jebmo’s posthaven

On the deal announcement, Fox (NASDAQ:FOX) (NASDAQ:FOXA) shares sold off considerably on the headline deal number of $52 billion perceived to be low and the sizeable $8.5 billion estimated tax liability which would be funded by issuing $9 billion of debt at NewFox as well as the antitrust risk (particularly related to the RSNs). With FOX shares at $33-34, we think that there is a compelling opportunity to buy FOX shares and create the NewFox stub extremely cheaply as well as participate in potential upside if the tax liability ends up being less than estimated.

Fox is selling selected assets to Disney (NYSE:DIS) for $68 billion in enterprise value ($54 billion in equity value) including the assumption of $13.7 billion of net debt by Disney and the tax liability at the parent which will be paid for by a dividend from NewFox. As consideration FOX shareholders will receive 0.2745 shares of DIS plus one share of NewFox. At DIS’s current share price of $107.61, this works out to $29.50 per share plus the value of NewFox.

Source: Own calcs and transaction presentation (here)

The Bottom Line is NewFox is Very Cheap

Based on the current share price, FOX is currently valued at $75 billion and the transaction creates NewFox at $15 billion or 5.3x estimated OIBDA of $2.8 billion including standalone company costs. Basically, investors in FOX have the opportunity to buy NewFox at $4 per share when it generates $1.10 per share in FCF. The valuation of NewFox is extremely compelling and we think that the NewFox should conservatively trade at 9-12x EBITDA or a 8-10% FCF yield which would imply a deal value of $29.50 plus $9.55-$14.09 or $39-44 per share. Applying a 10% discount to reflect a wider arb spread, we think FOX should trade at least at $37-40.

NewFox is a Cash Machine and Will Delever Quickly

NewFox will have $7.5 billion in net debt and generate around $2 billion in free cash flow annually enabling it to delever quickly with this value accreting to shareholders. If NewFox is able to pay down $7.5 billion in debt this would create around $4 per share in value to NewFox shareholders. Additionally with the FCC recently relaxing regulations on local media ownership, NewFox can deploy excess cash flow into M&A to acquire television stations and news assets.

Potential Upside from Lower Tax Liability

The headline tax liability number is misleading because the transaction is smartly structured to be tax neutral as it will result in a step up of NewFox’s tax basis resulting in $1.5 billion of annual tax savings for 15 years at the spinco. The huge tax benefit to NewFox means that shareholders are not taxable on either side of the transaction.

There is also a provision baked into the deal whereby NewFox shareholders would benefit substantially if the tax bill ends up lower than $8.5 billion. The first $2 billion of savings will flow directly NewFox through a lower dividend payable to the parent per section 2.01(F) of the Merger Agreement (available here). Anything over $2 billion results in an upward adjustment of the exchange ratio, further benefitting FOX shareholders.

The upside from a lower tax liability would provide a small but nice bump to the value of NewFox.

Conclusion

FOX shares look extremely compelling even without considering the potential upside in pro forma Disney shares largely due to the hidden value in NewFox. We are comfortable owning FOX without the hedge as we are bullish on the pro forma DIS and NewFox and see them benefiting from lower corporate tax rates. The buying opportunity exists because of the convoluted arb structure and regulatory dimension to the deal/long time frame to closing. We think that the deal closing risk is partly mitigated by the $2.5 billion regulatory break-up fee payable to FOX ($1.35 per share), FOX’s reasonable valuation at 10x OIBDA and the presence of other potential interested parties in FOX’s assets (e.g. Comcast (NASDAQ:CMCSA)). When taking into account the breakup fee and where the break price would be if the deal fails ($28-$29), we like the risk reward at current levels.

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Disclosure: I am/we are long FOXA FOX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.