An earlier analysis (Disney: Valuing the Reorganization, May 9, 2018) investigated the consequences of Disney’s March 14th-announced reorganization on the company’s valuation. While a detailed look at the company’s revised investing, financing, and dividend policies projected an increase of $65.3 billion in value, the effect of Disney’s proposed $52.4 billion acquisition of 21st Century Fox (“Fox”) assets was omitted. This paper examines the impact of the proposed acquisition for Fox to the shareholders of The Walt Disney Company (“Disney”).
Specifically, an intrinsic valuation using a discounted cash flow approach determines the fundamental drivers of value. With the exception of parks and resorts, Fox operates across the same business segments as Disney: cable network programming, television broadcasting, and film entertainment. Thus, Fox faces a similar competitive environment as Disney, discussed in the competitive analysis section of Disney: Valuing the Reorganization. This paper starts by examining the strategic response of Fox to competition. Next, a brief summary of the acquisition is provided. Then, digging into the financials and investing, financing, and dividend policies, the critical factors of value in both Fox and Disney are identified to calculate the value of the acquisition of Fox to Disney shareholders. The value of Fox is analyzed in three parts: value of control, value of synergy, and value of Fox as a stand-alone entity (Fox “As Is”).
Strategic Response of Fox
To better face the new competitive challenges, in December 2016 Fox bid GBP10.50/share for the remaining 61% of shares in the British media company Sky plc (“Sky”) it does not yet own, valuing Sky at £18.5 billion ($24.6 billion). Although Sky’s board initially supported the bid, a counter offer by Comcast on April 25, 2018 of £12.50, or £21.5 billion ($28.6 billion), led to the board’s withdrawal of support. According to The Wall Street Journal, the British government is unlikely to open an anti-trust review into Comcast’s bid for Sky. Furthermore, even though Disney’s and Fox’s acquisition agreement stipulates that Disney is prohibited from making a direct offer for Sky, the rejection by the UK’s Panel on Takeovers and Mergers of Fox’s bid for Sky would likely solicit a full offer by Disney. On April 12, the Panel announced that should Disney successfully acquire Fox the House of Mouse would be required to make a full bid of at least £11.7 billion ($15.6 billion) for Sky. With Sky’s shares currently trading at 1350.00 pence (as of June 4, 2018), the market clearly anticipates a bidding war. As it stands, Fox is highly unlikely to outbid Comcast (nor Disney) for Sky, thus this analysis disregards the impact of a full takeover of Sky by Fox. Moreover, rumors of a possible bid for Fox by Comcast are swirling, running up FOX (non-voting) and FOXA (voting) shares to $38.44/share and $38.66/share, respectively.
Summary of the Disney-Fox Acquisition
Under the terms of the agreement, shareholders of Fox will receive 0.2745 Disney shares for each 21st Century Fox share they hold (subject to adjustment for certain tax liabilities as described below). Also, Disney will assume roughly $13.7 billion of net debt of Fox. This acquisition price implies an equity value of about $52.4 billion and firm value of $66.1 billion as of the offer date on December 14, 2017. In return, Disney will receive select entertainment assets of Fox that excludes Fox’s television, broadcasting, news, and sports and Sky Sports F1 racing channel.
Valuing the Acquisition of 21st Century Fox
The analysis of the acquisition starts with a valuation of Fox on an as-is basis given existing investing, financing and dividend policies. This valuation acts as a base from which control and synergy premiums can be calculated.
Value of Fox = Value of Fox “As Is” + Value of control + Value of synergy
Value of Fox “As Is”
The status-quo scenario represents Fox prior to Disney’s bid. A three-stage discounted cash flow (DCF) model is employed consisting of a high growth phase for Year 1 to Year 5, transition phase for Year 6 to Year 10, and stable growth phase for Year 11 and after. Trailing twelve month (TTM) financials are used throughout this report, including Fox’s Third Quarter 2018 results (released May 9, 2018).
Despite the lower marginal corporate tax rate of 21.0%, U.S. companies will continue to employ tax-saving strategies to minimize their tax payable liability. For Fox, 15% to 20% indicates the likely range based on history; so, a 17.5% effective tax rate is set.
Last year’s return on capital (ROC) of 7.04% is used during the high growth phase, remaining stable forever. A reinvestment rate of 29.8%, last years’ rate, is used during the high growth phase, also remaining stable into perpetuity (slightly lower for perpetuity due to rounding). All combined, the expected growth rate of 2.10% (7.04% ROC x 29.8% RR) is presumed to remain constant into perpetuity (again, slightly lower due to rounding).
Fox is a highly financially levered company. The debt ratio currently stands at 51.22%, which includes marketable debt obligations and accrued net benefit liability for pension and other postretirement benefit plans recognized as of June 30, 2017, altogether adjusted to a market price of $22,867 million, is expected to stay stable across all phases. In addition, debt incorporates off-balance sheet commitments including capital leases, sports programming rights, entertainment programming rights, and borrowing agreements equaling $52,344 million, for a total debt of $75,202 million.
The Capital Asset Pricing model (CAPM) forms the framework for establishing a firm’s risk profile. Inputs for Fox’s cost of equity include 2.94% risk free rate (US treasury 10-year yield), 1.35 beta, and 5.61% equity risk premium (This analysis calculates a bottom-up beta as described in Appendix B: Bottom-Up Beta and an implied equity risk premium as described in Appendix C: Implied Equity Risk Premium of Disney: Valuing the Reorganization). Fox’s cost of debt of 4.14% is based on the prevailing 10-year risk free rate (US Treasury 10-year yield) plus a default spread of 120 bps based on the company’s current Baa1/BBB+ credit rating. For the high growth phase, cost of equity stays at 10.50%, declining gradually from Year 6 to Year 10 to 9.67%, influenced by a drop in the company’s beta to 1.0 as Fox reaches maturity and a jump in its cost of debt to 5.26% due to rising interest-rate levels as implied by forward rates. Altogether, the cost of capital rests at 6.80% during the high growth phase and increases linearly to 6.85% by Year 10 into perpetuity.
Based on these inputs the firm value of Fox is estimated to be $93,935 million.
For a copy of Fox’s 2017 financial statements and 2018 third quarter report, please refer to Appendix A: 21st Century Fox Financials.
Value of Control
A control premium represents the added value that acquiring management can imbue on the target company. With a reputation of successfully integrating acquisitions and training new staff on its operational and financial processes and the Disney way, Disney management aims to maximize its control premium. The calculation of the value of control starts with a valuation of Fox under the leadership of Disney management, referred to as Fox “Optimized.” Once complete, the value of Fox “As Is” can be subtracted to yield the potential control premium.
The Value of Control at Fox
Under the guidance of Disney’s management, the value of Fox is anticipated to rise. Improved efficiency and productivity pushes ROC up to 12%, but below that of Disney. Reinvesting jumps to 40% as the battle for OTT/DTC services heats up. Expected growth in operating profits-before-interest-and-taxes, as a result, rises to 4.8% during the high growth phase. As Fox matures by Year 10, ROC declines to 8%, while reinvestments remain stable at 40%. As a result, the perpetual growth rate is expected to be 3.2%, slightly above the long-term expected growth rate of U.S. GDP, but by then its international business will be driving the company. Next, let’s look at the firm’s capital structure.
Ideally, Disney management would reduce Fox’s financial leverage. However, shifting Fox’s debt ratio from the current 51.22% to, say, the level of Disney “Reorganized” of 37.5% would result in a 12.5 billion drop in value. Under the leadership of the Murdochs, Fox pushed the envelope to attain a Baa2/BBB+ rating despite large off-balance sheet commitments. A synthetic rating of Ba2/BB, carrying a 238 bps credit spread, would seem more appropriate given its current interest coverage ratio of only 2.00. As a stand-alone entity, Fox’s valuation is maximized by maintaining its current debt ratio.
The cost of debt during the high growth phase remains at 4.14%, but the more volatile OTT/DTC services drives the beta and cost of equity to 1.86 and 13.46% that increases the cost of capital to 8.24%. Cost of debt, beta, cost of equity, and cost of capital move to 5.25%, 1.00, 9.72%, and 6.87%, respectively, as maturity sets in after Year 10.
Based on these inputs the firm value of Fox is projected to rise from $93,935 million to $104,763 million. From this an estimate of the value of control can be worked out:
Firm value of Fox (optimally managed) $104,763 million
Firm value of Fox (as-is) $93,935 million
Value of control $10,828 million
Value of Synergy
Like many acquisitions, Disney hopes to realize synergies between the combined firms. Valuing this synergy starts by determining the stand-alone value of Disney. The valuation of Disney, referred to as Disney “Reorganized,” will incorporate the reorganization efforts currently underway. The following valuation has been revised from a similar analysis published several weeks ago (Disney: Valuing the Reorganization). Again, trailing twelve month (TTM) financials are used, including Disney’s Second Quarter 2018 results (released May 8, 2018).
The restructuring of Disney rearranges the Magic Kingdom to compete in the rapidly changing entertainment and media space where technology morphs in to a core component of operations. The ability to collect and store big data from virtually all sources (both internal and external) and formats (visitor and customer data only represent a piece) and the ability to synthesize and analyze that data in real-time and deploy what has been learned throughout the organization in seconds is the next big thing. The newly captured knowledge unceasingly feeds back to propel disparate parts of operations ahead. To be sure, executing such a strategy across a large organization as Disney will be challenging as all areas need to be on-board. New processes, innovations, skills, and incentives need to be rolled-out with urgency – drawing on staffs’ inner-Dash couldn’t hurt. The right partner with established technologies and meaningful data points could jump-start this effort immensely, while simultaneously sending a clear message that Disney intends to dominate the 21st century (sorry, couldn’t resist). Nevertheless, superior entertainment and content production and marketing and distribution along with an ever-expanding brand portfolio still embody the primary drivers of success in the entertainment and media arena.
Consequently, Disney is expected to increase its value. Improved efficiency and productivity pushes ROC up to 15%, while heavy reinvestment in tech-related research and development, internal capital expenditures, and acquisitions and operating investments propels the reinvestment rate to 50%. Expected growth in operating profits-before-interest-and-taxes, as a result, leaps to 7.5% during the high growth phase. As Disney matures by Year 10, ROC slides to 10% with reinvestment falling back slightly to 40%, but keeping pace with technology innovations and delivery systems is now mandatory for entertainment and media firms. Just to note, this implies a long-term growth rate of 4%, which is right around the long-term risk-free rate implied by forward rates. And, while higher than expected long-term US GDP growth rate forecasts, this analysis projects Disney to be a truly global media giant bringing Mickey Mouse, Iron Man, and future sagas of Star Wars to China, India, and all of Africa. The higher reinvestment rate may raise concern for some existing investors, particularly, those keen on maintaining dividend flow; but, The Happiest Place on Earth is expected to generate strong free cash flows to firm (FCFF) to safely cover its 1.63% (trailing) dividend yield. Next, let’s look at the firm’s capital structure.
Disney’s optimal capital structure would likely be constrained by the desire to maintain an A to A- credit rating. This reorganized scenario bumps up the debt ratio from about 34% to 37.50% that would likely maintain its A1/A+ (with an interest rate coverage ratio of 5.91). Interestingly, the optimal capital structure of about a 48.00% debt ratio maximizes Disney’s equity value at $234,549 million, or $157.36/share, but carries a likely Baa2/BBB rating that would probably cause the board to cry wolf or the Hulk to go on a rampage.
A downshift in Media Networks combined with an upshift in Direct-to-Consumer and International plus higher reinvesting and additional leverage bounces the beta all the way to 1.43 which raises the cost of equity to 10.73% and cost of capital to 7.85% in the high growth phase. But, beta, cost of equity, and cost of capital drop to 1.00, 9.52%, and 7.42%, respectively, as maturity sets and the cash machine kicks in after Year 10.
Based on these inputs the firm value of Disney is estimated to be $272,385 million.
The value of the combined firm (Disney and Fox), with no synergy, should be the summation of the values of the individual stand-alone companies.
Firm value of Fox (optimally managed) $104,763 million
Firm value of Disney (reorganized) $272,385 million
Value of combined firm $377,148 million
Thus, the value of the combined firm without synergy is $377,148 million.
For a copy of Disney’s 2017 financial statements and 2018 second quarter report, please refer to Appendix B: The Walt Disney Company Financials.
Value of the Combined Firm (Disney and Fox) with Synergy
The existence of synergies can boost the value of the combined firm. These synergies can be categorized into two sources: operating and financial. Operating synergies can be derived from economies of scale, improved pricing power, cross-functional strengths, and higher growth opportunities in new or existing markets that otherwise would not be available to one of the firms on its own. And, financial synergies stem from excess cash and previously foregone investment opportunities, improved debt capacity, and tax benefits. To be sure, synergies can emanate from either the acquirer or target firm.
To determine the value of the combined firm with synergy, plausible operating synergies are examined first. At the Question and Answer Session with Senior Management on December 14, 2017 Disney indicated that it expected $2 billion in cost savings between the two organizations after three years due to “overlap and [the] redundancies.” For the top line, the addition of Fox’s creative talent improves the chances of developing original “must have” content and the expansion of the breadth and depth of Disney’s content catalog provides pricing power in negotiating carriage fees and future DTC sales. For instance, Fox’s Regional Sports Network (RSN) and its loyal fan base gains access to the ESPN national and international network. Furthermore, majority control of OTT Hulu enables streaming of Fox Searchlight’s small and lower budget films, Fox 2000 films, and even FX and National Geographic content. Looking abroad, Sky’s pan-European footprint opens up Europe for Disney, while media giant Star India and its 720 million monthly viewers across India and over 100 countries offers a plethora of two-way production and distribution opportunities. Could a Disney Maharani of Jaipur be in the works? A sprinkling of Disney’s tentpole marketing dust across the House of Mouse’s newest brands extends monetization streams. But, operating synergies provide a secondary knock.
The uplift in income and cash flows from operating synergies expands debt capacity and could unleash bottled-up Fox projects. Its debt load of $75 billion acts like an anchor on Fox’s creative dreams. But, higher profits stemming from operating synergies are enough to support Fox’s debt as the combined firm whittles it down over the next couple of years.
These synergies are expected to add value to the combined firm. EBIT increases by $2 billion from economies of scale savings. A 5% bump in Fox’s revenues and operating profits, or an additional $270 million to EBIT is predicted. Also, another $432 million arrives from a 3% rise in Disney’s international profits thanks to the opening of new markets via Sky and India Star. However, ROC comes down 1% to 14% as some efficiency loss is to be expected in such a large combination. The target reinvestment rate remains at 50% to yield 7% expected growth rate, down from 7.5%, over the high growth phase. From Year 5 to 10, ROC and reinvestments drifts down to 10% and 40%, respectively, to arrive at a 4% perpetual growth rate for the combined firm.
The addition of Fox hikes Disney’s beta to 1.48 (Note 1) which raises the cost of equity to 11.11% and cost of capital to 8.15% in the high growth phase. From Year 5 to 10, beta, cost of equity, and cost of capital gradually declines to 1.00, 9.59%, and 7.53%, respectively. Equity risk premium for the combined firm is assumed to stay steady at 5.53% (Note 2) across all phases. As discussed, the combined firm’s strong cash flows will be used to reduce the debt ratio from 43.17% to 37.5% giving Disney a synthetic A3/A- credit rating with a 113 bps spread (based on an interest coverage ratio of 3.65) for a 4.07% pre-tax cost of debt in the high-growth phase, rising to 5.19% by year 10, based on forward rates.
Based on these inputs the firm value of the combined company (Disney and Fox) with synergy is estimated to be $402,764 million. Comparing this combined firm value to the combined firm value without synergy of $377,148, and taking the difference represents the value of synergy in the acquisition.
Firm value of combined firm (with synergy) $402,764 million
Firm value of combined firm (with no synergy) $377,148 million
Value of synergy $25,616 million
However, this synergy will not be realized immediately. According to Disney management, cost savings related to the acquisition are expected to take three years to impact the bottom-line. So, assuming that it will take an average of three years to create all synergies, the estimated present value of synergy can be calculated by using the combined firm’s cost of capital as the discount rate.
Present value of synergy = $25,616 million / (1.0815)^3 = $20,248 million
Valuing the Acquisition
Summing the value of control of $10,828 million, value of synergy of $20,248 million, and the value of Fox (as-is independent entity) of $93,935 million, results in a value of Fox with control and synergy equal to $125,011 million. Fox also has $75,202 million in debt, $1,252 million in minority interests, and 1,852.53 million shares outstanding (FOXA and FOX). The maximum value per share for Fox can then be estimated as follows (assuming no cash):
Maximum value per share for Fox
= (Firm value – Debt – Minority Interests) / Number of shares outstanding
= ($125,011 – $75,202 – $1,252) / 1,852.53
The estimated value per share for Disney (reorganized independent entity) is $125.19, based on the total value of the firm of $272,385 million, debt outstanding of $81,695 million, minority interests of $3,500 million, equity options of $592 million, and 1,490.523 million shares (again assuming no cash).
Value per share for Disney = (($272,385 – $81,695 – $3,500 – $592) / 1,490.523 = $125.19
The appropriate exchange ratio, based on value per share, can be estimated:
Exchange ratio (Disney, Fox)
= Value per share (Fox) / Value per share (Disney)
= $26.21 / $125.19
= 0.2094 Disney shares per Fox share
The acquisition was announced with the exchange ratio set at 0.2745 Disney shares per Fox share, above the calculated “fair value” ratio. Thus, Disney shareholders will lose to the benefit of Fox shareholders. Assessing the value of the offer:
Value per Fox share (Disney offer) = 0.2745 ($100.24) $27.52
Value per Fox share (assessed value) $26.21
Overpayment by Disney $1.31
Based on this assessment of value and control, Disney is overpaying on the acquisition for Fox by $1.31/share or $2,427 million.
This report presents a detailed composition of the valuation of 21st Century Fox and The Walt Disney Company with the goal of attempting to show the impact of the announced acquisition. Disney and Fox offer a unique opportunity to demonstrate this because it operates in the media and entertainment industry that is currently undergoing dramatic change. Those firms with the strategic foresight and ability to successfully execute their operating, financial, and dividend policies will be best positioned to lead in the global media and entertainment space. Strategic acquisitions can bolster existing capabilities, jump-start new initiatives, and even create operating and financial synergies to boost the value of the combined firm.
This analysis applied a series of comprehensive DCF models to ascertain the value of Disney’s acquisition of Fox. By focusing on the key drivers of growth – return on existing assets, expected growth rate, period length of growth – and closely scrutinizing and fine-tuning the capital structure and cost of capital of the combined firm, a value of Fox (as-is independent entity) of $93,935 million, value of control of $10,828 million, and value of synergy of $20,248 million results in a value of Fox with control and synergy equal to $125,011 million. Subtracting out Fox’s debt of $75,202 million and minority interests of $1,252 million gives an estimated equity value of $48,557 or $26.21/share for Fox. Based on this assessment of value and control, Disney is overpaying on the acquisition for Fox by $1.31/share or $2,427 million.
Appendix A: 21st Century Fox Financials
Appendix B: The Walt Disney Company Financials