This is a syndicated repost courtesy of David Stockman's Contra Corner » Stockman’s Corner. To view original, click here. Reposted with permission.
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It’s Merger Monday again on this holiday adjusted Tuesday. So the announcement of another humungous debt-fueled M&A deal is right on schedule.
This time it involves the utterly pointless combination of two giant, quasi-monopoly cable companies—–Time-Warner Cable (TWC) and Charter (CHTR)—– that are already on their homeward journey to Joseph Schumpeter’s Walhalla of creative destruction. But not before da boyz in the casino have one last go at a positively lunatic speculation.
To wit, during the last 12 months, TWC and Charter have managed to generate a combined total of $4.6 billion in free cash flow (i.e. EBITDA less CapEx). At the moment the market is valuing their combined TEV at $116 billion. That computes to a free cash flow multiple of 25X!
But that’s not evidence of a bubble. No sir. Over the weekend Blogger Ben assured the world that the financial markets are neither exuberant nor irrational:
BERNANKE: NO LARGE MISPRICINGS IN U.S. SECURITIES, ASSET PRICES
That’s right, the TEV of Charter is $41 billion and today the market is valuing the take-out of TWC at $75 billion. Blogger Ben, do you really think that $4.6 billion of free cash flow in the dying cable industry is worth $116 billion?
Needless to say, Ben couldn’t possibly know. He has been superintending a world of falsified debt prices for so long that he would not recognize an honest cap rate if he saw one. In this case, scroll back 10 years when Ben was heralding the Great Moderation and you will see that TWC and Charter had combined debt of $24 billion.
As of last Friday that number had grown to $44 billion and with the announcement of today’s deal, which contemplates borrowing another $32 billion to pay stockholders $100/share in cash plus munificent deal fees, another huge dollop of debt will be added. So upon deal completion, the cable debt mountain at the “New Charter” will total $76 billion.
Now lets see. In an honest free market, the risk free 10-year treasury rate would be at least 4%. That assumes 2% inflation, which in fact has been the case for the entirety of this century, and is the holy grail of Fed policy, anyway. Throw on a marginal tax rate above 40% and you still do not have much of an after- tax and after-inflation return.
Then layer on a 500 basis point risk premium for junk debt. While that’s consistent with historic loss rates in the high yield market, it actually does not even begin to account for the risk of loss that will occur when the 33-year bond bubble finally ends. Upon that unavoidable day of reckoning, the scores of zombie companies currently carrying upwards of $4 trillion of junk bonds and loans will be unable to “extend and pretend” when maturities come due massively after 2016. And that’s even before consideration of the fact that the cable industry is an economic dinosaur following in the footsteps of the yellow pages industry. The latter was also massively leveraged 15 years back—-before the whole sector went pear-shaped and ionized billions of junk debt.
In short, the free market debt yield on these newly betrothed dinosaurs would be upwards of 10%, meaning an annual interest bill of $7.6 billion at the indicated $76 billion of borrowings. But don’t ask how the New Charter would pay that interest tab with only $4.6 billion of free cash flow. Ben and Janet have already taken care of that particular inconvenience by herding yield starved “investors” into junk debt at rates 300-500 bps below an honest free market price.
And that’s not all the falsification of prices that you can put at their doorstep in the instant case. The New Charter is not even worth the indicated $76 billion of post-deal debt, but then you must account for the equity value, too. At today’s close, that particular bubble weighed in at $40 billion.
Yes, the casino is so confident that the Fed will keep debt rates lower for longer and never let a stock market dip turn into a full fledged bust that it is essentially valuing worthless equity at nose bleed prices—-at least long enough for the fast money traders to cash-out their chips.
Indeed, why would any rational investor want to own the New Charter stock, even before it became the proud owner of $76 billion of debt. The fact is, during the last 10 years, the “Old Charter” never generated one dime of free cash flow.
That’s right. During the period 2004-2014 Charter generated $11.8 billion of operating free cash flow, but consumed $12.7 billion in CapEx. Needless to say, that did not stop the free money carry traders in Ben’s casino from bidding up the stock price of a worthless company by 6X over the last five years alone.
But here the thing. The New Charter is a sunset company—–the accumulated flotsam and jetsam of old-fashioned territorial cable monopolies which are going out of business. That’s because even the bountiful political war chests of the big cable companies cannot hold back technological progress in the form of broadband delivery and on demand content production by hundreds of new entrants from Netflix and Amazon on down.
At the moment the casino gamblers are unperturbed by the handwriting on the wall. They continue to value cable equity—- and to overlook the mountains of cable company debt—–based on the once and former regime of predatory pricing by the cable franchises.
Needless to say, the $77 billion in revenue taken in by the Old Charter over the past decade did not represent free market pricing; it amounted to quasi-monopoly rents that were paid out to debt holders and other investors. But those payouts were not real economic earnings. Instead, they were the returns to regulatory scarcity created by the labyrinth of Federal, state and local cable regulation.
Stated differently, during the LTM period ending in March, the combined revenues of the New Charter amounted to $32 billion. But the $11 billion of EBITDA harvested from that inflow, reflecting a 35% margin, did not represent management genius at work or anything else which could remotely be called economic efficiency. Instead, those fat margins represented the remnants of the predatory cable pricing that over the last 30 years have made the cable industry ground zero of leveraged crony capitalism and the massive extraction of economic rents by Wall Street from main street households.
Not for much longer. It is only a matter of time before Google Fiber and like competitors for the last mile of broadband scare the bejeezus out of the cable companies, forcing them to drastically reduce their rates on both traditional cable “packages” as well as broadband internet services themselves.
Stated differently, when quasi-monopoly franchises can no longer be bestowed by the state owing to the creative destruction of new technologies and new entrepreneurs, the likes of New Charter will not be able to strip-mine upwards of $32 billion from its 20 million customers. Accordingly, there will presently be a great sucking sound on the EBITDA line, meaning that cable equity values will plunge and Ben Bernanke’s junk bond yield chasers will be in for a rude awakening.
None of this is new information. As exemplified in the attached three-year old story from Business Insider, the threat to the last cable mile has been gathering momentum for some time now. In an honest free market, cable equity values would have been drastically slashed long ago as the bottled regulatory air embedded in cable earnings got purged from valuations.
But not in Ben’s casino. Free carry trade money for 80 months running, cheap portfolio hedges and the Greenspan/Bernanke/Yellen put have destroyed the shorts, who would have otherwise driven price discovery into a more rational zip code.
So, of course, Blogger Ben sees no bubbles. Almost single-handedly he destroyed the capacity of the financial markets to do anything except foster exceptionally large “mispricings”(aka bubbles).
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