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US West Media to Pay $5.3 Billion To Buy Continental Cablevision

 "U.S. West Media group agreed to acquire Continental Cablevision Inc. for $5.3 billion in cash and stock, plus the assumption of $5.5 billion in debt - the biggest combination ever of a Baby Bell and a cable-television operator.

The acquisition is the first such deal announced in the aftermath of new federal telecommunications legislation, which permits local telephone companies, long-distance companies and cable operators to go after each other’s markets."

PREMIUM!

Definition

Premium is synonymous with additional over a "benchmark." Additional What? It is the additional price, over pre-acquisition market price that an acquiring company has to pay to the target company’s shareholders to induce them to sell their stocks.

How much?

"... a premium of between 11 and 12 times cash flow compared with previous averages of around 10 times cash flow."

The WSJ is using "premium" to mean price! This is not how it’s used in finance textbooks. In other words, the price to cash flow ratio is between 11 and 12 times, i.e., [price/(annual cash flow)] = between 11 and 12. Moreover, you have to infer that the time period is annual, otherwise the number would not make much sense. Thus, to be technically correct, the premium is only one over the previous averages.

The second part of the quotation should indicate to you how the ratio can be used in valuation. It is one method of estimating the value of an asset. Thus, given an asset’s annual cash flow, say, the most current year’s, you can impute the value/price of future cash flows by multiplying that number by the ratio.

Your intuition is right if you thought that this multiple varies across lines-of-business. In the cable industry, the average ratio is 10, as indicated by the quotation. Furthermore, this is a rough and extremely fast way to estimate value compared with a Discounted Cash Flow (DCF) method, for example.

How is US West Justifying the Premium?

"US West Media executives said the company will make up for the premium it is paying through additional revenue from non-stop shopping- a package of cable TV, telephone offerings and Internet-access services via cable lines and powerful cable modems."

My objective is not to validate this argument, but to draw your attention to some of its interesting implications. The most crucial word in the above quotation is "additional," i.e., incremental cash flows that would only be generated if the two separate companies were combined.

Moreover, you might think of similar merger justifications that some companies pursued in the 1980’s. Sears’ and American Express, for example, attempted to provide a wide range of financial services, only to realize later that each service would be worth more if owned separately rather than under one company.

Story Source: WSJ, 2/28/96, p. A3