Deals

Leila Abboud is a Bloomberg Gadfly columnist covering technology. She previously worked for Reuters and the Wall Street Journal.

Tara Lachapelle is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Shareholders in 21st Century Fox Inc. aren't wild about Rupert Murdoch's affection for Sky Plc, the British pay-TV company he founded almost 30 years ago. They don't hate it as much as his passion for newspapers, but almost.

They should give the patriarch and the prince, James Murdoch (CEO of Fox and chairman of Sky), more credit. With Fox's offer for the 61 percent of Sky it doesn't already own, the Murdochs are on track to get full ownership of an asset with earnings growth at a knock-down price -- helped by the Brexit-induced drop in sterling.

Better Days?
Sky earnings are in a trough because of investments and higher content costs
Source: Bloomberg
Note: Fiscal year 2017, 2018, 2019 are consensus estimates

Of course, Sky shareholders should try to squeeze more out of Fox, as we've said before, even if their board has capitulated. The uncertainty around whether investors will back the deal explains why the shares sit well below the bid price, as does the risk of political opposition in the U.K.

Buy at the Bottom
Before Fox's offer, Sky's valuation was at lows not seen since 2012. The current offer price implies a P/E ratio of 18.7 times for 2017 and 16 times for 2018.
Source:: Bloomberg, Exane Research

Still, if the Murdochs' decision to tough it out at 1,075 pence per share does pay off, you can understand their reasoning. The Murdochs say they have studied various ways to allocate capital and decided this was the best way to create value. Bringing together Sky and Fox would certainly give them more combined clout when buying content or creating their own, as they do battle with Netflix Inc. and Amazon.com Inc.

Sky's Now TV model, where it delivers content over the Internet, is also of interest as Fox tries to cut its exposure to advertising. Meanwhile, owning 39 percent of an asset is never ideal, so they had a choice of either selling out or going for full ownership. If they can get to 100 percent on the cheap, then why not?

With Fox itself valued poorly right now, Sky should bring a welcome shot of growth. The deal will add about 12 percent to earnings per share next year, according to Bloomberg's merger calculator. Fox also expects a tax benefit, given lower rates in Britain.

Right now, the U.S. company trades at a similar multiple to basket case Viacom Inc., whose TV ratings have fallen much more steeply on its main networks. Fox content is also superior. Aside from Fox News, the company's behind hit series such as rap opera Empire and the best-selling movie Deadpool. When's the last time Viacom had a hit show?

Cheap Stock
Viacom has suffered falling sales amid weak ratings for its networks such as MTV, VH1 and Comedy Central. Yet Fox, a far healthier company, fetches nearly as low a valuation
Source: Bloomberg

One downside of the Sky deal is that Fox will have to load up on debt. Net debt is about 2.2 times Ebitda, rising to 3.4 times after the deal, according to Bloomberg Intelligence analyst Stephen Flynn. Debt will increase to about $36 billion, so ratings downgrades may follow.

Even if it manages to cut debt relatively quickly, Fox is probably out of the deal-making game for now. Shareholders should welcome that, given the Murdoch tendency toward empire building.

This deal still has a way to go to win over doubters, as shown by the share price. There are concerns about British regulatory approval, which may take a while to secure. If Sky's business improves in the meantime, shareholders would probably want a higher price. Just 15 percent of the Sky register would be enough to block a deal, since Fox can't vote its shares. Yet if the prince and the patriarch can get this one over the line, they may be onto something.

With assistance from Chris Hughes

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Leila Abboud in Paris at labboud@bloomberg.net
Tara Lachapelle in New York at tlachapelle@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net