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Thanks, But No

Time Warner is not being secretive about setting its sights squarely on ailing Adelphia Communications’ 5 million subscribers. Chairman Dick Parsons openly acknowledges he has billions of dollars to spend and wants to spend them on bulking up his cable portfolio.

Cable operators are deal junkies, and a war for Adelphia might be good for stocks and system values. So executives are genuinely excited over the prospect of an approximately $17 billion bidding war between Time Warner and a cluster of Wall Street buyout firms that have been circling, including Kohlberg Kravis Roberts, Thomas H. Lee Partners and Providence Equity.

But would it be good for Time Warner? It is so natural for cable giants to grow by gobbling each other up that questioning a deal would have been heresy just a few years ago. There can be tremendous economies of scale for small cable companies that get increasingly larger.

However, too many media megadeals have turned out to be train wrecks (AOL-Time Warner) or merely mediocre (Viacom’s takeover of BET). Now big media investors have stopped fixating on acquisitions and are instead clamoring for media giants to spend—or even borrow—billions to buy back their own stock or to pay out dividends.

So should Time Warner pass on Adelphia?

Adelphia is no prize. After two years spent mired in bankruptcy and financial scandals, new managers (Bill Schleyer and Ron Cooper) have exorcised the worst operating habits of the Rigas family (to say nothing of the outright fraud). But Adelphia’s operating-cash- flow margins are an anemic 28%. (Time Warner’s are 38%.) What is disturbing is that the margins haven’t improved.

Adelphia expects to solicit formal bids by the end of January. To attract Wall Street financial players who might not be big enough to swallow the whole thing, Adelphia has divided its systems into seven “clusters” worth $1.5 billion to $4 billion each. Some systems are lucrative, like West Palm Beach, Fla., and a large swath of Los Angeles. Many systems are not, including those in rural Vermont and the Pennsylvania mountains. Adelphia last week extended the bidding deadline to the end of January.

It was John Kornreich who showed me the light. A senior managing director of multibillion-dollar money manager Sandler Capital, he has a reputation for being a bit irascible. In the world of big media, you are bound to encounter Kornreich at some conference or company meeting, peppering a CEO or CFO with questions.

Media executives pay attention to Kornreich not only because he is a seasoned media investor who has been following their companies for decades. They also watch him because he likes to ask tough questions that other investors or analysts won’t ask in public—and he often asks the ones that everyone wants to have answered.

That is why it was fun to watch Kornreich call out Time Warner Cable Chairman Glenn Britt on the subject of Adelphia. During Britt’s presentation at Credit Suisse First Boston’s recent media investor conference, Kornreich said he had a simple question: “Why?”

To Kornreich, Time Warner is already huge. A company like 3 million-subscriber Cablevision might be able to generate better deals with cable networks or other economies by adding 5 million subscribers. But what does the second-largest cable operator gain by acquiring the fifth-largest? “You have 11 million subscribers now, and the evidence of economies of scale frankly are dubious right now … Why is going to 16 million subs going to benefit the company?”

First, Time Warner likes the cable business and is happy investing in it—at the right price, says Britt. “This business is becoming a business of scale across the board … the RBOCs are huge companies compared to any company, even Comcast,” he says, referring to regional Bell operating companies. “DirecTV is now bigger than we are, and EchoStar is catching up fast.”

Did you get that? Time Warner, the largest media company on the planet, with $40 billion in revenues, worries that it is too small. Britt declined a request for an interview last week.

To some extent, it may be true. While Time Warner Cable controls systems serving 10.9 million subscribers, it doesn’t truly own all those properties. Partner Advance Newhouse’s Brighthouse unit has claim on around 2 million subs. And Comcast owns 21% of Time Warner Cable, a legacy of its takeover of AT&T Broadband.

Time Warner and Comcast are bidding for Adelphia jointly, planning to use the deal as an opportunity to unwind the Time Warner Cable partnership. So Adelphia’s subscribers could keep Time Warner a 10 million-subscriber player over the long run.

Time Warner Cable clearly does a great job running cable systems. But at what cost? In bankruptcy court, bondholders—who in this case are owed billions—call most of the shots. And Adelphia’s largest bondholder, W.R. Huff Asset Management, has declared that the bidding for all the systems must reach $17.5 billion.

Huff CEO Bill Huff didn’t return calls last week, but cable executives think he is bluffing. “You can say that if you’re prepared to own it,” says a finance executive with one operator. “I don’t think he is.”

Time Warner might make better use of Adelphia’s hidden asset: a giant tax shelter. Adelphia’s financial problems generated $6.7 billion in net operating losses (NOLs). That means some buyer may be able to shelter billions of dollars of future income from taxes. But gauging NOLs is a tricky game, and Adelphia warns that it has no clue how much of those NOLs the IRS will ultimately allow the company to use.

A buyer who can exploit that shelter can afford to bid more. But that doesn’t mean Parsons should. If the media giant can win with a lowball bid, the returns could make the deal worthwhile. And if it can’t, then why bother?

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