Case 2 Cox Communications, Inc PDF

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Case 2: Cox Communications, Inc. (1999) Questions to address by each group before presentations: 1) What changes are occurring in the cable industry? Do you believe that CCI should be concerned about these changes? Are they in a good position to benefit from these changes? Why has CCI undertaken so many acquisitions recently? ● The cable industry was experiencing major technological advances in the late 1990s that was transforming the industry. These changes included the internet, fiber optics, wireless communications, and deregulation. This combination of change forced cable companies to shovel out large sums of money to remain competitive in the new landscape. Cable companies began replacing outdated coaxial cables with fiber optic cables that offered much larger capacity, and offered new services such as pay-per-view and digital cable television services. Internet speeds increased immensely as a result of fiber optic cables. These vast changes rearranged the competitive landscape and allowed newly labeled “broadband” companies to compete with satellite systems, telephone, companies, and wireless companies. This put pressures on Cox Communications to upgrade its network and introduce new services to satisfy customers, and introduced a need to acquire more assets within the industry. ● Cox Communications should be weary of all of these changes occurring within their industry, and need to develop a plan to create growth and profitability. These technological advances create an opportunity for growth of the industry, but Cox must be able to implement new strategies to capture this growth before competitors. An important strategy that ensued was growing the companies subscriber base, to spread fixed costs over a larger number of customers. Satisfying this need was done through aggressive acquisitions to achieve this scale. However, this proved to be expensive as the demand for cable systems and assets was rapidly rising. This competition resulted in a rising cost of acquiring new customers, as the number of available cable assets began to shrink rapidly, and left companies to pay high prices for new customers. Cox Communications should be very concerned about these changes and should act proactively to purchase cable assets while they are still on the market, or face becoming a second-tier cable company. I believe the acquisition opportunities that Dallas and his team have identified position Cox to growth their customer base substantially and are timed appropriately. The only stipulation behind the aggressive acquisitions is Cox’s ability to fund nearly $7.6 billion necessary to acquire these assets. The result of these acquisitions are reliant on regulatory approval and transfer of franchise rights by local communities, and could take just over a year to finalize. However, these acquisitions would increase Cox’s customer base by 5.5 million ranging across 18 states, making Cox the fifth largest cable company. Therefore, if barring unexpected events Cox is in a good competitive position to take advantage of their industry’s changing landscape. The only concern for Clement and his team is financing these large mergers. ● These acquisitions come at the cusp of an evolving cable industry, which has been highly competitive in nature. Every company in the industry is searching for a leg up on the competition, and as a result the industry have been subject to large consolidation. The consolidation that is occurring is an effort to capture a larger share of the market, and second tier cable companies or companies with some cable assets are using this

environment to sell their asset and customers, but at a premium. Instead of being gobbled up by a larger company, Cox wants to be a major player in the industry going forward. Cox currently has a strong balance sheet and financial flexibility to pursue these acquisitions, but will they stretch themselves too thin with their financing capacity. They have already financed their capital expenditures with $1.9 billion from internal cash flow along with $1.9 billion in an issuance of debt, and $370 million in equity. However, the owners of the business wanted to preserve their ownership stake and not dilute it any further, and were reluctant to increase leverage of the firm to maintain and investment grade rating. These strategic initiatives for Cox placed a constraint on how Dallas and his team were to finance these acquisitions.

2) The Gannett acquisition is still under negotiation. Why is CCI acquiring Gannett? Does the Gannet acquisition make sense at $2.7 billion (assume a WACC of 9.6%)? What is the NPV of this deal? What is the growth rate necessary for this NPV to be positive? ● Gannet’s assets were very attractive because CCI was focusing on a strategy of concentrating viewers in geographical areas to achieve local economies of scale and scope. The acquisition would also increase their subscriber base by 60%. CCI was trying to position themselves as large players in the cable market industry. Having acquired many other companies in a recent aggressive expansion, they saw another great opportunity in Gannett. The acquisition of Gannett would bring about another 522,000 customers in a tight region that Cox was already interested in. The issue at hand however, was that the price/customer acquired had gone from $2300 in 1994 to about $4000 in 1999, and the price continuing to rise. Gannett recognized this and saw an opportunity to make some money by selling their company. CCI saw the value in further expansion and offered them a bid of $2.7 billion, at this bid price of $2.7 billion dollar the price per customer would be $5,172. Cox is expecting 3% to 5% natural growth going forward from the increase in their subscriber base. At at growth rate of 3% NPV of the project would be -$1118 million using the companies pro forma cash flows from 20002003. At 4% growth or discount rate using the same pro-forma cash flows, NPV would be -$924 million. At the 5% growth rate, NPV would be -$647 million. As you can see the NPV at these growth rates would be negative for Cox. A contributing factor is the historically high price of the customer at $5,172. The growth rate for the NPV of the Gannett acquisition to be positive, at a price tag of $2.7 billion, would be 6.85%. However, the current equities market and economic health of the United States is currently experiencing turbulence and yields uncertainty in the future. This uncertainty could result in changes in the cost of debt, equity, and CAPM. The current companies WACC of 9.6% could change moving forward, and changing the outcome of the NPV calculation. CCI is currently evaluating the best financing options for these acquisitions, which will have a significant impact on their WACC For this reason we felt a sensitivity analysis of future growth rates and WACC would provide a better depiction of the future benefits of the acquisition. At the current bid price of $2.7 billion dollars with the growth rates ranging from 3% to 5% and a WACC of 9.6% the company is overpaying for the

Gannet assets, and would need a growth rate of about 7% in order for NPV to be positive.

3) What is the menu of financing choices available to CCI? What are the costs and benefits of each choice? ● CCI has four financing choices available to choose from. First, CCI can choose to issue common shares. There would be more costs associated with the issuance of common shares than there would be benefits to it. The first cost is the issuance would cause CEI to lose some of its majority of the ownership of Cox. This is a big factor because the chairman and CEO of CEI is also the chairman of the board of Cox. Maintaining the family’s ownership is one of the major financial objectives of the company. Another cost would be that Charter Communication, a rival, was expected to make their IPO in the fall. If Cox tried to issue shares after Charter’s IPO, this could cause investors to not want Cox’s shares as much because Charter and Cox appeal to similar investors. Overall the shares would not be worth as much. Cox would have to issue before Charter’s IPO to get the most value. The main benefit of issuing common shares would be that it would help keep the company on course to their goal of doubling the company every five years. Second, CCI could issue debt or borrow. The cost of issuing debt would be risky for Cox. The company already had a good amount of financial leverage, and the adding more debt could potentially hurt their debt rating, which they want to maintain investment grade. To maintain that grade, the company has to pay close attention to multiple variables like the Debt/EBITDA ratio. If Cox became a non investment grade firm, they would have trouble finding access to credit at times. The benefit of issuing debt is that the cost of debt would be lower than issuing equity. Third, the company could issue Hybrid Securities called FELINE PRIDES. FELINE PRIDES will be explained better in the next question. The major cost of using these hybrid securities would be the complexity of them. Cox would make sure that they fully grasp what FELINE PRIDES are, and how to use them to their advantage. The benefit of these securities is that the securities would not show up on the balance sheet as debt. For tax, Cox would be able to deduct the interest payments made on the debt, but for financial reporting, the securities would appear to be equity. Cox would be able maintain investment grade and not lose shares using FELINE PRIDES. Lastly, Cox could sell off some of their assets to help finance some or all of the acquisition of Gannett. The main cost of selling off their assets would be the major tax burden that would cause on Cox. An outright sale of assets would make Cox pay taxes on the capital gains. On the other hand, Cox could

tax-efficiently dispose of certain assets to help avoid the heavy tax burden. Overall, trying to sell certain assets would be challenging for Cox, and probably not the best method to use to try to come up with the funds to acquire Gannett. 4) What exactly are FELINE PRIDES securities and how are they structured to provide the benefits of both equity and debt? How does the use of these securities create value for CCI? What are the advantages/disadvantages to firms using this security? ● Feline Prides are an equity-linked hybrid product which had the elements of both debt and equity. The PRIDES were a unit consisting of an obligation by the investor the purchase a fixed dollar amount of Cox’s Class A Common Stock in three years, and preferred equity. An investor would pay $50 for an Income Pride unit and receive a 7% preferred dividend yield for three years, on a principal amount of $50. At the conclusion of the three years the investor would purchase Class A common stock by exchanging the preferred equity for shares, or by purchasing the shares with cash and keeping the preferred shares. The number of shares Cox delivered to the Income Prides for their $50 varied depending on the current market value of Cox’s shares. The higher the stock price in three years, the smaller number of shares the Income Prides holders would receive. A major benefit of issuing these hybrid products is that the preferred equity component of the security would be tax deductible. Since the investor would be forced to buy Cox’s equity at maturity, the securities were treated as equity financing for financial reporting purposes. Therefore, the issuance of these securities would not appear as debt on the balance sheet. Cox company could create a Trust, and was able to issue debt to itself in the form of bonds with a 7% coupon that the trust bought. The Trust would then turn around and issue preferred equity paying a 7% dividend yield, and with the income from the PRIDES securities sales would purchase CCI’s bonds. This allowed Cox to essentially finance itself off the balance sheet, because the Trust would appear on the right side of Cox’s balance sheet in the minority shareholder interest account. The left side of the balance sheet would reflect the revenue obtained by issuing these securities.. The Trust will sell the a FELINE PRIDE to its customers. As for the debt, the firm could have the full control or partial control over the trust and then still have control over the debt, which is good for some companies that have a conservative attitude toward the debt. The higher Cox’s share price at maturity the lower the number of shares it had to deliver to the PRIDES’ holders, which reduced the dilution for existing shareholders. This served as a hedge to the majority interest of the owners stake, as these PRIDES have payouts similar to options as we discussed in class. The contract is priced along the underlying assets, being Cox’s stock.

5) How can the FELINE PRIDES be accounted for in calculating the leverage ratio and the Cox family’s equity stake in CCI? What is the correct value of Cox family’s economic equity stake after the issuance of FELINE PRIDES?

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Cox’s family stake will be diluted when the PRIDE securities come to maturity. However, since the conversion of the securities into stock is dependent on Cox’s stock price in 3 years, the dilution effect will be lower versus a pure equity issuance. Since these Prides are being sold through a trust and are not reflected on the balance sheet, the leverage ratio should remain the same with the acquisition of Gannett. These securities will not negatively affect Cox’s investment grade rating and align with the family ownership structure. Funding with a combination of $680 million in equity, $720 million in PRIDES, and some debt, the family’s ownership stake is currently 65.1%. If the worst possible scenario that Cox has to convert 1.4414 shares per unit of Prides, this will decrease the ownership stake to 63%. These issuance of these PRIDE securities would allow the company to maintain its debt-to-EBITDA under 5 and retain its investment grade rating....