investors, banks and high yield bond issuers finance the takeover of a company. The LBO usually adds substantial debt to the balance sheet and uses the cash flows from operations (after capital expenditures), cost reductions, and the sale of non-strategic business units to pay the debt's interest and principal. Shareholders' return is based on the difference between the amount of equity invested in the deal at the beginning and the ending value of the business after paying off the debt.
To calculate the 28% internal rate of return on this $113 billion deal, I made many assumptions:
- 20% premium. Time Warner shareholders would receive a 20% premium over the current stock market value of $74.9 billion, or $89.9 billion;
- Assumption of debt. The new owners would refinance all of Time Warner's $23 billion in net debt;
- Interest rates. The debt would be split 39% bank debt and 61% high yield bonds with interest rates of 9% and 12% respectively;
- Fees. Fees to merger, legal, and accounting advisers; private equity investors; banks and high-yield bond issuers would total an astounding $2.2 billion which would be added to the amount borrowed;
- Timing. The deal would close in December of 2006 and the value enhancing initiatives would be completed in 2010; and
- Investment/ending value. By financing the deal with 70% loans and junk bonds and 30% equity, equity investors would invest $33.9 billion in 2006 and the enterprise would be worth $90.5 billion in 2010.
The mountain of debt in this proposed deal would be paid off through the pretax free cash flow that the business generates coupled with key value-enhancing initiatives, including the following:
- Cut expenses. Carl Icahn and Dick Parsons have already agreed that Time Warner would cut $1 billion in expenses. This is included in my calculation;
- Sell AOL in 2007. The Lazard Report estimates that AOL is worth 20 times Operating Income Before Depreciation and Amortization (OIBDA). The 95% that Time Warner owns would be worth $18.9 billion after tax in 2007 assuming $2 billion in OIBDA and that AOL's cost basis is higher than the sale price. (The 35% corporate capital gains tax is applied on the difference between the sale price and its cost basis -- but since AOL would be sold at a loss, I assume no tax would be due);
- Sell Filmed Entertainment in 2008. The Lazard Report estimates that Filmed Entertainment is worth 7.6 times OIBDA which is forecast to be $1.6 billion in 2008. Assuming a zero cost basis, the sale of Filmed Entertainment would yield $7.8 billion in after tax proceeds;
- Sell Publishing in 2009. The Lazard Report estimates that Publishing is worth 7.2 times OIBDA which is forecast to be $1.5 billion in 2009. Assuming a zero cost basis, the sale of Publishing would yield $7.2 billion in after tax proceeds; and
- Pay off debt in 2010. This would leave the Networks and Cable businesses with a 2010 value of $127.5 billion (12.2 times Networks' OIBDA of $4.5 billion plus 8.5 times Cable's OIBDA of $7.3 billion plus the $10 billion in additional enterprise value resulting from the $1 billion expense reduction). Using this $127.5 plus the 2010 pretax free cash flow of $9.6 billion to pay off the remaining $41.4 billion in debt plus interest would leave an ending enterprise value of $90.5 billion.
Is this deal feasible? At $94 billion, the amount of LBO capital available at the end of 2005 was six times greater than 1988's $15 billion -- the year before the record RJR deal. Moreover, having just raised $25 billion in the first quarter of 2006, a 79% increase over the same period in 2005, a club of big players such as KKR, Blackstone Group, Texas Pacific Group, and Bain Capital could probably come up with the $33.9 billion in equity needed. Nevertheless, the huge size of the deal might give them pause.
While banks and high yield issuers would likely salivate at the fees involved with this deal, the amounts to be raised are breathtaking. It remains to be seen whether Time Warner management and shareholders would receive sufficient incentive to go along with such an LBO. And it's unclear whether these businesses can find buyers at the prices assumed in the Lazard Report.
Over the last year, Time Warner shareholders have "enjoyed" a 1.7% stock price increase. The proposed LBO would give them an immediate 20% increase in share value (and private equity investors an even better 28% return). Whether current management can deliver such returns remains to be seen.
DISCLOSURE: I am neither long nor short shares of Time Warner or Lazard. For more about me, click here.
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Reader Comments (Page 1 of 1)
5-15-2006 @ 9:50PM
sarah gilbert said...
i loved your analysis, peter - i think the major question isn't so much, is the money there so much as, who would buy AOL, publishing and filmed entertainment?
it seems as if each of these units has some value, and i can't imagine that they are saving each other much money. it makes sense to me, splitting them up. even though i've always thought time warner was all about the TIME and the WARNER. as a standalone cable company... i kind of love it. are you listening, TPG? after all, guys, something's got to be done with your money.
5-24-2006 @ 10:28AM
Matt L said...
Nice idea, but a deal like this is 5 - 10 years off. There's no way a consortium of PE players would be willing or able to pony up $35b of equity, given their current fund size (restrictions on investing a maximum % of a fund in a deal would prevent a deal like this). Fund sizes would have to get much larger for the PE guys to contemplate something like this.
6-23-2006 @ 10:47PM
Steve said...
Excellent post; you've provided a lot of fun numbers to think about.
I have to echo Sarah's comment about the AOL sale -- indeed, who would buy it? The filmed entertainment business, however, would surely find a buyer in one of the media conglomerates or a private-equity group.
Synergy should work, but for some reason, it just isn't the flavor these days. By all accounts the market should be valuing TWX higher, but it just simply refuses to do so; perhaps if the company would increase its dividend significantly after retiring a bunch of shares...