Competitive Intelligence

Disney & Comcast: House of Mouse Under Siege in Cable Bid to Reshape Media Landscape

The Walt Disney Company kicked off a two-day analyst meeting yesterday at Disney World, just minutes before an impeccably-timed Comcast Corporation rolled out an unsolicited $54.1 billion takeover offer, sending Disney's stock up almost 15 percent by day's end, a level sure to continue for the foreseeable future.

Comcast took everybody by surprise - not least of which Disney itself, which never saw itself nearly as vulnerable as its amorous suitor seems to find it. We'll see what happens when Disney's board travels to Comcast's headquarters town of Philadelphia in March for its board meeting.



In the meantime, as Disney responded to the Comcast offer by politely patting them on the head and saying their board would consider the proposal, behind the curtains Disney was scrambling to plot a defensive strategy, get investment bankers hired and try to fend off what is likely to become a hostile suitor. Tactically, the quarterly earnings announcement, demonstrating much improved results, was moved up to try and blunt the impact of Comcast's own news conference.

It was an audacious move by Comcast in attempt to create what would become the world's largest media and entertainment company, leapfrogging more sizeable competitors Time Warner and Rupert Murdoch's News Corporation, both of whom have said they're not interested in competing (so far) with Comcast for Disney... However, I think it's safe to assume other suitors would emerge to either block the combination of Comcast's distribution channel with more than 21 million cable subscribers and Disney's TV and film franchises, including the ABC television network, ESPN and other cable networks, the Disney and Miramax movie studios, and Disney theme parks around the world. (That’s why Bill Gates appears in both photos above.)

But Comcast's bid won't come easily, if embattled CEO Michael Eisner has anything to say about it - and the likelihood of a takeover battle is largely responsible for Disney's stock move yesterday. Comcast is two-thirds Disney's revenue and owns or controls entertainment properties of its own, with cable channels such as E!, the Golf Channel and Outdoor Life Network, as well as its cable systems, and such a bid by the company for Disney really shouldn't have been such a big surprise. CEO Brian Roberts, son of the company's founder (both pictured with Gates above), nearly went after Vivendi Universal's TV and motion picture assets before they were sold to General Electric to be merged with NBC.

Its peers in the industry seem to approve. Viacom Chairman Sumner Redstone said the combination "would be a transforming event for Comcast, which would elevate it from a cable company to a media giant, and Brian is undoubtedly on the right track." He added, "But, for Disney, Eisner might justifiably take the position that the company is doing better, the earnings and stock are rising and that he does not need a merger partner."

But the key to understanding the deal is to first realize the new environment and competitive dynamics first established by Rupert Murdoch and News Corp.

In the future, media and communications will be dominated by hybrids such as News Corp., which recently acquired satellite-TV operator DirecTV, and Comcast has embraced this future as one where Disney and other programmers no longer hold the balance of power in distribution deals. The cable-TV business isn't just a collection of small family companies running regional outfits anymore and it has to compete with satellite-distribution companies (like DirecTV) that are also national in scope and with DirecTV under Murdoch's control, Disney simply can no longer compete without a distribution partner of comparable stature - a partner like Comcast.

Comcast's studio acquisition is designed to counter the competitive threat posed by News Corp., which controls both satellite television services around the world, 20th Century Fox Studio and the Fox News and Sports networks. Cable companies worry that Murdoch will develop exclusive Fox entertainment and sports content for its satellite operations, putting local cable services at a major disadvantage. But buying Disney gives Comcast a nice hedge against Murdoch, while positioning Comcast to offer advanced products, such as improved on-demand movie service to exclusive shows in the new high-definition television format.

Indeed, buying Disney would give Comcast a rich source of programming for video on demand and establish Comcast as the premiere company in the rapidly converging markets for delivering broadband Internet and video entertainment to households. That will help it fend off competition from other telecommunications and satellite companies that are vying for the same consumers.

Industry insiders commented that Time Warner was scheduled to hold a conference call with investment bankers yesterday afternoon to discuss the possibility of making a run at Disney, while Pixar Animation Studios' Steve Jobs was thought to be in active discussions with a range of parties, including cable operators and others, about putting together an alliance to grab Disney.

A Disney-Comcast combination touches virtually every aspect of a rapidly converging media and Internet landscape, from range and control of programming to cable-television rates to online services to concerns about indecent content. By acquiring Disney's ABC network, Comcast, with 22 million television subscribers, would in several U.S. cities operate the only cable system while also owning one or more of the local broadcast stations. The FCC used to bar firms from operating cable and broadcast facilities in the same market, but those rules were thrown out by a federal court in 2002 and the FCC decided not to rewrite them.

The possibility of a recapitalization could preserve Disney's independence by recruiting a partner like Microsoft or John Malone's Liberty Media to inject some cash into the company, but however remote a recapitalization seems, the perception of one is likely to be good enough to achieve the desired effect - that is to get Comcast to increase its bid.

Indeed, Comcast both expects and welcomes an auction process: "We encourage them to run an open process," said Dennis Hersch, Comcast's attorney at Davis Polk & Wardwell. "We feel pretty confident and think this is a great, logical combination." Comcast's confidence comes from a reputation for being a disciplined buyer unafraid to walk away from unreasonable expectations or too-rich prices, regardless of how logical or great the combination may be, having done so with both MediaOne and VUE.

At Comcast's crowded New York news conference yesterday announcing the offer, CEO Roberts said he'd approached Disney's Eisner on Monday about a merger of the companies, but that Mr. Eisner, without consulting Disney's board, had told him, "It was not of immediate interest to put this together." Roberts wrote to Disney's board yesterday that, "Given this, the only way for us to proceed is to make a public proposal directly to you and your board."

But, Comcast's initial bid will not be enough to draw Disney in to negotiate, as the all-stock offer values Disney's shares at $26.47 apiece, just a 10 percent premium over Disney's closing price of $24.08 on Tuesday. Disney's stock leapt up 14.6 percent yesterday, to $27.60, already putting it out of reach of Comcast's opening offer. Disney reported first-quarter earnings of 33 cents a share, which beat analyst mean expectations of 23 cents, as revenues rose 19% to $8.5 billion from $7.2 billion with parks and resorts, studio entertainment and media networks all making contributions. Indeed, I'd put fair value for Disney way above $30 a share, maybe as high as $35 - if Comcast closes this deal for anything less, it's getting a bargain.

Clearly, one of the biggest challenges to completing this deal will be public outcry against media consolidation. Here's an excerpt from the Washington Post that describes how the deal would likely be received by regulators and consumer groups:

Like other mega-mergers of media companies, the Comcast-Disney deal "may well pose a risk to competition in the marketplace of ideas and the diversity of news, information and entertainment available to the American public," Sens. Mike DeWine (R-Ohio) and Herb Kohl (D-Wis.) said in a joint statement. The two men head the Senate Judiciary subcommittee on antitrust.

Consumer advocates and many in Congress fear that such continuing consolidation will result in four or five companies gaining the ability to keep out competition and diversity while stifling localism.

Mark Cooper, research director of the Consumer Federation of America, said it is inevitable that media companies will race to get as big as possible as they are freed from ownership limits and rules that force them to share their networks. "This is the merger that the industrial policy of the [Bush] administration wanted," he said. "You get outrageous sameness" of programming.

Cooper and others say that cable rates have risen as much as 50 percent in the past 10 years and that Comcast's market power would only increase.

Regulators did attach several conditions to the DirecTV acquisition, including requiring News Corp. to provide local channels in DirecTV's top 210 markets by 2008. News Corp. also would have to submit to arbitration in disputes over how much it can charge rival networks for its Fox programming.

To some, the more ominous consequence of the Comcast deal would be in controlling Internet service. Comcast is the country's largest provider of high-speed Internet service via cable, with 5.3 million subscribers.

Increasingly, consumer groups and many technology heavyweights, such as Microsoft Corp., Apple Computer Inc. and Amazon.com Inc., have urged the FCC to ensure that the few major Internet service providers not be able to keep certain Internet content off their systems.

Suppose, for example, that Time Warner's cable Internet service decided to make it hard to get non-Time Warner movies online. Or Verizon's DSL Internet service decided it was not in its interest to let non-Verizon Internet telephone traffic over its network.

"As a content company, it [Disney] was a powerful force in favor of keeping the net neutral - so it could compete equally with other content companies to sell its content," said Stanford University law professor Lawrence Lessig. "But why compete when you've got control over the pipes?"

Internet service companies have repeatedly said they have no interest in content discrimination, saying it would only drive customers to seek alternatives.

And FCC Chairman Powell, who has championed deregulating the media and Internet industries, has resisted seeking network-neutrality rules. But in a speech last weekend, he for the first time sent a message to industry that "net freedom" is an important principle and that the FCC will be watching for violations. "As we continue to promote competition among high-speed platforms, we must preserve the freedom of use broadband consumers have come to expect," Powell said.

However unlikely between companies don't directly compete, regulators might scuttle it before it gets off the ground if it looks as though the deal might have a negative impact on consumer prices. "I don't know if Comcast will get Disney or not, it's a hostile bid," Michael K. Powell, FCC chairman told John McCain during Senate Commerce Committee testimony yesterday. "A merger of that magnitude will undoubtedly go through the finest filter at the commission as is possible, I assure you."

Further, Roberts managerial skill in the more turbulent world content programming is still relatively untested, reminiscent of the disastrous mega-media-mergers of the past – AOL with Time Warner and Vivendi with Seagram - a pair of deals that collectively squandered nearly a quarter of a trillion dollars of shareholder value.

After the blows Disney's suffered in the past year, from the board turmoil to the Pixar alliance crumbling, Eisner will not survive this challenge, and Comcast may prevail in the end - it became market leader among cable operators after a similarly hostile $50 billion transaction to acquire AT&T's cable operations, after a similar reaction by AT&T as Disney's, under interestingly similar circumstances among boards.

But Comcast has weaknesses of its own - Roberts family members have special shares that give them a 33 percent voting stake with financial ownership of only 2 percent, which could make an excellent excuse for Disney to reject the offer.

Comcast president Stephen Burke is a key player in pulling off this deal, having been a Disney executive for 12 years before joining Comcast in 1988 and was one of many once thought a possible successor to Eisner. Burke's father was a top exec at Capital Cities, which bought the ABC television network before it merged with Disney. Yesterday, Burke criticized the performance of several Disney divisions and predicted that Comcast would be able to increase the company's cash flow by between $800 million and $1.3 billion within three years.

The most interesting part of the developing story is whether a white knight will join the fray to compete and cobble together a deal with Disney. A renegade like Barry Diller has always wanted to own a network, but it's uncertain whether he's got the wherewithal to compete in a bidding war. And, Viacom, who owns CBS and Paramount, and GE, who is currently occupied integrating NBC with Vivendi’s Universal media empire, would both face regulatory scrutiny that would almost certainly kill any of their attempts. Likewise, cable competitors Cox and EchoStar don't have the resources to make a run and neither does Time Warner really. Murdoch's News Corporation has said he's not interested... which isn’t very surprising at the moment, but might change if he smells fear on either side.

Microsoft is perhaps the most intriguing possibility (thus the pics of Bill) - a combination that would make things interesting to say the least, but which would be fairly out of character for Microsoft, which prefers arms-length cooperation with content creators and distributors, despite relatively small investments in vehicles like MSNBC and Slate.com - plus, they've never done an acquisition of more than a couple of billion dollars. But, following last week's joint collaboration announcement between Disney and Microsoft on protecting digital content assets for distribution over the Internet, and the ample resources Microsoft has at hand ($53 billion in cash), the combination would be a powerful one.

Whatever happens, because Microsoft already owns 7.4 percent of Comcast, it would control some 4 percent of a combined Disney-Comcast. And, that could give Microsoft leverage over the course of the deal and afterward as it looks to push its software beyond the maturing market for personal computers and into the developing boom in digital entertainment. With the next version of Microsoft's market-dominant Windows OS not expected for another two years or more, digital audio and video will need to keep PC sales humming. Even a minority ownership in the combination would be enough to strengthen links between Microsoft's software, Comcast's distribution and Disney's entertainment assets.

"At one time Microsoft seemed very intent on expanding its media role, particularly when looking at the perceived threat of then AOL and Time Warner," said Joe Wilcox, analyst at Jupiter Media, "But right now, the company is now focusing on getting back to basics." Microsoft also proved to be a key player when Comcast acquired AT&T's cable business, exercising its influence both through its stake in Comcast and a $5 billion investment it made in AT&T.

In the end, timing is everything, and it will prove once again the quality and importance of good timing if Roberts can lure the board to the negotiating table, given the current perception of Disney weaknesses at the moment, not least of which has them lacking a poison pill to help block such an attempt. Whether we think this deal makes as much sense as the AT&T deal did in 2002 - after all, what does Comcast know about running theme parks, sports teams (hockey's Flyers and basketball's 76ers, notwithstanding) and merchandising to children - Comcast still buys content from companies like Disney and if they can pull it off, it will represent a change in perspective for everyone in the media sector, as scale and scope becomes paramount to compete with Murdoch and Comcast-Disney.

My final verdict: on balance, I think far from a done deal, but if Disney's stock price takes any hits and Comcast can boost its own - or Microsoft gets involved, it's over for Eisner. Can Disney compete without Comcast? Probably, but only if it can make an acquisition of its own - Cox is looking awfully attractive lately.

- Arik

Posted by Arik Johnson at February 12, 2004 01:10 PM | TrackBack