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Disney-Fox: Hell Freezes Over

With the Disney-Fox deal moving closer and closer to inevitability – most reports say that it could be announced as early as next week – Sanford Bernstein media analyst Todd Juenger said that despite earlier beliefs that Fox would never sell, market forces and personal taste may have played a role in the decision to come to the table.

In a note to clients, Juenger wrote that faced with a decision to either build the infrastructure needed for its streaming video plans or buy them, Disney choose the buy path. While that will require a lot of upfront capital, it will also take a lot less time, Juenger said, adding that the Fox assets are perhaps the closest thing to giving Disney what it needs – a strong content studio, sports assets and popular cable networks.

“But Fox would never be for sale, right?” Juenger wrote. “Well, apparently, hell has frozen over, and (most of) Fox is for sale.”

Juenger speculated that the change of heart at Fox, which just a few years ago was a buyer – remember its failed attempt to buy Time Warner? -- could have been caused by two factors: a realization that its business is a declining asset and its peak value is now; or that CEO James Murdoch is frustrated over sexual harassment scandals and the conservative bent of Fox News and wants to get out.

Both scenarios, Juenger wrote, have a “ring of truth” to them.

As far as the deal goes, Juenger estimates that the Fox assets Disney will be acquiring are worth about $57 billion, leaving about $31 billion in properties – Fox broadcasting, Fox News, FS1, etc. – that could be combined with the Murdoch’s newspaper business (News Corp.) and perhaps taken private.

One asset that appears to be a key piece of the deal – Fox’s 39% interest in the Sky satellite service in Europe, could also be a wrinkle in the deal. Fox is in the process of buying the 61% of Sky it doesn’t own – the Murdochs have said they expect it to clear by the end of the year – but a sale will likely hold up the regulatory process even further. Juenger estimated that UK regulators put the deal on hold again, wait for the Disney deal to pass U.S. regulatory muster and then start the whole process again.

Given the size of the deal – Juenger estimated that Disney would pay $78 billion for the Fox assets (a 30% premium) -- it would need to extract about $1.6 billion in synergies to make the transaction break even for Disney on an earnings per share basis.

The analyst added there are some very good reasons for Disney to buy the Fox properties, mainly that it gets to market faster without having to weather the many years of earnings declines a build out would require. But there are costs, too. Juenger estimated that Disney will have to pay about $20 billion more than what the Fox assets are worth to get a deal done and some of the assets – FX Network – are not family-friendly.

“The Studio and National Geographic make perfect strategic sense to us,” Juenger wrote. “Beyond that, it gets questionable. The FX/FXX networks have a pedigree of having created some of the most memorable serialized drama series on cable television. They are also filled with violence, language, and sexual themes that absolutely do not fit with the 'Disney' brand.”

So Disney has an important choice to make, the analyst continued. If it wants to build an OTT service for the widest possible audience, including the FX networks in the mix with their edgy, grown-up programming is the way to go. It gets trickier if it wants to be true to a brand that is arguably the most well-known in the media space. If that's the case, then it has to protect that brand at all costs.

“One way Disney could bridge this gap is to put the 'R-rated' content into a different brand wrapper – such as Hulu,” Juenger suggested. “On one hand, this fragments Disney's OTT offerings in an already fragmented space. But, Disney could also bundle/unbundle its different OTT products (sports, 'Disney', Hulu) in packaged offerings to consumers.”

But that also hinges on whether Disney ends up with full control of Hulu – it will acquire Fox’s 30% interest in the deal, bringing it to 60%, but it still has other partners in NBCUniversal and Time Warner for the service.

The sports assets also present another dilemma – sports programming is one of the biggest drivers of live TV viewership, but RSNs have been a thorn in some distributors’ sides because of their high cost and consumers who believe they shouldn’t pay for them if they don’t watch them.  

"Perhaps Disney is willing to live through the pain of that transition, to eventually emerge with a more appealing OTT sports product that offers both ESPN and the RSN in each applicable market,” Juenger wrote.

The analyst was less optimistic on the deal’s impact to Disney shares and the cable network sector in general. While Disney could be considered to be the Walmart of the content space – the old-school retailer is behind Amazon but receives a premium from investors because it has scale – it all comes down to the multiple the market assigns the stock. Currently trading at about 15 times earnings, that multiple would need to climb to 20 times to justify the deal.

“The market would have to *really* believe Disney is creating something special, to re-rate the multiple several turns upward in the face of all the downward pressures,” Juenger wrote.

As far as other stocks in the sector like AMC Networks, Discovery Communications and Viacom, the signal Disney (we’re not big enough) and Fox (get out while you still can) are sending presents another problem. Juenger doesn’t see any larger potential buyer for those companies, adding they may have to combine together themselves, probably at little or no premium.

“On that basis, especially if Disney acquires Fox, we would expect the already bleak outlook for these little, over-levered pure play cable network companies to be even worse,” he wrote.

Illustration by cpuga/Getty Images.