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Sunday, November 19, 2006

BSkyB / ITV: Strategically Brilliant but Really Expensive Move

I think everyone was surprised by Friday nights announcement that BSkyB had acquired 696 million shares of ITV at a price of 135p giving it 17.9% ownership. It was looking increasingly likely that ITV was going to bought by either NTL or RTL. The total cost of the transaction was approximately £940m which BSkyB plan to be paid for out of an existing borrowing facility.

RTL is Europe largest free-to-air (“FTA”) broadcaster and part of the Bertlesmann group. It owns the least popular FTA channel called Five which it would probably have to sell if it buys ITV. BSkyB has had opportunities in the past to buy Five and has shown no interest. I don’t believe BSkyB for one second is worried about RTL buying ITV.

I believe the whole rationale behind the transaction is to keep both NTL and ITV weak and thereby keep the BSkyB PayTV money machine rolling on. BSkyB generated just a touch over £1bn of cashflow from its PayTV operations and I suspect BSkyB considers a NTL/ITV merger as a potential long term threat to this franchise. Personally, I think a large part of the BSkyB success can be attributed to its near total domination of “live” Broadcast Sports Rights in the UK. NTL/ITV could theoretically have a large enough market to break this near domination in the long run. Even if the risk is slight, it is enough for BSkyB to spend £1bn on what I think is a spoiling strategy.

The twaddle on the Friday Night call about ITV being a quality company and BSkyB wanting to support the board is just a tactic to avoid the transaction being referred to the “Office of Fair Trading” who rules on UK Competition Policy. BSkyB has not contravened any OFCOM Communication ownership rules although it was claimed by NTL that Sky had broken the spirit of the law.

The main thrust of the counter attack this weekend seems to come from the Virgin Group, who is the major shareholder in NTL and has always had an eye for UK Broadcasting assets. I suspect that this is because NTL has very little political or consumer support here in the UK. It is much better PR for Richard Branson of Virgin, the UK favourite entrepeneur, to stand up and claim this is manoeuver by the Murdoch to totally dominate the UK Broadcasting market and therefore the politicians should force him to sell its shareholding in ITV and allow Virgin on the cheap to run ITV.

All nonsense of course, but I suspect that Virgin/ntl cannot now afford to buy BSkyB out and therefore the only course is political lobbying not financial logic. This fight could get really nasty and will definitely be fought in the public.

There is another problem that Virgin/NTL face and that is if BSkyB prefer a weak standalone NTL and ITV, so will the BBC and Channel4. Also, the last thing that the BBC will want right now is another review of the UK TV market, especially at such a delicate time of the licence renewal negotiations. I’m also not so sure that Virgin/NTL can rely on the government for support, especially with the likelihood of general election in the next couple of years.

On the Friday night conference call, Jeremy Darroch, said the net cost of the investment to BSkyB in 2006/7 would be £10m and in 2007/8 would be £14m. This is patent nonsense:
• BSkyB will have to “mark-to-market” the investment in the accounts. Therefore BSkyB is adding a non-controllable non-cash variable to its profit equation. The profits will rise and fall with the ITV share price;

• The £1bn Revolving Credit Facility that BSkyB has utilised charges interest at 0.5% over LIBOR (currently around 5.3%), so the cost of £940m per annum is around £55m. ITV paid a final dividend last year of 1.8p/share and this year an interim dividend of 1.35p which gives total annum dividend income for the stake of around £22m. This gives net cost per annum of around £33m. Of course, BSkyB has used some of its cash balances rather than completely using the borrowing facility for the whole amount and therefore the “net cost” looks a lot better;

• Really BSkyB should be using its weighted cost of capital (“WACC”) for the true investment cost. I can’t believe that the BSkyB WACC is below 10% - so at a minimum, this investment will be costing around £100m in WACC terms; and

• BSkyB can buy up to 19.9% which implies an additional 2% purchase or around £110m is on the cards.
The other way to look at the investment is that the BSkyB annual cash inflow was £1bn in the 12 months to June 2006. An investment of £1bn in a minority equity position in a competitor to protect these revenues is not a lot to pay in the long run. It also puts the investment of around £650m in broadband into context.

BSkyB once again is showing the whole of the UK Communications that is prepared to invest heavily to secure its long term future. Having said that, I am really looking forward to the battle between Branson and Murdoch.