Cox Communications case
The main purpose of this report is to evaluate an appropriate financing strategy for Cox Communications. Cox Communications is one of the largest players in the cable industry. In 1999, the firm expected to make several acquisitions over the following years, spending around 7$-8$ billion in the process. Given this possibility, the firm had to find out its external financing needs and the securities it should issue to fund these acquisitions.
Cox Communications could choose between plain vanilla equity, debt, asset sales, and equity-linked securities, and must make this decision facing several constraints from the market and from the firm itself. The financing strategy had to address some corporate objectives, which included maintaining financial flexibility for future acquisitions, keeping the firm’s investment-grade bond rating and preserving the current shareholder structure.
We begin by analyzing the possibilities of financing the firm has available and the constraints and disadvantages that each of those options imposed on Cox Communications. This will allow us to understand if the acquisitions make sense from a financial and strategic points of view. We used the adjusted present value method to value Gannett’s acquisition and to get a more robust conclusion. After a careful analysis, we recommend Cox Communications to finance the acquisition of Gannet with the feline PRIDES securities.
Even though this option doesn’t satisfy all the constraints of the firm, it is still the one that is closer to fulfilling the goals of both the Cox family and the board of directors. Background In 1898, when Cox Communications Inc. was founded it started its business in the newspaper industries. However, in 1962 the firm expanded, entering into the cable television business. By the late 1990’s the industry suffered a technological revolution full of innovations like the internet, fiber optics and wireless communications.
Coaxial cables were replaced by fiber optic bundles, which provided 1000 times more capacity, and consumers could have pay-per-view and digital cable television services, high speed internet access and digital telephony. By that time satellite systems, telephone companies and wireless companies had then become part of industry, increasing the number of rivals and thus, boosting competition tremendously. Thus, the scalable nature of the business encouraged firms to grow horizontally, by acquiring extra cable systems and additional client portfolios simultaneously.
It is important to note that all of this was only possible due to the deregulation of the industry at that time. If this business line had been as regulated as the traditional part of the cable industry, would the increasing rivalry and underlying growth taken place in another industry? Given this highly competitive environment, Cox Communications Inc. intended to make some acquisitions. It was increasingly important to assure its segment of market share considering the very high fixed costs and the underlying possibility for economies of scale.
At a local level, the bigger the proportion of the market the company can cover, the lower the marginal costs are. This is because, in the same area, the cables for all costumers can be shared, as well as the service’s technicians and vans. At a national level the savings can be obtained by assuring a higher bargaining power with suppliers of producers and distributors of programming. Therefore, and since competition was increasing a lot, the firm had to extend the acquisitions that it was considering in the beginning to a much higher number to be able to compete in this new market.
Gannett and other acquisitions: possibilities and constraints of financing Gannett was also a communications’ firm, like Cox, had approximately been on the market for as long as Cox and was going to put its cable proprieties for sale. If Cox was able to buy these, it would be gaining about 522. 000 new customers. This acquisition, along with the others Cox was already negotiating, would allow Cox’s subscribers’ base to grow over 60% only in 1999, so it was in fact an extremely important purchase.
Cox Communications had four different types of financing choices. It could finance them through equity (issuing new equity), through debt (by borrowing money or issuing bonds), through hybrid securities, which is a type of financing that mixes the properties of equity and debt, or it can be financed by non-strategic assets selling. The Cox family had the intention of preserving the control of the firm and it was a top priority for them that the rating of the firm was maintained.
However, since in our point of view their control is sufficiently large to be further diluted and still control the firm, there can be a change in the family’s plans. If that is the case, the financing must be done as soon as possible, taking into consideration that it has a direct cost of 2%-3% of the amount raised (fees and expenses) and that the price of shares usually decreases when new shares are issued (according to academic studies the reduction is around 3%-4% of the stock price, nonetheless it varies across firms and over time).
Nevertheless, any possible issuance of new shares must be done before Charter’s IPO and must be consistent with the firm’s unique ownership structure. Charters, a similar company and competitor, is planning to do an IPO and the target investors for Charters and Cox Communications are the same. Therefore, the firm believes that issuing stock after Charters’ IPO would be a failure, since the appropriate segment of the investors would have already bought a very substitutable product provided by Charters.
Furthermore, an issuance of common equity must be composed only by class A and C shares. Class A has one vote right per share, and class C has ten votes’ rights per share. Given that the Cox family has 379,2 million out of 533,8 million class A shares ( 71%) and all of the 27,6 million class C shares outstanding (giving them a total control of 81% of the voting rights), there seems to exist some space to issue new shares, maintaining the family in control of the firm. Alternatively, the firm can issue debt, which could be in the form of public debt or bank borrowing.
Yields are ranging between 65 and 115 basis points above the U. S treasury obligations of similar maturities. Due to this and because the firm has a policy that the debt/EBITDA ratio shouldn’t be greater than five (when it is already very close to five), executives are concerned about the effect of increasing financial leverage in rating. Additionally, they want to order to protect the company against a possible decrease in rating, and, consequently, an increase in financing costs.
Therefore, issuing new debt does not seem to be a very reasonable option to cover the financing needs of the firm. Hybrid securities seems to be the solution to Cox’s financing problem. Products like mandatory convertibles are less senior than debt and do not have voting rights. Moreover, banks perceive them as being equity, since this participation is subordinated to theirs. In the case of bankruptcy, these participations would only be paid after paying debt. Thus, the issuance of hybrid securities does not seem to influence the rating of the company.
Additionally, since these participations do not have voting rights, they won’t enter in conflict with the family’s intention to keep the control unchanged. The firm held substantial equity investments in communication firms, along with smaller stakes in some other companies. Thus, the other possibility would be to finance the acquisitions by selling assets. Nevertheless, selling these participations to the public represented a high tax burden. Moreover, Cox faces a tax rate of 35% on its gain on sales of assets, meaning that this burden highly decrease the benefits of selling assets.
So, the alternative is to finance it without trigger a taxable event, which is possible throughout swapping its AT&T shares for shares in AT&T subsidiaries that owned cable assets. Cox Communications does not seem to be able to finance its needs throughout neither debt, nor equity. The most adequate possibility appears to be issuing hybrid securities and to swap securities without trigging a taxable event. Nevertheless, issuing a small amount of equity does not appear to be harmful to the family and, in our point of view, could be considered as an additional method of financing. The firm not only needs
to secure enough financing to carry the investment, but also the company’s future funding needs depend on the type of financing Cox is actually going to choose. In the short-term, the other deals, aside from Gannett, that were already announced by the firm (if completed) would require nearly 7. 6$ billion (divided between cash, equity, debt and shares) and internal cash flows would not be sufficient to fund them. On top of this, there is still the 2,7$ billion of Gannett’s acquisition. So, if the firm decides to issue debt to fund these acquisitions, it will need to pay it back in the future.
In the long term, it is important to note that one of the firm’s objectives is to double its size in five years. So, if all, or some, of these acquisitions go through, the firm will need additional external funds to keep up with that particular objective. Additionally, these acquisitions would increase Cox’s customer base to 5,5 million, which would probably mean that they would need to make some capital expenditures in order to be able to fulfill the increase in demand. This too would be another source of possible external financing.
Feline PRIDES securities: benefits and costs for Cox Communications Feline PRIDES Securities (FPS) is “an equity-linked hybrid product, developed by Merrill Lynch” that comes up in the context of financing Cox’s growth. With these securities, Cox Communications established a Trust which issued preferred equity and common equity. All the common equity of the Trust would be bought by the firm, and the preferred equity would be sold to investors as these Feline PRIDES securities. With the money obtained from selling the FPS’s, the Trust would buy new Cox’s debt, and the firm would pay 7% of interest rate for it.
The 7% would go back to the investors as preferred dividend yield (the Trust obtained the 7% as interest rate from Cox’s debt and gave it to the investors as the dividend yield of the preferred equity). Three years after buying the FPS’s, the investor would have to buy (with cash or by exchanging the Trust’s preferred equity) Cox’s class A common stock. This form of financing could be very beneficial for the firm for two main reasons: it would not be accounted as debt, because the Trust was owned by Cox, so instead of appearing in the balance sheet as more debt, it would be reported as “minority shareholder interest”.
Hence, this financing scheme would allow the firm to receive the same rating as before. Yet, it still allowed Cox Communications to deduct taxes on the interest payments made to the Trust, making them have the same tax benefits as if this financing form was plain debt. By comparing the FPS’s with the alternative sources of financing, we can see why this would be a more valuable option. First of all, it would not have the costs of an equity issue or make such a significant reduction in the price of the firm’s stock.
Also, it would not reduce the Cox family’s economic ownership of the company, as mentioned before. Secondly, it would not directly increase the financial leverage, at least not in a way that would imply losing the current debt rating of the company. So, the change that may be seen in the leverage ratio cannot be attributed to it. Still, even if it were, this level stays always within the desired specifications, not representing an inconvenience.
However, as it may be depicted by the cash flow scenario (in the Excel spreadsheet attached, sheet “Exhibit 8d”) where this hybrid solution is used, the Cox Family’s equity stake in CCI from 2002 onwards is below 65% – minimum level of equity the family would want to hold in the company. This means that the family would not be happy with this solution, but this is the worst case scenario situation. Given that their equity stake will never drop below the 63% limit, it will not be much lower than the minimum limit of 65% required by the Cox Family and the benefits brought about by the solution may surpass this inconvenient.
Also one must consider as well that the family would keep their 75% voting rights until 2002, and only have them decrease to 73% from then onwards. Having this in mind, we may assume that the family’s position in the company will still be considerable and it would not be too hard for them to buy their stakes back in the future for reasonable prices, in order to recover their preferred position. Lastly, it would not overburden the firm with the high taxes that the asset sale financing would bring.
Of course there are some costs implicit in the FPS’s financing, such as the cost to form the Trust or the purchase of the Trust’s common equity, but they are not enough to make any of the other types of financing able to compete with this. Plus, this is the only kind of financing that fulfills the family’s requirements of not losing their large ownership and the current debt rating. So, through these ways, these securities create value for the company. One unit of Feline PRIDES Securities can be valued through option pricing theory. It is known that, from an investor’s perspective,
once he has paid the $50 per one FPS, his payoff in three years will be one of three possible outcomes (see exhibit 7 of the case): a) if Cox’s stock price goes below $34,6875, the investor gets 1,4414 shares (50/34,6875), and the value of his payoff is the current stock price times 1,4414; b) if Cox’s stock price goes above $34,6875 but below $41,7984, the investor gets the number of shares correspondent to 50 divided by the stock price, which means the investor’s payoff in this case will be $50; c) if Cox’s stock price goes above $41,7984, the investor gets 1,1962 shares(50/41,7984), and the value of his payoff is precisely the current stock price times 1,1962. The two graphs bellow resume this situation: If we look at the second graph that shows the final payoff for the investor, we can divide it into:
Basically, the payoff for the investor who bought $50 in FPS’s is equivalent to buying a call on Cox’s stocks with an exercise price of $41,7984 and writing a put on Cox’s stocks with an exercise price of $34,6875. But the short put maximum payoff should be zero, meaning that the horizontal part of the put line should be on the horizontal axis (to be equal to zero) and it is not, it is shifted up by 50 units. So, added to the put, this option strategy would also borrow $50 at the risk-free rate. Yet, we must notice that this is not exactly like a simple option on the stock because the payoff is never S-K or K-S. Instead of the current stock price, S has to be multiplied by 1,4414 or 1,1962 shares.
So, to price this “option strategy”, we should start by pricing the call option through a binomial tree. We know that the final payoff is the max(0; S*1,1962 – 41,7984). If we knew U and D (which could be easily calculated if we knew the volatility of Cox’s stock), we could build a binomial tree, figure out the probabilities of the stock price going up or down, and obtain the price of the long call option. For the price of the put option, we would do exactly the same thing, except that the final payoff would be the max(0; 34,6875 – S*1,4414). Again, using the same rationale, if we knew the volatility of the firm’s stock, we could figure out the put price.
The thing here is that we are short and not long on this put, so our actual payoff would be the min(0; S*1,4414 – 34,6875). Also, instead, of paying the price we computed, as in the long call, we will be receiving this price. So, the actual value of this strategy would be the price of the call minus the price of this put. To that value, we would have to add the $50 that the investor would borrow. Illustrating this with a simple numerical example: U 1,1 t=0 t=3 Call Option D 0,9 S 38,25 42,075 t=0 t=3 rf (3yrs) 5,70% 34,425 C 0,2054 0,277 R 106% 0,000 pu 0,78 Value of Option Strategy S(0) 38,25 0,1520 Put Option K(call) 41,7984 t=0 t=3 K(put) 34,6875 P 0,0534 0,000
0,2625 Since we don’t know the volatility of Cox’s stock and for simplification, we assumed a U of 1,1 and a D equal to 0,9. Also, because we don’t know the current accurate value of firm’s stock, we assumed a simple average between 34,7 and 41,8 for S(0). With this, we found the future possible values of the stock. Then, we had everything we needed to calculate the final payoffs of both the put and the call. Having those, through the formula of the call and put, we obtained the values shown above. Subtracting the put price to the call, and adding the 50$, we found that the unitary FPS would be worth $50,1520. Valuation of Gannett acquisition
Gannett’s acquisition can create a lot of value to shareholders. On one hand, by buying Gannett, the firm will gain additional cable assets that will increase its capacity and more customers. This would allow the firm to enhance its revenues. Moreover, operational savings on a local scale, economies of scope and scale, marketing gains and more market power are all examples of possible sources of value creation from this acquisition. It is possible to state that cable properties are, then, worth more when consolidated than separately. Even though the Gannett acquisition is still under negotiation, it is important to value it taking into account the estimated price of 2,7$ billion for this acquisition.
In order to calculate the net present value (NPV) of this acquisition, we computed the total NPV of the firm if it did not purchase Gannett and the NPV of the firm with the purchase of Gannett in each possible scenario (through the issuance of debt, equity or a combination of both). So, we performed the following calculation: – Gannett Price + (NPV with Gannett’s acquisition – NPV without Gannett’s acquisition). This computation allowed us to take into consideration only the incremental cash-flows of the Gannett’s project. Although this calculation seems straightforward to do, we had to make some assumptions relative to the valuation method to use and the necessary inputs. WACC-based models work best when a company maintains a relatively stable debt-to-value ratio.
If a company’s debt-to-value ratio is expected to change, WACC-based models can still yield accurate results but are more difficult to apply. In such cases, it is recommended an alternative method, such as the adjusted present value (APV). APV specifically forecasts and values any cash flows associated with capital structure separately, rather than embedding their value in the cost of capital. The APV valuation model follows directly from Modigliani and Miller propositions, which propose that in a market with no taxes (among other things), a company’s choice of financial structure will not affect the value of its economic assets. According to this hypothesis, only market imperfections, such as taxes and distress costs, affect enterprise value.
Since, during the period in which the firm is expected to do these acquisitions (1999 to 2003), the D/E ratio of Cox Communications is not expected to stay constant over time (due to the different possibilities of financing these acquisitions), we will use the APV method to value Gannett’s project. Afterwards, we will use the WACC to discount future cash flows, assuming that the firm will be able to maintain a certain target D/E ratio. As Gannett’s cable properties have similar characteristics to Cox’s, the inherent risk associated with the expected cash flows generated by this acquisition was assumed to be equal to the risk of Cox Communications.
The APV is equal to the present value of the unlevered company discounted at the unlevered cost of equity (as if the firm was 100% equity financed) plus the present value of the tax shield (discounted at the cost of debt – rd). . In order to compute the present value of the unlevered firm for the APV, we needed to calculate the total cash-flows in each year (cash-flow from operations plus cash-flow from investment) and then discount them at unlevered cost of equity (ru). This unlevered cost of equity is not directly observable and it must be estimated. Thus, in order to calculate it we used the CAPM equation: ru = rf + ? u * market risk premium, where rf stands for the risk-free rate and ? u for the unlevered beta. The CAPM assumes that investors are perfectly diversified and that the only risk that matters is the systematic component.
The exhibits of the case provide us the risk-free for ten years (5,83% yield for 10-year Treasury Bonds) and we assumed the historical market risk premium of 6%. So, the only input missing to obtain the unlevered cost of equity was the unlevered beta, which was calculated through. ?lev stands for the levered equity beta of 0,68 (given in exhibit 2), ? d for the debt beta, t for the tax rate (equal to 35%, assuming the average tax rate in the US for this period) and D/E for the debt-to-equity ratio in 1998 (equal to 0,2 in exhibit 3). The debt beta was calculated trough the CAPM using a cost of debt assessed from industrial average yields, according to the credit rating the firm had.
Thus, the cost of debt to employ in the valuation of Gannett’s assets should be the yield on A-rated bonds with maturity of 10 years – 6. 93%. With all this information, we were able to calculate a ? u of 0,6229. The unlevered cost of equity was, thus, 0,0957. Then, we had to re-lever the beta in order to adjust to the new D/E ratio of 1999 equal to 0,17. So, = 0,6917. With this value we computed the cost of equity re-levered using, again, the CAPM. All the results obtained and the data used for the computations are shown in the tables bellow. Then, we had all the necessary inputs to calculate the WACC: , where E/D+E (equity value) was calculated using the D/E ratio of 1999.
Additionally, we calculated the tax shield in each year using the formula interest rate * tax rate * debt and discounted the tax shield values at the cost of debt to get the present value of the tax shield. The interest rates that we considered were calculated using the following formula for each year: -interests/ending total debt. The interest rates for each period are shown in the tables of the appendix. Since we only have data available until 2003, we needed to compute the terminal value. In order to do this, we assumed the cash flows of the company would grow at 8,5% rate, since it is stated that the additional services are expected to make cash-flows grow from 8% to 15% annually.
Thus, the terminal value would be , where r is the WACC, since we assumed that after 2003 the firm will keep a constant debt-to-equity ratio. We also discounted this value until year zero. Adding the present value of cash flows with the present value of the tax shield and the terminal value gives us the total NPV of the firm. We performed similar calculations for all the possible financing scenarios so that it would be easier to compare them. The detailed results are shown below in the appendix. However, we present here a table that summarizes the final results. Funding this acquisition through debt gives a negative NPV of Gannett’s project. Therefore, this possibility of financing is excluded. The other two alternatives give a positive NPV to the project.
The decision between these two has to be made not only considering the values for the NPV but also the advantages and disadvantages of each alternative. Thus, even though the NPV of the project financed with equity presents a higher value than the one financed through feline PRIDES securities, we must take into consideration the constraints of both alternatives. Conclusions and recommendations From our analysis and valuation we take three major conclusions and a recommendation for Cox Communications. First of all, it is clear that Cox Communications is taking an aggressive position in the market, making many purchases and investing a lot, to be able to cope with the rhythm of an industry going through deep changes and increasingly competitive.
Thus, for a firm to stand out in this business, it is essential to work hard to keep up with these transformations. Secondly, the firm is still largely owned by the Cox family which naturally has some demands when it comes to the decision-making process in the firm. The two greatest demands are that the family never loses the majority ownership and that the company does not lose its debt rating. In order to surpass these difficulties and, at the same time, keep up with the market, Cox Communications needs to take caution and make the decisions based on these criteria. It should also take into account the constraints imposed by the market presently, such as financing costs that will restrict the firm’s decisions.
Lastly, the acquisitions that the firm was already planning to do plus the Gannett cable properties’ purchase would allow Cox Communications to grow immensely, with a much more significant presence in the market. Additionally, the firm would be able to better serve its clients and with the profits brought by these satisfied clients, have better results to present to the shareholders, which, ultimately, is every company’s goal. Taking all of this into consideration, and after valuing Gannett’s acquisition with all possible financing scenarios, we recommend that Cox does in fact purchase Gannett’s cable properties through Feline PRIDE Securities because that represents the only way of financing that better fulfills the Cox family’s requirements and has a positive NPV.