TWTR - Lessons Of The Twitter Saga: Comcast And Disney Investors May Be In For A Surprise

Summary

• Twitter's victory over Elon Musk is a reminder of the need for even experienced management teams to consider carefully before making legally binding acquisition offers.
• Comcast is increasingly signaling that it believes Disney is undervaluing the 33% Hulu stake it's due to sell by 2024. It wants to defend the value it was counting on.
• The nature of arbitration likely means that Comcast could only do that by submitting a legally binding bid for all of Hulu, including Disney's 2/3 stake.
• A bidding war between the two companies is quite possible, since Comcast seems to sincerely believe Hulu is a strong asset and probably isn't worried about being 'stuck' with it.
• Given that Hulu runs more or less at breakeven at the moment, some company will soon have a considerably higher debt load for more or less the same profit they're reporting now.

The purpose of this article is to focus closely on one particular aspect of Disney ( DIS ) and Comcast ( CMCSA ) operations, their joint venture Hulu and, more importantly, its potential deleterious impact on their balance sheets - or at least one of their balance sheets - going forward.

Today's News

In case you missed it (but how could you?) the Twitter ( TWTR ) saga seems to finally be over . In a letter today Tesla ( TSLA ) CEO and founder Elon Musk indicated his willingness to basically go back to square one with the company and proceed with the original merger deal he’s spent a good portion of the year trying to get out of.

Musk lost no time portraying his decision as a boon to him because it will accelerate his plans, allow him to fix the company, etc. But in reality, most on Seeking Alpha believe it was for a far simpler reason: he was always going to lose at trial and have to proceed anyway, so might as well save himself some judicial trouble. It’s not clear yet if the need for deal financing will have any significant impact on Tesla stock or not.

Seeking Alpha has a number of analysts who have already done great work on this issue and analyzing Twitter as a company. And certainly there is no shortage of Tesla analysis here. But as I was reading the news today, I couldn’t help but be struck by the implications of this news for two other companies who, admittedly, had not a single dog or puppy in the Twitter debacle. And those companies, in turn, might have a lesson for Twitter and Tesla going forward.

Communacopia Cornucopia

It was quite a (suitably dignified) spectacle just a few weeks ago, at the Goldman Sachs ( GS ) Communacopia industry event. Bob Chapek and Brian Roberts, the CEOs of Disney and Comcast, took the stage within hours of each other to give their perspectives on Hulu.

Chapek in his comments essentially went out of his way to talk down Hulu a little bit - within reason, after all he’s about to own it - and explained why it probably wasn’t worth all that much, even though he very much looks forward to owning it. It’s a delicate line to walk, but he did his best. And the import of the message was certainly aided by the veritable collapse in media stocks, especially streaming stocks, over the past few months.

It wasn’t long after that, Roberts took the stage to respond. And despite the calm even tone, he wasn’t exaggerating when he said he’d “take strong exception” to Chapek’s comments. In something between boldness and arrogance, he basically dismissed the current market repricing of streaming stocks as irrelevant. He insisted that if the whole of Hulu were put up for auction - the only metric he thinks should be relevant to the decision - a lot of companies would be very interested in buying. That list would include - and this is the only part of his statement that has to be taken as more than bluster, and perhaps a major shift in Comcast’s future strategy - Comcast itself.

I don’t know that public markets are the way to judge the value

-- Comcast CEO Brian Roberts

That last bit is the key, and here is the crucial point: this willingness to submit a bid, assuming he’s not just bluffing, has major implications for Comcast and Disney regardless of whether Comcast’s bid succeeds or not .

The Comcast Disney Deal

To recap in a nutshell: Comcast and Disney are co-owners of Hulu, with Disney owning two-thirds of the company and Comcast the remainder. Under a deal signed in 2019, Comcast can be required to sell the remaining stake to Disney, but Disney has to pay the higher of a guaranteed minimum - probably irrelevant at this point - or fair market value.

Some believe that the statements a few weeks ago were rather meaningless because they only indicate something any fool already knows: that each side wants to get the best deal for itself that it can. My own take is that this is, or at least could be , far more significant than that, a real indication that something is changing in the relationship between arguably the two biggest players in pay-TV, the largest distributor and the largest producer.

To be fair, it’s probably both.

Yes, the companies are jockeying for position. Comcast is talking up the value of Hulu because it’s scheduled to sell it, and Disney is talking down the value of Hulu because it’s planning on buying it.

But there’s more than just PR and influencing third parties at stake here; Comcast and Disney are both going to have a decision to make very soon, and these statements may be indicative of how they’re leaning - unless they’re bluffs, in which case they’re indicative of something else investors should care about.

The Game's Afoot.. . Almost

The key point is this: pretty soon, the joint ownership will end and someone is going to end up with all of Hulu as an asset, while the other will end up with a lot more cash than they had before. Hulu as an asset is a fixed component of such a deal; the key question now is the amount of cash for the runner up.

As recently as late last year, Roberts had good reason to think that Comcast’s cash haul would be quite substantial for its stake. Industry analysts were putting the value of Hulu as high as $57 billion all-in. While that may have been a little optimistic, it wasn’t out-of-bounds, as Hulu remains one of the biggest players in streaming media and that figure represented only about 25% of Netflix’s ( NFLX ) market cap at the time.

But then, Netflix stock collapsed, and the rest of the media world followed it right on down. It isn’t entirely clear what value an independent arbitrator would assign Hulu now, but if they went by public markets it would probably be a lot less - doubtless why Roberts is so insistent that Hulu not be valued that way.

But even his alternative of evaluating Hulu through the prism of an arm's length auction probably wouldn’t get him back up anywhere near what Comcast was counting on just a short time ago. If Roberts wants to get back anywhere near the $19 billion industry analysts thought he was in store for a year ago, he needs someone to step up and start aggressively bidding on Hulu to demonstrate market value. But with strained credit markets and looming recession, it’s not clear who is going to do that.

Unless Comcast decides to do it themselves.

The Play And The Pitfalls

There’s a bit of a problem with that scenario in that the existing deal between them doesn’t require Disney to engage with Comcast for its majority stake of the business: Comcast buying out Disney just isn’t something the two management teams were contemplating when they wrote this thing. But Comcast can’t just bid for its own stake as a “buyer,” either; since it would be paying itself it would be free to write in any ridiculously large number and essentially nullify the contractual commitment to sell it made to Disney. So an arbitrator might reasonably tell Comcast that the relevant test is what a buyer other than Comcast would pay for it, to keep the auction fair.

Comcast needs, essentially, a back door way to become a bidder.

This brings me back to the Twitter deal. Like I said, Musk’s “I was gonna suggest that” spiel notwithstanding, this deal is going through because Musk had already signed a legally binding offer before he realized that he’d probably overpaid. In order for an arbitrator to take Robert’s figure seriously, he’d probably have to do the same.

The Potential Pathway

What Comcast could conceivably do is this: even though Disney isn’t required to offer up its Hulu stake under the existing deal, Comcast could essentially “pull a Musk” and send Disney, completely outside and separate from the auction process for Comcast’s 1/3 stake, a legally binding offer sheet for Disney’s 2/3 Hulu stake and essentially leave it on the table. Critically, this would not be just a “tentative proposal,” it would be a final offer sheet with full terms.

At that point, Roberts would be able to say to the arbitrator, “we have an open offer on the table to Disney and it’s good for the next 90 days,” or whatever length of time. Like Musk, this would be a gamble, because it would be legally binding. Essentially, Comcast’s signature would already be on the completed contract, and the contract would sit in Disney’s possession for a period of time and if they sign it too, the deal’s done.

If, on the other hand, Disney doesn’t sign it, Roberts would have real leverage to go to the arbitrator and say, “Hulu is worth that much money and the way I know is I’m willing to pay it if no one else is. Disney’s not selling because they know it’s worth that much too.”

The Implications Of A Bidding War

Admittedly, this is somewhat speculative on my part, but hear me out. Roberts is certainly talking like a man who wants to get in on the bidding if he can, and I believe I have described a viable way for him to legally do so without looking like he’s manipulating the auction process.

Assume, for a moment, that I am correct. If that’s the case, Disney and Comcast are about to play a high-stakes game of chicken, with major implications for both companies.

Comcast gets the first move in this game; the starting gun of the staredown is Comcast writing an offer. Unlike the auction process, Comcast can’t be accused of manipulation here. But it has a vested stake nevertheless because for every $2 if offers Disney for its stake, Disney has to offer $1 for Comcast’s stake. If Comcast wants to, it can even go back to the old $57 billion number by submitting a bid for $38 billion for Disney’s share; if it doesn’t take it, it has to pay Comcast $19 billion for the last 1/3 of Hulu.

Essentially, Comcast can dictate the price Disney has to pay for Hulu, notwithstanding the arbitration deal, if it is willing to stand by the number when Disney elects to play turnaround. If, as is more likely, Disney wants Hulu for itself, Comcast can essentially raise the cash haul for its stake without actually being out any cash itself.

Does Comcast Really Value Hulu This Highly?

The downside risk is obviously that Disney takes the legally binding offer and it overpays for Hulu. Elon Musk can certainly warn Roberts about the dangers of that. But there is reason to think that Roberts might not be so worried about that. Comcast has never been unhappy with Hulu, despite agreeing to sell it; they’ve said in the past they liked the old three-way arrangement with their two companies and Fox ( FOX ) ( FOXA ) - back when it was 21 ^st Century Fox, not Fox Corporation - very much.

The sale of Fox’s assets to Disney, including their one-third stake in Hulu, prompted Comcast to agree to a similar sale once Disney obtained clear ownership and strategic control of the asset. So getting “stuck” with Hulu may not seem to Roberts like such an awful risk. Worst case he actually gets to buy a valuable asset.

And it's not just the Netflix-equivalent SVOD service, either; Hulu Live seems to be holding steady around four million subscribers, or perhaps a little more. While bringing it onboard is unlikely to halt Comcast’s own in-house video decline, it could let it punch near the “king’s throne” 20 million weight a little longer and save it the indignity of falling below Charter to #2 nationwide.

Why Investors Should Care

I recognize that for some readers, this may seem too speculative to take action on immediately. The reason I am writing about it is because if investors wait for Roberts to make things official, it may be too late.

The reason is debt. Like I said, one of these companies is going to end up with a nice streaming asset, but they’re also going to end up with substantially more debt to pay interest on, which depending on how interest rates move and how long a term the new bonds carry could potentially be very significant.

This is especially so when both companies sit at the apex of the rapidly collapsing pay-TV linear bundle; which means that there is a small but not inconsiderable chance that their cash flows will begin trending substantially downward even as their interest payments begin trending upwards.

Debt Door #1: Disney Buys Hulu

Debt would have to be a significant consideration even for Disney. It’s currently sitting at $46 billion in debt, so if Comcast did take things all the way back to late 2021 levels it could conceivably have to hike that number to $65 billion to complete the acquisition. At even a 5% interest rate, such debt would knock nearly $1 billion off of Disney’s net income.

What should trouble Disney investors about that so much is that due to its majority ownership, Hulu’s revenues are already reported on Disney’s earnings. This means that when Disney buys Hulu, regardless of whether my Comcast bidding theory pans out or not, it will essentially be adding to its debt load without adding anything significant to the revenue it reports.

Of course, it will be reporting more profit, since it no longer sends 1/3 of Hulu’s income out the door to Comcast. But that may not be the consolation you think; Hulu almost certainly doesn’t report much profit, despite the sky-high valuations that were being attached to it last year.

Hulu was first reported to be turning any kind of profit at all last summer , well over a decade after launch. Since then it has generally continued to grow revenues, but Disney confirmed its operating income went down Y/Y last quarter , and the 2021 number has only been estimated at around $300 million to begin with.

Acquiring Comcast’s minority share of such a small pie probably won’t jump off the page to investors as much as the interest expense will if Disney ends up paying through the nose.

Debt Door #2: Comcast Buys Hulu

It would be even tougher for Comcast. Comcast is currently sporting a mammoth $95 billion debt load, and it would have to spend twice as much to take Disney’s larger stake. Post-acquisition, again assuming 2021 pricing, Comcast would be carrying a $133 billion debt load - almost equal to what AT&T carried at the height of its (extremely ill-advised) merger mania. The only saving grace for Comcast would be that it is not currently reporting Hulu revenues on its books, so it would at least get some nice revenue growth for its troubles.

But could Comcast even get the money? This is the other issue that will have to inform Comcast’s decision about how much to bid (if it bids.) The $95 billion of debt already represents almost half of Comcast’s Enterprise Value. Lenders would probably be willing to go above that, even in turbulent times, but a debt downgrade would become a real possibility.

Timing

If Comcast is just trying to maximize its payoff from Disney and has no intention of actually taking Hulu on itself, this isn’t necessarily an urgent matter; it can simply wait for the 2024 scheduled sale to come around before it does anything. On the other hand, if it actually is starting to think about getting its hands on the asset - because its convinced Disney is going to try to lowball it - then it might behoove it to move sooner. As we saw during the Twitter/Musk showdown, being caught in limbo is not good for any going concern.

And that’s particularly the case where an asset is scheduled to go to auction like Hulu is. Like I said, Disney, which has strategic control of Hulu at the moment, is incentivized to minimize, rather than maximize, Hulu’s value until closing the deal to reduce what it has to pay. Hulu is definitely missing out on opportunities under the current system.

For example, Disney’s refusal to countenance Hulu’s international expansion - instead creating a separate ‘Star’ tile for more mature content on Disney+ outside the US - is almost certainly at least in part an attempt to hold down Hulu’s value when the time comes for the arbitration panel to decide Hulu’s value. If Disney does in fact take over Hulu in full, CEO Bob Chapek has already indicated a similar fate would probably await Hulu - ie., it would be a tile on Disney+ not its own independent service.

If you’re Comcast and you’re actually planning on maybe taking over this asset, you want to get your hands on it sooner rather than later because that minimizes the loss of Hulu’s early mover advantage. Right now, Hulu is producing significant numbers of Originals, just like Netflix is, but unlike Netflix, it is only monetizing them over the American customer base instead of worldwide.

When Does All This Kickoff?

In my view, investors should at least begin to factor the risk of a bidding war between Hulu’s two co-owners into their assessments of both companies now. While it could be late ’23/early ’24 before this plays out, it could also be that a genuine desire to secure Hulu as an asset for Comcast leads to an early start on the negotiations.

Once word gets out that both sides are circling the asset, one company or the other is going to end up taking on a considerable amount of debt for an asset that probably won’t be generating much profit to offset the expense. Essentially, one of the companies will soon be sporting a considerably higher debt load for a profit stream that’s about the same size as it is now.

Investment Summary

The interesting thing about the Twitter saga was that the company was essentially suing someone to force them to buy a company they no longer wanted. That obviously isn’t great for employee morale, since they know they’re about to have an owner who doesn’t really believe in them. For Hulu, it's even worse, since not only does Disney not seem to believe in Hulu as such, but it apparently doesn’t even intend to preserve it as a going concern. In some ways, Comcast would actually be the better owner since it obviously thinks Hulu has potential and wants to preserve the company itself, instead of just transferring its content rights to a different service.

But regardless, investors may currently be getting a somewhat overly rosy picture of whichever company ultimately owns Hulu, since neither Comcast nor Disney seems inclined to let the other have it at the rates public markets are currently penciling in. Instead, it seems increasingly likely each will try to force the other to pay through the nose. That means that a considerable portion of the debt it will take to acquire Hulu is not yet on either company’s balance sheet, while the low profits at Hulu means the profit stream won’t be increasing when the debt does.

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