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Charter-TWC merger: Why Time Warner Cable’s CEO wants out

May 26, 2015, 7:32 PM UTC
A Time Warner Cable service technician works on cable service from a van parked on the Upper West side of the Manhattan borough of New York City
A Time Warner Cable service technician works on cable service from a van parked on the Upper West side of the Manhattan borough of New York City, May 26, 2015. Charter Communications Inc, controlled by cable industry pioneer John Malone, offered to buy Time Warner Cable Inc for $56 billion, seeking to combine the No. 3 and No. 2 U.S. cable operators to compete against market leader Comcast Corp. REUTERS/Mike Segar - RTX1EMR2
Photograph by Mike Segar — Reuters

Time Warner Cable is getting bigger by going smaller.

On Tuesday morning, Charter Communications (CHTR) announced that it was buying Time Warner Cable (CHTR) for nearly $79 billion, including debt. That cable companies feel they need to get bigger is not new. Cable firms want more bargaining power in their negotiations with large content providers like Time Warner, which owns HBO and spun off TWC a few years ago, and Twenty-First Century Fox, not to mention Netflix. That was the logic behind Time Warner Cable’s proposed deal with Comcast, which was called off last month.

But a quirk of Tuesday’s deal is that Charter, the company now buying Time Warner Cable, is actually the smaller of the two, by a lot. TWC had revenue of $23 billion last year. Charter’s revenue was less than half of that, at $9 billion.

It’s not clear why TWC is the one selling out, versus the other way around. TWC CEO Robert Marcus has been on the path to handing over control of his company for a while. In late 2013, when Marcus was taking over the top job at TWC, he said he was open to doing a deal if it created more value. What’s more, it doesn’t appear that colleagues have great faith in Marcus’ ability as a CEO. Marcus is a former lawyer who had joined TWC in its mergers department before working his way up the executive ladder. Still, a former COO of TWC said Marcus was much better at doing deals than being a top executive. So, perhaps investors, too, would have been wary of Marcus running a bigger company.

Another reason: Marcus appears to have a pretty big financial incentive to sell. Marcus’ employment contract contains a change of control provision that could net him as much as $85 million over the next year-and-a-half. But Marcus only gets the money if he leaves the newly combined company, which he hasn’t said he will do, though it’s likely he will. The top job at the combined company will go to Charter CEO Tom Rutledge. What’s more, Rutledge appears to have an even larger golden parachute than Marcus. His contract guarantees him nearly $111 million if he loses his job after a deal, a payout that Rutledge could still get if he leaves.

Marcus also said that he thought TWC would have to significantly increase its capital expenditures if it were to remain a standalone company. Last year, TWC spent just over $4 billion in capital expenditures. TWC would have to nearly double its spending to match Comcast. And with $1.4 billion in annual interest payments, that probably wasn’t possible.

The biggest reason Charter made the offer—and not the other way around—probably has to do with John Malone. Malone has a large stake in Charter, through his ownership of Liberty Broadband, and it looks like he has been the driving force behind the deal. Malone, a cable industry vet, reentered the U.S. cable market in 2013, saying there was a need for more consolidation.

The result is a deal that will have a lot more debt than if TWC were the buyer and Charter were the seller. TWC could have paid for Charter in stock, and it would have owned roughly 70% of the combined company. Instead, Charter is paying TWC shareholders roughly $100 in cash and $95 in shares in the new company as part of the deal. (TWC shareholders have the option of taking slightly more cash if they like.) That keeps Charter’s ownership (along with partner Advance/Newhouse) of the new company at above 55%.

But it will also add $23 billion in debt to the deal. Assume an interest rate of 5% and Charter’s interest payments are likely to be around $3.5 billion next year alone. That’s a big chunk of the nearly $13 billion in combined cash flow generated by the two companies last year. Add to that $7 billion in projected capital expenditures, and that doesn’t leave the company a lot of room if the merger should hit some bumps.

The combined company will have a strong position in the broadband market. But with the cable business facing a growing threat from streaming services and the Internet as a source of entertainment in general, Charter-TWC should expect some turbulence.