Here's Why a Mega-Merger Between Time Warner and Twenty-First Century Fox is Unlikely

Source: Time Warner

Jul. 16 was a great day for shareholders of Time Warner (TWX). After news broke that Twenty-First Century Fox (FOXA), the parent of Fox News, had offered to buy the entertainment giant in a deal valued at $76.1 billion ($96.4 billion including Time Warner's long-term debt), shares of Time Warner shot up over 16%, hitting a new 52-week high in the process. Despite the fact that the company shot its suitor's bid down on the grounds that Time Warner's strategic plan will create "significantly more value" than "any proposal Twenty-First Century Fox is in a position to offer", rumors abound that the company is still interested in proceeding with a transaction.

Why does Twenty-First Century Fox want to make a deal work?
With a market cap of $75.4 billion, Twenty-First Century Fox is a pretty large company, but with other proposed mergers in the cable network industry taking place, management wants to find innovative ways to grow. Just based on the size of the deal, acquiring Time Warner would roughly double the company's market presence and, with revenue of $29.8 billion compared to Twenty-First Century Fox's $27.7 billion, significantly add to its top line.

Source: Wikimedia Commons

In particular, Twenty-First Century Fox appears to be interested in two areas when it comes to growth; cable networks and film production. In 2013, $12.3 billion (or 41%) of Time Warner's sales came from its Warner Bros. segment, which serves as the company's feature film business. From a profit standpoint, the segment made up $1.7 billion (or 23%) of the company's $7.5 billion in operating income (excluding depreciation and amortization).

An acquisition of Time Warner would serve to increase Twenty-First Century Fox's Filmed Entertainment (its Warner Bros. equivalent) segment's revenue to $21 billion and its operating income to $3 billion. This would represent 36% and 22% of the combined business's revenue and operating income, respectively.

Source: Wikimedia Commons

In addition to theatrical operations, Time Warner has a lot to bring to the table in the form of cable networks through its Turner segment. By acquiring the business, whose sales in this segment came out to nearly $10 billion (or almost 34% of revenue) in 2013, Twenty-First Century Fox's Cable Network Programming segment would see revenue grow to $20.9 billion (or 36% of consolidated revenue).

From a profitability perspective, the results would be even more impressive. With $3.7 billion in operating income, representing 50% of Time Warner's operating profit, the company's Turner segment is the company's most profitable. If Twenty-First Century Fox can seal a deal with Time Warner, its operating income stemming from cable networking would climb to $7.9 billion and account for 57% of the combined business's total operating profit.

But can Twenty-First Century Fox seal the deal?
Given Time Warner's language in its rejection letter, it seems unlikely that Twenty-First Century Fox is anywhere near what Time Warner's management team believes is a reasonable price. While a higher bid may come, the Foolish investor shouldn't expect anything that values the company much higher.

As part of Twenty-First Century Fox's initial proposal, the company would pay using 1.531 shares its own stock for each share of Time Warner, but would also use cash totaling $32.42 for each share of Time Warner that's currently outstanding. With 882.1 million shares on the market, this implies aggregate cash consideration of $28.6 billion, which is significantly higher than the $5.5 billion on Twenty-First Century Fox's balance sheet and the $3.5 billion Time Warner's.

Source: Twenty-First Century Fox

In order to afford even its shot-down proposal, the acquirer would need to issue debt exceeding $20 billion. With $18.3 billion in long-term debt on its balance sheet and $20.2 billion on Time Warner's, the combined business will already be highly leveraged, so shareholders would be burdened with debt that would probably be in excess of $60 billion.

Even if a higher offer from the company is arranged and accepted, the interest paid on that debt could serve to offset any synergies created as a result of the merger. An alternative approach for Twenty-First Century Fox might be to issue more shares to Time Warner's shareholders, but with shares of the prospective acquirer already down 5% on news of its proposal, the dilutive effect might serve to erode value for both parties.

Foolish takeaway
Right now, it makes sense that Twenty-First Century Fox is interested in Time Warner. In addition to creating a business approximately double its current size, the rise in profits and any synergies stemming from the transaction could prove beneficial to the company's existing shareholders. However, with Time Warner indicating that it's not interested in consummating any sort of relationship at the moment, and with a higher bid carrying with it some downside risks, it might be a better idea for shareholders to look elsewhere for opportunities.