A Motley Fool Obituary: Comcast-Time Warner, We Hardly Knew Ye

After Comcast's (CMCSA -0.52%) successful purchase of NBC just a few years ago, many analysts thought the company's planned merger with Time Warner Cable (NYSE: TWC) would meet with similar success. Join us to learn why the deal broke down, why Comcast didn't fight harder, and whether this is good or bad news for investors.

Meanwhile, Time Warner already has another suitor lined up and ESPN and Disney (DIS 1.54%) are filing suit against Verizon (VZ 2.85%). Tune in as this consumer goods edition of Industry Focus zooms in on the ultra-profitable cable industry, who's fighting over what, and what it all means to consumers and investors.

A full transcript follows the video.

Sean O'Reilly: America breathes a collective sigh of relief, on this consumer goods edition of Industry Focus.

[INTRO]

Greetings Fools, I am Sean O'Reilly, here at Fool Headquarters in Alexandria, Virginia. I am joined today with the one and only Vincent Shen. How are you today?

Vincent Shen: I'm doing great, Sean. How are you?

O'Reilly: I was trying to think of a cool adjective for you but then I was like, "We'll just go with the tried and true method."

Shen: I like it.

O'Reilly: Thank you! Big news last week. The Comcast / Time Warner Cable merger is dead.

Shen: Yes, it is.

O'Reilly: After I picked up my jaw off the floor, I dove into the deal. I wish I could say I saw this coming, but they pulled off the NBC merger -- and we'll talk about this a little bit later -- a couple of years ago. There were a bunch of conditions to that, but they pulled it off.

I just assumed that would happen again. A lot of people assumed it would happen again, and that wasn't the case. What's going on?

Shen: I think that in the past few weeks there's definitely been a bit of sentiment, rumors in the grapevine, that things were starting to go awry for Comcast and Time Warner, for their deal.

O'Reilly: They've been meeting with the FCC for like 14 months now.

Shen: And the Department of Justice as well. When the deal was first announced in February of last year, I would say that the majority of people on Wall Street and the industry in general though that it was a slam dunk. The deal was going to go through. It was going to create this giant company that ...

O'Reilly: Part of the argument there -- just so everybody knows -- this thing would have been huge; like 60% of broadband customers in the United States, 30% of pay TV.

However, because there was not huge overlap in the markets that these companies served, it was assumed to be OK. Because they weren't in the same markets, it was like, "Oh, OK. That's fine."

Shen: That was one of the major foundations of their argument for why this deal should go through. They basically said to each other, "We don't compete in the same markets, so this isn't really anti-competitive." But that speaks to the industry at large, doesn't it?

O'Reilly: Yes, it does. Because there are three companies!

Shen: Yes, exactly. I'd say in the past few weeks there had already been rumors that the regulators were going to start coming out against the deal.

O'Reilly: They felt it was best to resign than get fired.

Shen: On Wednesday, Comcast and Time Warner representatives probably had some of their final meetings with regulators, trying to make that final push, but they came to the point where I think no concessions would have satisfied them so they realized, "We can just walk away from this."

From what I recall, there was no penalty fee either, for walking away from the deal, so it does seem like Comcast recognized, "It's possible this does not go through," so they were able to work that into the negotiations with Time Warner.

O'Reilly: Do you think they really ... how do I frame this? Do you think Comcast really wanted it? Because they kind of threw in the towel. I'm not going to say they threw in the towel easily, because they spent 14 months on this thing, but they didn't fight them. They didn't take the last breath and force the government to say no.

Shen: I think that ultimately comes down to the overwhelming negative sentiment from consumers in this country toward the deal. There were reports that the regulators in general received something like over a million comments coming out from the public, against the deal.

O'Reilly: Yes. I actually read this very interesting piece before we headed in here. It was by the former commissioner of the FCC. His name is Michael Copps. He had an op-ed piece in The Washington Post just in the last couple of days here.

He noted that he thought it was because the FCC doesn't trust Comcast, because they kind of didn't follow through on a lot of the conditions of their purchase of NBC a few years ago. They were supposed to offer $10/month cable service to about 2.5 million low income housing. They made it very, very difficult for these people.

They had to allow access for content from competitors -- because they own NBC, which is the content side, and they're the distribution side originally -- and they didn't really do that, so they kind of don't trust them anymore!

Shen: I think that's actually another big piece of the story, that "fool me once."

O'Reilly: Right.

Shen: The regulators learned their lesson. They've seen that Comcast at the time was really unwilling to follow through on all of their concessions and all the terms of the previous deal. Now that they're even bigger, with this deal, what incentive do they have to follow through on any other concessions?

O'Reilly: Right. There was really no upside here for consumers, at all. There was only downside.

Shen: It depends on who you ask, but ultimately without coming out too much one way or the other, I generally agree with you.

O'Reilly: Since this is The Motley Fool and we like to deal with investing, interestingly enough the stock price did not fall on this news.

Shen: You're absolutely right. Comcast is very steady. I think it's still trading within 1% from when the news really broke on Thursday afternoon. Time Warner, on the other hand, is actually up 5% since the news is out.

O'Reilly: That does not happen often!

Shen: I think a big part of that is because of the new rumors. Time Warner has been kind of busy with all this courtship lately.

O'Reilly: It's always nice to have a backup!

Shen: Yes. Basically the company potentially has a new suitor in the form of Charter Communications (CHTR 0.46%).

O'Reilly: This is kind of a redux, because a year ago Comcast and Charter were bidding on Time Warner Cable.

Shen: That's right. Charter made an offer in January -- the month before the deal was announced between Comcast and Time Warner -- for about $37 billion. Comcast ended up besting it with their $45 billion offer, but Charter was definitely trying to get in on the action.

I think this time they're going to come around and see if they can make this deal happen. They even said, right from the get-go, "If the Comcast deal falls through, we're going to be right there again, trying to go for this."

O'Reilly: That's so weird. It's like "Well, if it doesn't work out with that person, just come back home. It's fine."

This is what happens in mature industries. We've seen it. We've had our little sin stock series, when we talked about tobacco. When you've got a mature industry and you don't have anywhere else to grow, you start merging. That's what's going on here.

How bad a time do you think the FCC is going to give Charter and Time Warner Cable? You're still talking about number two and number three, and they'll still be a number two to Comcast, but you're talking about a duopoly at this point.

Shen: That's an interesting one. I don't want to say that what we saw here from the regulators is going to apply directly to the same approval process.

O'Reilly: They probably aren't as jaded, because of the whole Comcast/NBC ...

Shen: It's obviously a different deal. Like you said, Comcast is going to be the number one player, but the combined entity if Charter and Time Warner were to go that route and try to join together, it still creates a form of a duopoly.

But Charter has been very busy. In March, they made an acquisition for a smaller company, the sixth-largest cable operator, Bright House Networks, for about $10 billion, so they're busy on the consolidation front.

O'Reilly: Just $10 billion.

Shen: Just $10 billion, exactly!

O'Reilly: What do we think, as obviously industry observers, potentially investors, of what's going on in the broader cable industry? Even in the last five years, this industry has become ridiculously profitable. I don't think people realize the returns that these companies are generating internally.

Shen: Yes. This was something that I'm glad you had brought up to me and I was able to look into it before the show, because Comcast joined with NBC Universal in 2011. Their revenue has grown 23% in the years since then.

O'Reilly: So annually, like 5% or something.

Shen: Yes. A decent rate considering, like you said, the maturity of the industry. Their earnings, on the other hand, much more impressively have doubled since 20011.

O'Reilly: This is cost savings and increased ad revenue, all kinds of good stuff?

Shen: Yes. I think Comcast did a great job getting that deal through because now you not only control the content but the distribution of that content. It's a very, very profitable combination for them.

But Time Warner hasn't exactly been slacking either. Their return on equity was about 15% in 2010. It's now at 27%.

O'Reilly: That is astronomical. Coca-Cola (KO 0.15%), Buffett owns that because it's a great business with great returns on invested capital, and that's in the 30s. For a cable company that's not growing to show returns on equity of 27% compared to ... the average S&P company's got what, 12%? This is crazy high.

Shen: Big numbers. Their revenue over that same time since 2010 is up 20%. Their earnings, similarly, have almost doubled.

Time Warner in particular is in an interesting position because they I think cleaned things up quite a bit, got operations streamlined. They're cleaning up their debt balance a little bit in preparation for what they thought would be ...

O'Reilly: Trying to make themselves the belle of the ball.

Shen: Exactly, their joining with Comcast. So now, their balance sheet is a little stronger, customer service they say is stronger, their offerings are better. Maybe they're in a position where they don't need to necessarily join with anybody and they can actually start looking for targets themselves. We'll see.

O'Reilly: We're both millennials. We like our streaming. I have a very basic cable package -- do you even have cable?

Shen: No, I do not.

O'Reilly: What do you think, long term, of how this plays out? The industry has shifted in the last 12-14 months since the original Comcast deal got announced.

Shen: Yes, that's something else I wanted to talk about.

O'Reilly: We've got HBO Go. We can watch "Game of Thrones."

Shen: The deal was announced February of last year originally, for Time Warner and Comcast, and some of the things that have popped up since then -- and I think also turned out influencing the regulators' decision -- are things like Sling TV came out, Sony (SONY 0.31%) released their TV service, HBO split off their service.

Apple has rumors of bringing out a new set-top box, and Netflix (NFLX 4.17%) is at something like over 40 million subscribers. Their growth has continued at a very rapid rate. All these things, I think, came together to make regulators realize, "You know what? The Internet is coming about to be the next big frontier for providing content."

O'Reilly: For media.

Shen: For media. So, to have one company controlling 60% of that, that has its own interests with content? It seems like a very dangerous combination.

O'Reilly: Yes, iffy.

We're probably going in the direction of more choices of content. How do I say this? In the last five years I've noticed that the price of just cable has gone up to where ...

I was making a decision. My wife and I recently moved and, don't quote me or anything but it was like $40-50 for just Internet, or I could get a basic cable package with my Internet for $60. It was like, "Okay, fine. Just take my extra $15. I'll take the basic cable."

It's like they see the writing on the wall and they're starting to try to fight this trend. We actually saw that with this ESPN/Disney lawsuit against Verizon the other day, because they just announced something very, very interesting.

Shen: Two points from what you just mentioned. First of all, cable prices are going up. In 2013 cable packages on average across the country went up I think along the lines of 6% -- basically four times the rate of inflation -- and they've gone up that approximate annual rate for the past 15 years.

O'Reilly: That seems a little excessive, given that the cables are already in the ground.

Shen: Yes. Something is bringing up those ROE numbers for those companies, right?

O'Reilly: Yes indeedy.

Shen: This lawsuit though is I think, again, a little sign of the writing on the wall. Verizon released this service. It's called FiOS Custom TV. It includes a base package of let's call it 40 channels. It has some major networks like CNN, AMC, Food Network.

O'Reilly: Oh, I can watch the last episodes of "Mad Men." Good!

Shen: The cost of that is $55. Then they give you a choice, to choose two more additional packages out of seven. These are categories like Lifestyle, Entertainment, Sports, Kids. Each of these packages is $10 and you can choose two of them.

ESPN is unhappy because they're not part of the basic level package that's $55. They're part of the Sports edition, that's $10.

O'Reilly: I know the answer, but why is that, Vince?

Shen: ESPN is probably one of the most expensive networks for the cable companies.

O'Reilly: It is, yes. If you calculate it ... we've had a lot of great analysis put forth by some of our writers on Fool.com. Your average channel like an AMC, I think they calculated is somewhere between 50 cents and $1, and CNN is in the same range.

ESPN comes at over $6 as part of your cable. You're paying $6 out of your $60, $70, $80, $100 cable package, for just the ESPN. I like "Sports Center" as much as the next guy, but that's six times what we're talking about here!

Shen: Yes. ESPN is not happy. They're suing. They're basically saying, "This isn't part of the contact that we originally signed with Verizon." Whereas Verizon is playing to the consumer and saying ...

O'Reilly: "Pick a la carte."

Shen: Yes, "We want to give consumers what they want, what they've been asking for. We see the trends with these different services." The cord-cutting, they're trying to head that off and provide consumers with this offering that I think a lot of people will be happy with -- though I think it's still on the pricy side.

O'Reilly: Yes.

Shen: Considering you choose your two packages, you're still paying $75 for television.

O'Reilly: Right. It goes to the branding aspect of the a la carte thing, but it's not cheap or anything like that.

I do want to point out, the a la carte service, if you broke out ... technically bundling, if you still want 50-100 channels the bundling angle and paying $80 to your cable company is actually still a good deal.

The a la carte thing is really only good if you, Vincent Shen, you want ESPN, AMC, NBC, ABC, and something else. If you want five things. All of a sudden it's like, "Why did we put these cables in the ground?"

I was not surprised when I saw this lawsuit come out. Not surprised at all. I was like, "Oh, first shots fired!"

Shen: Yes. We'll see what happens as things play out, if either side decides to back down. Just call it another indicator of changing tides.

O'Reilly: The friction there, yes. Before we go, I really wanted to quickly relate this around. How do we think this relates to Title II and the recent FCC regulations that came out?

Shen: When the ruling came out in February, where it was basically decided by the FCC that they were going to start regulating broadband providers under Title II of the Communications Act, I think pretty much every company in the industry came out and said, "FCC can't do this. We're going to appeal and sue them."

Now we are in the initial stages of that legal battle. USTelecom, which is an industry trade representative for companies like AT&T (T 1.17%) or Verizon, have fired the first shots over the bow -- is that the expression?

O'Reilly: Yes. If it isn't, it works!

Shen: The rules were officially published in the Federal Register, so they would take effect in mid-June. Companies are putting in their lawsuits, and we're going to see how long it takes for this legal battle to unfold.

O'Reilly: If they drag it out ... I was surprised that the stock prices of the Time Warners and the Comcasts of the world didn't really move when the Title II regulations came out, that they were going to regulate them under Title II.

It's interesting to me because Wall Street doesn't apparently think this is going to affect them, or they think they'll be able to fight it? I don't know what the game plan is there, but we shall see.

Very good. Thank you for your thoughts, Vince.

Shen: Thank you, Sean. I appreciate it.

O'Reilly: We'll see you next week.

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For Vincent Shen, I am Sean O'Reilly. Thanks for listening, and Fool on!