Poor Earnings and Stagnant Growth Are Fueling Cable Merger Talks

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The U.S. pay-TV space is once again abuzz with speculation about the potential for blockbuster mergers and takeovers that could reshape the industry. The latest catalysts for these rumors come in the form of lackluster earnings reports from a slew of big-name cable companies. After years of growth, it appears that the U.S. public's appetite for cable and satellite television services has plateaued. As new media companies continue to disrupt the operations of once-dominant broadcasters and cable firms, investors will rightly look to consolidation to drive profit growth.

Overseas, the picture is not so bleak. However, companies like Charter Communications (NASDAQ: CHTR) and Cablevision lack major international footprint. While other firms like Time Warner Cable (NYSE: TWC) and Liberty Media (NASDAQ: LMCA) do have exposure to still-expanding overseas markets, such diversification might not be enough to drive profits. Additionally, Liberty Media's recent split with Liberty Global has reduced its leverage in Europe and elsewhere.  

Who are the players?
The current merger-related chatter centers around three public firms that are involved in two specific situations. The first involves Charter and privately held Cox Communications, a smaller cable company that operates out of Atlanta and maintains a robust sphere of influence in the American South. The second centers around an alliance between Charter and Liberty that could wind up taking over Time Warner Cable. This potential deal has the backing of John Malone, the aggressive and astute chairman of Liberty Media and Liberty Global.

There are subtle differences between these three companies. Most importantly, Time Warner Cable is not to be confused with the much larger Time Warner. Time Warner Cable specifically provides cable, phone, and internet services to customers in the U.S., Canada, and the Caribbean. Although it is most competitive in specific markets like the New York metropolitan area, the Ohio Valley, and Southern California, it serves nearly 30 million customers in total.

Meanwhile, Charter has a far smaller base of residential customers, but enjoys robust support from small business clients. Radio-focused Liberty Media sloughed off its cable operations on Liberty Global during the recent spin-off, but its chairman is eager to get back into the game.

Charter is struggling to remain profitable. Its 2012 EBITDA came in at $2.7 billion, but a range of charges forced it to post a "book loss" of $252 million. Meanwhile, Time Warner Cable's net profit came in at $2.2 billion on about $21 billion in revenue. Due to the spinoff, Liberty posted an eye-popping profit margin of nearly $10 billion. Without the split-related windfall, the company earned a more down-to-earth $637 million on $2.8 billion in gross revenue.

The Charter-Liberty-Time Warner scenario
For investors, the Charter-Liberty-Time Warner tie-up is the more intriguing of these two deals. In May 2013, Liberty disclosed a 27% stake in Charter and revealed that it was exploring options for a leveraged buyout of Time Warner. Speculation accelerated in late June with John Malone's assertion that such a deal would be financially possible.

However, industry observers caution that Time Warner Cable would have little to gain from an acquisition by two smaller rivals. This situation has been further complicated by reports that Charter is also considering an offer for New York-area rival Cablevision. Until more is known about this specific situation, investors should be cautious about making plays for either potential target.

The Charter-Cox situation
At this point, a tie-up between Charter and Cox appears to be more likely. Given Liberty's large stake in Charter, Mr. Malone would undoubtedly have a hand in this deal as well. Since Cox is private, its precise value is unknown. However, Charter would probably require some form of leverage for this deal as well. Cox's management team has been coy about the prospects of this deal, but seasoned market-watchers believe that something will eventually happen here. Aggressive investors may wish to position themselves ahead of a more official announcement.

Where does Cablevision fit in?
As a smaller, more locally-focused firm that operates in its home market, Cablevision would also be a natural fit for Charter. If Charter and Malone are unable to negotiate a deal with Time Warner Cable or Cox, they may feel pressured to settle for a controlling stake in Cablevision. A full takeover is possible as well. Given the pressure on Charter's board to produce some sort of deal, Cablevision may be able to negotiate for a better price. 

Is there opportunity here?
At this point, the possibility of a deal between Charter, Liberty, and Time Warner Cable is somewhat remote. It is more likely that Charter will opt to buy privately held Cox Communications or publicly held Cablevision. As such, investors may wish to initiate a tightly-controlled position in Cablevision. This is a risky strategy: If a deal fails to materialize, Cablevision's stock price could fall by a significant amount.

More conservative investors may wish to settle for a long position in Liberty Media. This would provide some much-needed insulation from Charter's volatile price movements without eliminating the potential for medium-term gains. In either case, due diligence is essential.

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