cox communications

NOVA School of Business and Economics

Spring Semester 2013/2014

REPORT TO THE BOARD OF DIRECTORS

Recommendations on Gannet’s acquisition and Capital Structure

Applied Corporate Finance

Professor: Paulo Pinho

T.A’s: Raul Afonso; Ricardo Barahona

Group 8:

Daniela Gameiro #701

Luís Faria #715

Catarina Batista #750

APPLIED CORPORATE FINANCE Cox Communications, Inc.

Frederic Muller #774

TABLE OF CONTENTS Executive Summary.......................................................................................................................3

1. Cox Communications, Inc. And the Market................................................................................4

2. Computing the NPV within Gannet’s Acquisition.......................................................................52.1. Weighted Average Cost of Capital (WACC)..............................................................................................52.2. Estimating Cash Flows.............................................................................................................................62.3. Discounting the cash flows......................................................................................................................7

3. Short-term and Long-term Financing.........................................................................................8

4. Constraints on the financing needs..........................................................................................104.1. Cox Family.............................................................................................................................................104.2. Financial Flexibility.................................................................................................................................114.3. Strong Balance Sheet.............................................................................................................................124.4. Strong credit rating................................................................................................................................124.5. Market behavior....................................................................................................................................13

5. Type of financing choices.........................................................................................................14

6. Feline Pride Securities..............................................................................................................16

7. Final Recommendation............................................................................................................19

8. Appendices..............................................................................................................................20

GROUP 8 Spring Semester 2013/2014 2


EXECUTIVE SUMMARY

The underlying report will focus on Cox Communications, Inc. (CCI) a major U.S. telecommunications

conglomerate. Hereby we will mainly assess the company’s cable operating segment which is serving almost

3.7 million subscribers by the beginning of 1999. Regarding its cable systems CCI is facing substantial

technological innovations and deregulations which increased the segments competitive dramatically.

Therefore the firm was obliged to adapt its intended acquisition strategy to react to the changing market

characteristics and maintain or even increase its market share. In addition to acquisition plans already

implemented CCI discovered the opportunity to expand its cable systems even further through the purchase

of Gannett Co. In order to accomplish this acquisition CCI’s management team has to keep in mind the

interest of two important stakeholders, namely the Cox family that doesn’t want to see its majority stake

being diluted and the Board of Directors which is mainly concerned to retain a favorable investment grade.

Initially we focused on an evaluation of the existing cable market conditions and their future implications to

assess if an acquisition of Gannett would be beneficial. In order to evaluate Gannett’s acquisition value of

$2.7 billion we analyzed its NPV discounting the cash flows with a WACC of 9.65% considering different

scenarios for growth rates ranging from 3 – 5%. Our results indicate negative NPV’s for the respective

growth range which signifies that an acquisition price of $2.7 billion is too high in relation to future cash

flows generated. Subsequently we examined the various funding options and their implications on long- and

short term financing CCI is confronted with in case the firm wants to undertake the transaction. Those

options, more precisely the issuance of common class A shares, the issuance of debt, asset sales or a hybrid

product off-balance sheet financing option called Feline Prides where then compared to each other to

determine the most advantageous alternative for CCI.

It is our opinion that the best alternative would be to initiate a deal through financing with Feline Prides.

Although this product may not align perfectly with the interests of the financial department it is definitely

favorable to the conditions stated by the Board of Directors and the Cox family. Unfortunately Feline Prides

issued amount of $720 million would not be enough to finance the acquisition in total. Therefore we advise

to structure a combination of Feline Prides, debt and equity since it can be adjusted more easily and

considers the long-term financing needs of CCI. Conclusively we recommend CCI to acquire Gannett

overlooking the negative NPV and focusing merely on future benefits of the deal especially in terms of

competitiveness and market growth. Ideally CCI would be able to renegotiate the deal with Gannett in order

to define a more legitimate acquisition price.



1. COX COMMUNICATIONS, INC. AND THE MARKET

To understand Cox Communications intentions behind its aggressive acquisition plan throughout 1999 it is

important to examine the profound changes taking place in the cable industry during the late nineties.

Founded in 1898 as a newspaper publisher Cox Communications had been starting to diversify its business in

1962 with the purchase of several television cable systems. By 1999 the cable business had been expanded

to reach almost 3.7 million viewers being accountable for a substantial stake of Cox Communications

revenues. Therefore the company was eager to maintain and even expand its market share significantly and

drew an acquisition plan that intended to spend between $7 – $8 billion over the next three to five years.

Due to significant changes through technological innovations such as fiber optics, the Internet, wireless

communication and deregulations the late nineties constituted a major challenge for cable operators.

Especially fiber optic bundles had a great value because they provided 1.000 times more capacity. This so

called “broadband” allowed cable operators to provide pay per view and digital cable television, high speed

internet and digital telephony. All these products were seen as the future of cable companies. Furthermore

the industry was facing deregulations in form of the Telecommunications Reform Act of 1996 which allowed

cable operators and telephone companies to enter each other’s field of business.1 This act was the first

significant overhaul of the U.S. telecommunications law in over 60 years.2 Therefore the market had been

grown highly competitive and Cox Communications was facing tremendous competition by various cable

operators seeking to acquire valuable cable systems. Due to the growing competition numerous acquisition

objects of the company had come into play earlier than initially expected because it would be a vast

disadvantage if Cox Communications would lose these properties that could be combined with its existing

network to reach more viewers and create cost savings. Considering the changes aforementioned it becomes

obvious why the company had committed to over $7 billion in acquisitions until the end of 1999.

Acquisition targets during 1999 included established companies like Media General for $1.4 billion, TCA for

$4.1 billion and AT&T for $2.1 billion which amounted to a total of $7.6 billion. The purchase of Media

General would scale up CCI’s subscriber base by 260.000 customers and expand the company’s presence in

the Southeast.3 An eventual acquisition of TCA would leave CCI with 883.000 additional subscribers and

increased market share in Texas, Arkansas and Louisiana.4 Highly interesting would be a purchase of AT&T’s

cable business through a $2.1 billion share swap which would elevate CCI’s subscriber base by 495.000

viewers and further strengthen the firms market share in the Southwest.5

1 http://transition.fcc.gov/telecom.html2 http://www.ntia.doc.gov/legacy/opadhome/overview.htm3 http://money.cnn.com/1999/04/22/technology/cox/4 http://www.nytimes.com/1999/05/13/business/cox-to-acquire-tca-cable-for-3.26-billion.html5 http://money.cnn.com/1999/07/07/deals/cox/



Additionally Cox Communications found out that Gannett Co. was going to put his cable properties on the

market for an approximate bid price of about $2.7 billion. The considered acquisitions of Gannett’s cable

business accumulated with the others Cox Communications had recently committed to would increase the

subscriber basis by 60% compared to levels at the beginning of the year and make 1999 a truly extraordinary

year for the company. Gannett was particularly attractive because Cox Communications was focusing on its

strategy of concentrating viewers in geographical areas to achieve precious economies of scale and scope.

The acquisition of Gannett would not come cheap though. With an estimated price of $2.7 billion Cox

Communications would have to pay over $5.000 per subscriber which was remarkably higher than the usual

$4.000 per subscriber. Taking a closer look at the development of price per subscriber we can determine an

increasingly competitive market since these values have been growing from $2.000 as recently as 1998 to

over the aforementioned $4.000 in 1999.

2. COMPUTING THE NPV WITHIN GANNET’S ACQUISITION

Given the unexpectedly aggressive competition by its rivals, Cox could not afford to be left behind and

speeded up its acquisition plan. The firm is considering buying Gannett’s cable properties and would need to

bid about $2.7 billion to win the auction process. This indicates a price paid per customer of $5,172, clearly

superior to the average price between 1994 and 1999. In this fashion, in order to assess the feasibility of this

project one may evaluate if at a price of $2.7 billion the acquisition project has a positive NPV. To do that, we

discounted the cash flows from 2000 to 2003 at the unlevered cost equity and the terminal value at WACC.

2.1. WEIGHTED AVERAGE COST OF CAPITAL (WACC)

WACC=rd× (1−t ) DD+E

+reED+E

To obtain the WACC one should make several assumptions regarding the marginal tax rate, the cost of debt,

the cost of equity and the debt-to-equity ratio at market values.

Marginal Tax Rate(t=35%): The corporate tax rate in the US in the year of 1999 is 35%.

Cost of debt (r¿¿ d=6 .93%)¿: Considering the Cox’s bond rating (A-/Baa2), one may use as the

opportunity cost of debt the 10-year yield for an A- rated industrial bonds, which is at 6.93% in July 15, 1999.



This seems to be a reasonable value, as it is consistent with the rating, the currency, same implicit inflation

and maturity (given it is a long-term project).

Cost of equity (re=10 .52%): Regarding the cost of equity, it is assumed that the investors are well

diversified, measuring the risk of the company through its sensibility to systematic risk. Thus, we calculated

the cost of equity through the Capital Asset Pricing Model (CAPM):

re=r f+βe (rm−rf )

To keep consistency, the risk free rate is assumed to be the 10-year US Treasury bonds for July 15, 1999 at

5.83%. The market risk premium is 7%, which reflects an approximation for the average risk premium from

1982 to 1998, by using the S&P as a proxy for the market portfolio and the long-term US Treasury Bonds as

the risk-free rate (Harris and Martson 1999)6.

To calculate the levered beta for Cox we took into account the changes in the debt structure from 1998 to

1999. To do so, we unlevered the beta at a debt-to-equity in market values of 0.20 and then re-levered at a

debt-to-equity ratio of 0.177. By doing this we obtained an unlevered Beta equal to 0.59 and a levered beta

of 0.666. Given all the inputs, by applying the CAPM, we end out with a cost of equity equal to 10.52%.

Debt-to-equity in market values(D /E=0 .17): The DCF approach implies a constant debt-to-equity ratio,

which means that the annual amount of debt depends on the total value of the firm in market values, having

the resulting tax shields the same risk as that of the assets. In this way, we are assuming the value of 17% for

the last quarter available as the target for the coming years. Certainly, this value is not constant over time

and its changes have impact on the tax shields that would not be captured by the DCF. However, this seems

to be a fair approximation, as we are not considering the funding options behind Gannett’s acquisition,

which may change drastically the results.

WACC=6.93%× (1−35% )×0.15+10.52%×0.85=9.64%

6 Harris, Robert and Felicia Marston (1999) "The market risk premium: Expectational estimates using analysts'

forecasts." University of Virginia Darden Graduate School of Business, Working Paper 99-08.

7 Un-levering βu = βe*(E/D+E) + Bd*(D/D+E) and re-levering: βe = βu + (βu – βd)*D/E. βd is equal to 0.15 and was obtained by

using the CAPM (using the available cost of debt, risk-free rate and market risk premium).

βd is equal to 0.15 and was obtained by using the CAPM (already had cost of debt, risk free and market risk premium)



2.2. ESTIMATING CASH FLOWS

In order to estimate the incremental cash flows with the purchasing of Gannett, one may focus on the cash

flows from operating activities and investing activities as they allow to capture the incremental changes (the

cash flow from financing is just the inverse of the sum from the cash flow from operating and investment

activities).

Cox Communications already provides pro forma cash flows regarding four different possible scenarios,

dependent on the funding strategy between 1999 and 2003. As we only need the unlevered cash flows, the

information provided is sufficient to understand what is incremental by acquiring Gannett. In this fashion, by

ignoring the debt structure and subsequently the interest expenses, one may estimate the unlevered cash

flows in the case Gannett’s purchase goes through (see Appendix 1) or in the case it does not (see Appendix

2), and by simply taking the difference obtain the incremental cash flow with the acquisition (see Appendix

3). Adding the operating to the financing activities cash flows, the undiscounted cash flows are -$2,579,

$138, $151 and $165 million from the year 2000 to 2003.

2.3. DISCOUNTING THE CASH FLOWS

Since Cox did not anticipate paying taxes between 1999 and 2003, we do not need to take into consideration

the tax shields and may apply the unlevered cost of equity of 10%8 from 1999 to 2003. Note that in 2000 we

are discounting the cash flow in two different periods, considering the acquisition to be paid six months from

now (in 0.5 years) and the cash flows from Gannett to be received one year and a half from now (in 1.5

years). For the period from 2004 onwards, we had to estimate the cash flows to discount. In this case, we

need to consider taxes and the subsequent tax shield in order to apply WACC. To do that, we re-estimated

the cash flow from 2003 simulating the impact of paying taxes and then applied a constant growth rate until

perpetuity:

EBITDA 2003 190

-Depreciation -5

EBITDA - Depreciation 185

8 Obtained through the CAPM using the 0.59 as the unlevered beta, 5.83% as the risk free rate and 7% as the market risk premium.



-Tax Expense -64.75

= Noplat 120

+ Depreciation 5

- Capex -25

Free Cash Flow 100

Consequently, the present value of the growing perpetuity in 2003 is calculated in the following way9:

TerminalVal ue2003=100×(1+g)WACC−g

The company is expecting to have some growth after 2003 coming essentially from the expected rate

increase of 3% to 5% in the natural growth of the subscriber base. In that way, we took into consideration

three different scenarios to estimate the NPV (see Appendix 4), getting a NPV of -$1118 million, -$924million

and -$647 million for the 3%, 4%, 5% growth rates respectively. As we can see, within the expected growth

range while keeping the previously estimated WACC we never get a positive NPV.

Therefore, due to the sensibility of the NPV to the discount factor in the denominator we also tested for

changes in WACC. Actually, the calculation of the cost of capital is based on several assumptions and the

obtained result is just an approximation to the appropriate discount rate. Given our inability to consider all

the unpredictable changes, instead of overloading the model with more assumptions, we made a sensitivity

analysis allowing for small changes in the growth rate and WACC (see Appendix 5). As expected, given the

sensibility of the perpetuity to the denominator, small changes have a considerable impact. However, we

conclude that within the established growth rate, the only way to have a positive NPV is to consider WACC

two percentage points inferior to the one we obtained and a growth rate close to 5%

Once more, it is important to mention the limitations of the model we are applying. The assumptions

regarding the debt structure, the opportunity cost of debt, market risk premium or maturity of the risk free

rate may lead to significantly different NPVs. Despite the model being very sensitive to the denominator, the

Gannett’s cable properties does not look to be a good investment as it does not provide a positive NPV, even

when allowing for some changes in the WACC and the growth rate. Clearly, as we are going to discuss

further in this report, the price of $2.7 billion seems to be too high when considering the future cash flows

generated by Gannett.

9 Given the Terminal Value for 2003 we still would need to discount 4.5 periods more, as we did in Appendix 4



3. SHORT-TERM AND LONG-TERM FINANCING

Assuming that the Gannet acquisition goes through at $2.7 billion it is important to analyze the short and

long term financing needs in order to see if the company is able to comply with its obligations. When valuing

a company through time, the total uses of funds must always be equal to the total sources of funds. Uses of

funds consist of all the money that the company expects to spend in its operating, financing or investment

activities. In order to carry out these activities, the company can use the cash obtained from its operation

activities or from other external sources, such as equity or debt.

In this specific case (Appendix 6-9), it was considered as uses of funds the interest expenses and taxes that

came from the operating activities of the company. The payment of taxes was considered only in 1999 since

from 2000 and onwards it became a tax credit, which is not an actual cash flow. Also in this section the costs

with investing activities such as acquisition expenditures, capital expenditures and other asset acquisitions,

were considered. Finally, financing activities such as principle payments and debt retirement were also taken

into account. Regarding sources of funds, these were divided into internal and external sources of funds. The

internal sources of funds are EBITDA, monetization of non-strategic assets owned by Cox Communications

and other asset sales. The external funds considered in this case consist in equity and debt issues. Finally, the

entry called “Other uses of funds” was computed in order to have the amount of uses equal to the sources

of funds.

In order to make the analyses of the financing needs the short-term was taken as the period until 2000 and

the long-term the one from 2001 to 2003. As it can be seen in the appendix 10, the scenario that does not

account for the acquisition of Gannet is the one that has the lowest need for funds, while the other

scenarios require more funds. Specifically, the scenario of the acquisition by issuing equity is the one that

needs more funds in the short-term while the scenario where the company acquires Gannet by issuing debt

requires more funds in the long-run than the other scenarios.

It is important to analyze which of the activities in the company contributes the most for the total amount of

uses of funds, which we have done in appendix 11. The section that contributes the most is the “Investing

Activity”, especially as expected in the scenarios where the company acquires Gannet. Also, the impact that

this section has on the company is higher in the short-term, especially in the scenarios where Gannet is

acquired (2000).

Finally, it is of interest to analyze if the company has enough internal funds to fulfill its obligations or if it

needs to consider alternative funding sources. As it can be seen in the graph in appendix 12, the company

can almost fulfill its obligations by recurring to EBITDA, monetization and other asset sales. However it is in



the short-run that the acquisition has the biggest impact, coinciding with the time at which the company has

to resort to external financing solutions. This happens because Cox Communications requires an inflow of

external capital to finance Gannett’s assets. In the long-run the necessity to resort to external funds

diminishes. In fact, in the four scenarios presented, the one that issues equity is the one that has the lowest

percentage of need to finance by external sources of funds.

Despite the negative impact that recurring to external funds has on the company, the acquisition (compared

to the scenario with no acquisition) improves the pace of the company in the long-run as it reduces the need

of Cox for funding in the following three years.

4. CONSTRAINTS ON THE FINANCING NEEDS

Choosing the type of financing in order to meet the obligations of a company is very hard and the job is

further hampered if there are more constraints that need to be taken into account. Clement and his team

faced several challenges besides choosing the type of financing. They would need to balance five major

constraints:

4.1. COX FAMILY

Clement’s team would need to take into account the preferences of the Cox family since they were the

major owners of the company and wanted to maintain its majority in the firm. Through CEI, the Cox family

owns 379.2 million out of 533.8 million Class A shares (which give the right to one vote each) and all the

Class C shares (which give the privilege of 10 votes each). The family requested a minimum of 65%

ownership in the company, implying they had majority and thus avoiding problems that could arise in the

decision making process, for example when choosing the firm’s management. In this company it can be

noted the power of persuasion that the family holds over the chairman of the Cox’s Board, James Kennedy,

regarding the desire of the family to maintain their large majority in the firm. Moreover, this shareholder


Constraints

Cox Family

Strong Credit Rating

Market Behavior

Financial Flexibilit

y

Strong Balance Sheet


strategy allows for the control of agency costs through the combination of the interests of the management

and the shareholders. The fact that the company did not want the dilution of its position limited the issuance

of new equity. After the anticipated issuance of an additional 38.3 million shares of Class A to finance the

TCA transaction, the Cox family will own 67.3% of Cox’s common shares and 76.8% of the voting rights. In

this sense, Clement and his team could only issue a marginal amount of equity in order to maintain the

minimum of 65% ownership level in the company required by the family.

4.2. FINANCIAL FLEXIBILITY

In this company it has always existed an entrepreneurial spirit and the proof of that was the statement that

James Kennedy and James Robbins, the firm’s president and CEO, wrote in the annual report where the

company is constantly searching for new opportunities taking into account the value that these

opportunities could create for their shareholders. Nevertheless these initiatives by the company’s

management can be difficult to put in motion in the sense that it could be difficult to create sufficient

financial flexibility to continue to fund planned and unexpected business opportunities.

The concern is how to balance the amount of debt and equity in order to maintain enough financial flexibility

in the company. Having financial flexibility allows for the decrease in the risk of the company, while at the

same time allowing the company to take advantages of opportunities that may arise.

Financing a company through debt increases rigidity in the sense the company has always to fulfill the strict

repayments and covenants. On the other hand, financing the company’s project with equity despite the

inexistence of direct repayment decreases the leverage of the company through the probability of default.

Moreover, using equity is more expensive in terms of cost of capital compared with debt. There are issuing

costs that need to be taken into account that can range from 3% to 4% of the company share prices, as well

as the fall in share price that precedes a capital increase in the markets. Also, using equity has the

disadvantage of being more dependent on the fluctuations of the market, making it less easily accessible.

Funding Gannet’s acquisition by issuing debt (public debt issue or bank borrowing) has less transaction costs

of 2% as stated above; nevertheless as with equity there are constraints when using this type of financing.

Cox has the highest debt outstanding among all other Cox subsidiaries, which could make it difficult to

maintain the goal of a high debt rating.

The company could partly finance itself by selling some noncore assets that Cox has. Cox could sell, swap or

monetize some of its equity investments. However, only selling these investments in the market would imply

a considerable tax burden and that is why the company should be more tax efficient by recurring to



monetization and swaps. Nevertheless there were some limitations to dispose of these non-strategic equity

investments. For example, the Spring PCS investment could not be sold or hedged until November 1999.

Also, Cox owned large stakes in these firms where the average daily trading volume was low (lack of

demand), making it difficult to trade these positions.

Finally, there is the problem of management to double the size of the company every five years. The

problem is exacerbated when the good results that equity faced with the economic expansion suffers a

correction in the future. So it would not make sense to increase the number of new shareholders at a higher

price than the one that has been practiced. In this scenario, it is going to be difficult for the company to find

a perfect source of financing under the conditions mentioned.

4.3. STRONG BALANCE SHEET

Other major concern is related with the impact of the acquisitions in the balance sheet of the company

(known for having “strong balance sheet”). If the company does not go through with Gannet’s acquisition,

the internal cash flow of the company in the future may not be enough to fund the acquisitions that the

company announced to enter.

In order to finance its capital expenditures for network upgrades, acquisitions, capital investments and new

products the firm spent $1.9 billion from internal cash flow, $1.9 billion from net issuance of debt, $900

million from sales of non-strategic assets, and $370 million from issuing equity. Additionally, if the deals that

Cox announced in the beginning of 1999 go through, they would require approximately $7.6 billion 10 in gross

funding.

As mentioned above the company has as financial objective to double the size of the company every five

years which coupled with the minimum required by the Cox family ownership would limit the amount of

equity financing that the company could incur. Since this problem exists, the increase of the firm’s leverage

is a solution that once again can have its downsides. Regardless, CCI has exhausted its budget for

acquisitions it had planned for the next three to five years within only six months, and this clearly will have

an impact on the balance sheet.

4.4. STRONG CREDIT RATING

Following the debt financing constraints, it is important to mention the importance that this company gives

to financial leverage. For example, the company wants to keep a high debt rating since investment grade

10 Represents almost 60% of CCI’s total assets as of 1998



debt markets are less volatile and more liquid when compared to non-investment grade, that are known for

being very inefficient. If the company is able to have an investment grade rating it will have better financing

conditions.

The requirement that the company thought was adequate to achieve the preferred rating was through a

long-term debt-to-EBITDA not larger than 5. However, from 1996 to 1998 the company had a debt-to-

EBITDA larger than the target, which can have a negative effect on the investment grade rating of Cox.

Currently the management and the board were concerned with the debt level and increasing the financial

leverage of the firm. Being investment grade would not only allow for easier access to credit but also give

more flexibility to the firm as previously discussed. If the company is able to have a rating above the majority

of its competitors it will be able to finance itself at a below the average cost, even if the credit spread and

the treasury yields increase.

Currently the rating grades of the company are “A”- by Standard & Poor’s and “Baa2” by Moody’s. The

company has so far maintained a strong balance sheet making decisions in order to balance the proportion

of debt and equity. In fact, the debt-to-equity ratio has been decreasing since 1997 allowing the company’s

bonds to be classified as investment grade.

The issue present is whether the company will be able to maintain its investment grade. If not, this would

result in higher interest rates due to a higher probability of default and an illiquidity premium. The increase

that would happen in the cost of debt would be disproportionally large in the case of a downgrade to a

speculative grade.

Clement and his team have to pay close attention to guarantee that this does not happen and they can do so

by controlling some ratios such as the interest cover ratio and debt-to-EBITDA. As it was mentioned above

the company has not been able to fulfill the maximum imposed for the debt-to-EBITDA ratio, so when

choosing new investments they have to consider the contribution that it will have in the EBITDA and the

required debt to finance it.

4.5. MARKET BEHAVIOR

Besides the concerns that could appear due to problems within the company, there are also other external

factors that can constrain the funding. These external factors are market-related. Firstly Clement’s team was

worried that an IPO made by its rival, Charter Communications, would make it harder for Cox

Communications to issue debt. Charter Communications attracts the same type of investor that Cox does



and this firm is planning to do an IPO in the fall of 1999. If this actually happens, it would make Cox’s own

equity issue more difficult, in particular because the desire of the investors for its stocks would diminish,

potentially driving the price downwards. Clement knew that the equity issuance should be made before this

IPO, which created an important timing constraint.

Also there were concerns of how markets would perform later in the year. There are several examples that

could explain the concerns that arouse, such as:

“In the fall of 1998, the capital markets had almost melted down when the Russia defaulted on part

of its debt”

The Down Jones industrial average decrease 10% in the next two weeks

Credit spreads approximately doubled over the next five months

For A-rate borrowers, spreads increase from 56 to 135 basis points, while the spreads of BBB-rated

issuers increased from 95 to 181 basis points (Source: Bloomberg)

All these scenarios lead to the decrease of debt issues by the end of 1998. Although the markets recovered

somewhat in the beginning of 1999, the weakness in the bond markets led to the postponement of some

deals that were already announced. That is why Clement’s team should take into account the impact that

the acquisitions can have on the firm’s investment-grade bond rating. Finally, they were afraid that

computers that used two digits would malfunction when 2000 began. Despite this concern being unfounded,

the truth is that markets would be hostile to new issues that could be made until some of the risks had been

resolved.

The increase in economic uncertainty led to the concern that credit markets would impose higher spreads.

These expectation about the market behavior predicted a downturn in the markets after a decade of growth

and thus made Clement’s team very anxious, implying they should act very cautiously when finding the final

solution.

To sum up, Clement and his team have to find a solution that is consistent with the firm’s long-term ability to

grow further, cannot conflict with the company’s goal protecting the current investment grade rating, effects

of market behavior, maintain the ownership requirements and a strong balance sheet with financial

flexibility.



5. TYPE OF FINANCING CHOICES

To raise capital for the upcoming Gannett deal CCI did come up with a pool of four appropriate financing

options. These scenarios are depicted by the issuance of debt, issuance of fresh common class A shares,

emerging on an alternative called Feline Income Prides which represents a novel hybrid security recently

established by Merrill Lynch, through asset sales or lastly by disregarding the acquisition. However there are

several conditions Clement’s team has to take into consideration when evaluating the diverse financing

options. First of all it is of importance that the financing decision has to be consistent with CCI’s long-term

capacity for future activities. Secondly the team has to evaluate eventual impacts of their financing options

regarding CCI’s investment-grade bond rating. Finally the intentions of the Cox family which is eager to

maintain its super majority ownership of more than two-thirds of the company have to be taken into

account.

The first financing choice to be analyzed is the issuance of debt which could be through public debt issue or

bank borrowing. A major advantage of the debt issuance is that the costs would be less compared to an

issuance of equity due to the fact that transaction costs would be less than 2% effectively. Furthermore the

negative effect on CCI’s stock is estimated to be around 1% - 2% which is considered to be moderately low.

At first sight the debt option seems favorable with regards to the Cox family because it is not decreasing

their majority stake and maintains the voting rights. But on a closer look it becomes obvious that the good

investment grade of CCI is likely to be decreased due to the fact that the Debt/EBITDA ratio will increase, this

is a major concern of the Cox family. Currently CCI is targeting a Debt/EBIDTA ratio of no greater than 5

which enables the company to finance itself with yields ranging from 65 to 115 basis points above U.S.

Treasury obligations yields. Even though CCI is expecting these yields to increase in the future an increasing

Debt/EBITDA ratio will worsen the situation. Another fact that has to be taken into consideration is that CCI

is expecting to benefit from a significant amount of income tax refunds during the upcoming business

periods. Therefore the company would not fully benefit from the tax shield generated through debt

issuance. Conclusively we can adhere that even though the exact conditions of the debt issuance such as

coupon payments and maturity are not known there will be substantial disadvantages. According to this

debt issuance doesn’t seem as the most attractive option to exercise.

Secondly CCI has the choice to finance the transaction through the issuance of class A shares to the public.

The options of $2.7 billion class A shares requires the company to issue around 78 million additional shares

with a stock price of $34.6875 as of 8/9/99 taken as basis. Undertaking this option would be beneficial

regarding the company’s investment grade since it would actually affect the Debt/EBIDTA ratio positively.

Consequently outstanding class A shares rise from 533.8 million up to 650 million adding not only shares



from the Gannett deal but also 38.3 million shares from the TCA merger executed in May 1999. The Cox

family owns 397.2 million class A shares and 27.6 million of class C shares which implicates a problem

regarding the option to finance the Gannett acquisition with the issuance of class A shares. In case CCI would

go through with this choice the Cox family would see its economic stake be reduced to 59% and the voting

rights be decreased to 70%. Hence it would be highly unlikely that the Cox family would approve this

arrangement. Another negative characteristic of this transaction includes fees and expenses of about 2% -

3% of the amount raised. In addition a large equity issue might trigger a market impact which would affect

the stock price to decrease by 3% - 4%. Considering the enumerated negative effects of this option we can

see that financing through the issuance of class A shares is unfavorable for CCI.

As a third choice CCI could realize a sale, swap or monetization of its non-strategic assets for example the

$4.1 billion equity held in Sprint PCS, the equity investment of $2.5 billion in Discovery Communications, the

equity investment of $1.5 billion in @Home and the equity investment of $300 million in Flextech.

Nevertheless simply selling those assets to the market would leave CCI behind with a tax burden of 35%.

Therefore it is more efficient for CCI to look into methods of monetization for these assets. Regarding the

AT&T investment there is the possibility of a tax efficient disposal due to the fact that CCI had effectively

swapped its original AT&T shares into AT&T cable operator shares without triggering a taxable event.

Regarding a monetization of the other assets there are various practical limitations. The PCS investment for

example can’t be hedged or sold until November. In addition to that the stakes in @Home, Sprint and

Flextech are relatively large and will therefore be hard to liquidate on the market.

Finally CCI has the choice to issue a hybrid product created by Merrill Lynch called Feline Income Prides.

Those products have the characteristics of both debt and equity, comparable to preferred stock or

convertible bonds. In fact Feline Income Prides are considered to be extremely valuable regarding the

financing of the Gannett deal. Thus we will examine their structure and generated benefits in the following

part of this report.

6. FELINE PRIDE SECURITIES

One of the funding possibilities considered by Cox was the issuance of hybrid securities, in particular of a

recent innovation that resulted in a “mandatory convertible” and “trust preferred” security. On the one

hand, in mandatory convertible securities the investor is obligated to convert the contract into company

stocks; on the other hand, trust preferred securities combine both aspects of preferred equity and

subordinated debt, and are issued by a trust the company creates. Within this category Merrill Lynch’s

FELINE Income PRIDES were suggested to Cox’s treasurer. FELINE stands for Flexible Equity-Linked



Exchangeable and PRIDES for Preferred Redeemable Increased Dividend Equity Security. They are an equity-

linked hybrid product, each unit consisting of

An obligation by the investor to purchase a fixed dollar amount of Cox’s Class A Common Stock in

three years

Preferred equity

Thus one obvious benefit of issuing these types of securities comes from the way in which they are reported

in the balance sheet – the preferred equity component would be tax deductible. Moreover since the investor

would be forced to buy Cox’s equity at maturity, these securities were seen as equity for financial reporting

purposes and thus the transaction did not appear as debt on the balance sheet. So Cox was able to fund

itself by issuing something that looked like equity to debtholders and like debt to shareholders, but in reality

it was both. Through the Trust created, CCI was able to sort of issue debt to itself in the form of bonds with a

7% coupon, which the Trust bought. Then the Trust would issue preferred equity that paying 7% dividend

yield as previously mentioned and with the income from the PRIDES securities sale it would “purchase” CCI’s

bonds. Basically by using this method Cox would finance itself off-balance sheet, as it would be hidden in the

balance sheet – the Trust appears on the right side of Cox’s balance sheet in a minority shareholder interest

account (by the value of the preferred equity issue), and on the left side would appear the revenue obtained

from issuing the securities.

When looking into more detail at these securities it is possible to see that their payoff resembles real

options. The investor pays $50 for a unit of PRIDES and is entitled to receive a 7% preferred dividend yield on

that amount – this is the “interest bearing deposit” component. Then at maturity he is faced with the

purchase obligation, which he can deal with by either purchasing the shares with preferred equity or with

cash. Independently of his choice the number of shares delivered by Cox for each unit of the security will

depend on the stock’s market price at maturity (t = 3):

Cox Share Price (t = 3) Number of shares delivered Value of shares delivered

S3 ≤ $34.6875 = S0 1.4414 $1.4414* S3

$34.6875 < S3 < $41.7984 50S3

$50

S3 ≥ $41.7984 1.1962 $1.1962* S3

Hence the higher Cox’s share price at maturity, the lower the number of shares it had to deliver to PRIDES’

holders thus reducing dilution for existing shareholders. This makes it clear how the contract is priced along

the underlying asset – Cox’s stock – and how it could be related to options. If we take a replicating portfolio



with the full value issued in Feline PRIDES securities ($720 million spread in 14.4 million units) we would

obtain the same payoff (represented in Appendix 10) by holding Cox’s Common Stock, being long on calls

with strike price 41.7984 and short on calls at-the-money (of K = 34.6875). To determine the amounts of

each on the portfolio, the Black-Scholes model was used to value the options (due to only being exercisable

at maturity the securities resemble European options) with the assumption that the risk-free rate was 5.71%

(as the 3-year US Treasury Strip).

Replicating Portfolio

Asset Position Unit price Quantity Price

Call K = 41,7984 Long $10.78 22 201 523 $239 380 533

Call ATM Short $13.04 22 201 523 - $289 495 878

Common Stock Long $34.69 22 201 523 $770 115 345

Total $720 000 000

This result can be scaled for a single contract of Feline PRIDES as well knowing that each unit was priced at

$50.

Replicating Portfolio for one unit of PRIDES

Asset Position Unit price Quantity Price

Call K = 41,7984 Long $10.78 1.54 $16.6

Call ATM Short $13.04 1.54 $-20.1

Common Stock Long $34.69 1.54 $53.5

Total $50.0

Nevertheless for the holder of the security, the obligation part of the contract resembles more a forward

contract to purchase the underlying stock than an option. One further consideration it should be made

when assessing this funding alternative relates to both the leverage ratio and Cox’s family’s equity stake in

CCI.

On the one hand, Cox’s family stake will inevitably be diluted when the securities come to maturity. Despite

this, because the conversion of the securities into stock is dependent on Cox’s stock price 3 years after their

issue, this dilution effect will probably be lower than that achieved with the equity issuance. Furthermore if

employees and managers are aware of the need to preserve the family’s equity stake they will have an

incentive to perform at their best in order to keep the company’s stock price growing (assuming markets are

efficient and will see their effort as a good indicator that the company value is increasing).



On the other hand, due to the aforementioned benefits of this financing alternative not entering the balance

sheet as debt, the leverage ratio should remain more or less the same with Gannett’s acquisition. Moreover

it would most likely not deteriorate the debt’s investment grade rating, which was one of the company’s

concerns. Since there is an obligation to buy shares, rating agencies will expectedly only give an equity credit

rating.

Assuming Cox is interested in financing itself by combining several of the financing alternatives proposed, it

is possible to better assess the impact on Cox’s family stake. With a funding combination of $680 million in

equity, $720 million in Feline PRIDES and some debt the pro forma financial statement suggests that Cox’s

Family’s Economic Equity stake, although at first apparently unchanged at 65.1%, will in the worst possible

scenario – conversion at 1.4414 shares per unit of PRIDES – decrease to 63% when the Feline PRIDES reach

maturity. Cox’s family is very reluctant to have its stake diluted and risk losing their economic ownership of

the company so even though this is a small change it is still worth taking into consideration.

The issuance of these securities seems nevertheless a worthwhile alternative in terms of funding the

Gannett acquisition. Chemmanur, Nandy and Yan (2006)11 found that firms facing less information

asymmetry but greater probability of financial distress tended to issue more securities of the “mandatory

convertible” type instead of pursuing other more traditional financing alternatives. This is the case here –

right now, at the moment where CCI has to finance all its investments, it faces a greater chance of incurring

financial distress. On top of that, the viewpoint of Cox’s family is that they would rather not put themselves

in such a potentially risky position financially wise which could kill some of the projects that would be

beneficial in its long-run success. But the pursuit of these projects and in particular of Gannett’s acquisition

are almost certain to guarantee some degree of growth for the company, thus it’s also possible to bet on the

success of the company and reduce the asymmetric information problem a little. A company that was not

able to do this would be more reluctant to enter a mandatory convertible contract due to a higher

probability that its stock price would fall and its equity stake further diluted.

One potential issue that we do not consider here for lack of information are the fees that Merrill Lynch will

eventually charge Cox for the placement, coverage and advisory services they will provide with these

securities issuance. Regardless, if CCI’s main concerns are with their debt rating and the family’s equity stake

then it could be a necessary investment to obtain the required funding.

11 Chemmanur, Nandy and Yan, “Why Issue Mandatory Convertibles? Theory and Evidence”, SSRN working paper, 2006



7. FINAL RECOMMENDATION

Clement and his team are aware of the importance that this company gives to attractive growth

opportunities and thus they needed to find the perfect funding solution, taking into account the firm’s long-

run capacity to fund future activities. Their challenge from the beginning was how to finance the projects

taking into account several constraints that existed in the company.

The financing option has to respect the preferences of Cox family, who owns a super-majority in this firm,

and does not want its ownership interest diluted further than the established 65% floor. Also, the company

wanted to maintain its investment-grade bond rating since this would have a major impact on the flexibility

of the company to pursue new growth opportunities. In order to maintain the current rating, it is important

for the company to not allow the Debt-to-EBITDA ratio to be higher than 5. The non-compliance with this

target would put the company as a non-investment grade firm, making it harder to access credit markets

since for this rating they tend to be illiquid and inefficient.

Regarding the acquisition of Gannett by $2.7 billion the estimated NPV of this project is negative. Usually

when a NPV is negative the project is automatically abandoned, nevertheless this case is more complex. The

market has been growing and competition increasing as competitors are acquiring valuable cable systems

due to the technological innovations and deregulation that came from the Reform Act of 1996. Hence, the

desire of Cox to acquire Gannett’s cable business is essential to survive this new era in the industry. Gannet

would be the perfect acquisition since it was estimated that it would lead to an increase of 60% in users

while benefiting from economies of scale and scope.

We know that if the company does not acquire Gannet it will probably go out of business, so in this case is

not as linear to reject this project due to its negative NPV. We believe the company is overpaying for the

investment and that the final price should take into account a possible bubble in the market. From where we

stand, the growth of the price per subscriber in the market does not make sense – from $2,000 as recently as

1998 to over $4,000 by 1999. In fact, it is said that Cox would have to pay the $2.7 billion or, if it went to

auction, more than $5,000 per subscriber to win which we consider unreasonably high. We recommend

management to renegotiate this price downwards due to the factors previously mentioned.

Despite the negative NPV the company is facing with this project, we feel that the best funding alternative

for future acquisitions are the Feline PRIDES since they provide funding while keeping dilution at a minimum

and preserving their debt’s rating. Nevertheless the amount issued in PRIDES – $ 720 million – would not be

enough given the amount of funding needed so our recommendation would be to use a combination of

PRIDES, Debt, and Equity, since it allows for a certain degree of flexibility for future acquisitions. This

alternative would not compromise the investment grade rating as can be seen by the behavior of the



leverage ratio that varies between 2.4x and 4.2x between 1999 and 2003. This mechanism would allow Cox

to fund itself by issuing something that looked like debt to shareholders and equity to debt holders, where in

fact it was a mix of both. This method would also allow Cox to finance itself off-balance sheet, as due to its

hybrid characteristics it would be hidden. Nevertheless, in the worst-case scenario, this combination would

not allow Cox family to own a minimum of 65% of ownership in the company in 2002 and 2003, although

they would still have control of the company through its voting rights. Since the family is adamant in

preserving its majority in the company we would recommend a share repurchase program in the future.

We finalize by emphasizing the importance that the Gannet acquisition has for the future of the company.

We insist that a renegotiation of this deal would be in both companies’ best interest if a fair agreement is

reached, and if it is we recommend that the company use the financing mechanism mentioned above

combining debt, equity and the issuance of Feline PRIDES.



8. APPENDICESAppendix 1 – Pro forma unlevered cash flows if it purchases Gannett

1999 E 2000 E 2001 E 2002 E 2003 EOPERATING ACTIVITIES

EBITDA Cox + Acquisitions 878 1.344 1.490 1.697 1.913EBITDA Gannett 0 151 163 176 190Interest Expense 0 0 0 0 0

TOTAL CASH FROM OPERATIONS 878 1.495 1.653 1.873 2.103

INVESTING ACTIVITIESAcquisitions -2.673 0 0 0 0Gannett Acquisition 0 -2.700 0 0 0CapEx -983 -1.334 -1.103 -847 -759Total Other -122 48 34 10 10

TOTAL CASH FROM INVESTMENTS -3.778 -3986 -1069 -837 -749

Appendix 2 – Pro forma unlevered cash flows if it did not purchase Gannett


EBITDA Cox + Acquisitions 878 1.344 1.490 1.697 1.913EBITDA Gannett 0 0 0 0 0Interest Expense 0 0 0 0 0

TOTAL CASH FROM OPERATIONS 878 1.344 1.490 1.697 1.913

INVESTING ACTIVITIESAcquisitions -2.673 0 0 0 0Gannett Acquisition 0 0 0 0 0CapEx -983 -1.304 -1.078 -822 -734Total Other -122 48 34 10 10

TOTAL CASH FROM INVESTMENTS -3.778 -1.256 -1.044 -812 -724

Appendix 3 - Pro forma incremental unlevered cash flows if it purchases Gannett


EBITDA Cox + Acquisitions 0 0 0 0 0EBITDA Gannett 0 151 163 176 190Interest Expense 0 0 0 0 0

TOTAL CASH FROM OPERATIONS 0 151 163 176 190

INVESTING ACTIVITIESAcquisitions 0 0 0 0 0Gannett Acquisition 0 -2700 0 0 0CapEx 0 -30 -25 -25 -25Total Other 0 0 0 0 0

TOTAL CASH FROM INVESTMENTS 0 -2730 -25 -25 -25



Appendix 4 – Discounted cash flows considering different growth rates

Appendix 4.1 – NPV = -$1118 million

g=3% 2000 E 2000 E 2001 E 2002 E 2003 E Terminal Value

Period t 0,5 1,5 2,5 3,5 4,5 4,5Cash flows -2700 121 138 151 165 1554

DISCOUNTED CASH FLOWS -2574 105 109 108 107 1027

Appendix 4.2 - NPV = -$924 million




Appendix 4.3 - NPV = -$647 million




Appendix 5 – Sensitivity Analysis to WACC and growth rate

7,64% 8,64% 9,64% 10,64% 11,64%

0 -1.203 -1.346 -1.458 -1.547 -1.620

1% -1.050 -1.232 -1.371 -1.479 -1.565

2% -843 -1.084 -1.261 -1.394 -1.4993% -547 -884 -1.118 -1.288 -1.4174% -89 -598 -924 -1.149 -1.3145% 718 -153 -647 -961 -1.1796% 2.507 627 -218 -692 -9977% 9.889 2.360 536 -275 -737



Appendix 6 – Uses and Sources of Funds with no acquisition (Measured in $ million)

USES OF FUNDS

1999 2000 2001 2002 2003

Operating Activites 397 540 443 472 432

Interest Expense 312 540 443 472 432

Taxes 85 0 0 0 0

Investing Activites 3778 1304 1078 822 734

Acquisition expenditures 2673 0 0 0 0

Capital Expenditures 983 1304 1078 822 734

Other Asset Acquisitions 122 0 0 0 0

Financing Activites 0 1048 341 412 757

Principle Payments (1) 0 431 341 200 277

Debt Retirement 0 617 0 212 480

Other Uses of Funds 104 0 0 0 0

Total Uses of Funds 4279 2892 1862 1706 1923

SOURCES OF FUNDS

1999 2000 2001 2002 2003

Internal Funds 2121 2892 1524 1707 1923

EBITDA 878 1344 1490 1697 1913

Monetization 1243 1500 0 0 0

Other Asset Sales 0 48 34 10 10

External Funds 2158 0 337 0 0

Debt issued 2158 0 337 0 0

Equity issued 0 0 0 0 0

Total Sources of Funds 4279 2892 1861 1707 1923

Notes:

(1) Principle Payments are the payment of entry “Maturing Debt”

(2) Debt Retirement considered only the payments of the entry “New Debt Financed (Retired)” and if the Debt issued was negative it

was considered in this part

(3) Debt issued: Ending Total Debt – Maturing Debt – Beginning Debt (considered only the positive values)



Appendix 7 – Uses and Sources of Funds with Gannet’s acquisition by issuing Debt (Measured in $ million)

USES OF FUNDS

1999 2000 2001 2002 2003



Taxes 85 0 0 0 0

Investing Activites 3,778 4,034 1,103 847 759

Acquisition expenditures 2,673 0 0 0 0

Gannet Acquisition 0 2,700 0 0 0

Capital Expenditures 983 1,334 1,103 847 759



Principle Payments 0 431 341 200 277

Debt Retirement 0 0 0 169 437


Total Uses of Funds 4,279 5,005 2,101 1,883 2,113

SOURCES OF FUNDS

1999 2000 2001 2002 2003

Internal Funds 2,121 3,043 1,687 1,883 2,113

EBITDA 878 1,495 1,653 1,873 2,103

Monetization 1,243 1,500 0 0 0


External Funds 2,158 1,963 414 0 0

Debt issued 2,158 1,963 414 0 0

Equity issued 0 0 0 0 0

Total Sources of Funds 4,279 5,006 2,101 1,883 2,113

Notes:







Appendix 8 – Uses and Sources of Funds with Gannet’s acquisition by issuing Equity(Measured in $ million)

USES OF FUNDS

1999 2000 2001 2002 2003



Taxes 85 0 0 0 0








Debt Retirement 596 415 700



SOURCES OF FUNDS

1999 2000 2001 2002 2003

Internal Funds 2,121 3,043 1,687 1,883 2,113

EBITDA 878 1,495 1,653 1,873 2,103



External Funds 2,700 1,733 169 0 0

Debt issued 0 1,733 169 0 0

Equity issued 2,700 0 0 0 0


Notes:







Appendix 9 – Uses and Sources of Funds with Gannet’s acquisition by issuing Debt, Equity and PRIDES(Measured in $ million)

USES OF FUNDS

1999 2000 2001 2002 2003



Taxes 85 0 0 0 0








Debt Retirement 0 245 556



SOURCES OF FUNDS

1999 2000 2001 2002 2003

Internal Funds 2,121 3,043 1,687 1,883 2,113

EBITDA 878 1,495 1,653 1,873 2,103



External Funds 2,156 1,895 336 0 0

Debt issued 756 1,895 336 0 0

Equity issued 1,400 0 0 0 0


Notes:


(2) Debt Retirement considered only the payments of the entry“New Debt Financed (Retired)” and if the Debt issued was negative it





Appendix 10 – Uses of Funds

Short-Term Long-Term0

2000

4000

6000

8000

10000

12000

No Acquisition Issuing Debt Issuing Equity Debt, Equity and Prides

Appendix 11 – Percentage of each activity on the uses of funds

Shor

t-te

rm

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

No Acquisition Issuing Debt Issuing Equity Debt, Equity and PRIDES

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

Operating Activites Investing Activites Financing Activites Other Uses of Funds



Appendix 12 – Impact of sources of funds on the company’s needsSh

ort-

term

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

Shor

t-te

rm

Long

-ter

m

No Acquisition Issuing Debt Issuing Equity Debt, Equity and PRIDES

00%10%20%30%40%50%60%70%80%90%

100%

Internal Funding External Funding

Appendix 10 – Feline PRIDES Securities payoff at maturity (T = 3)

0 4 8 12 16 20 24 28 32 35 39 43 47 51 55 59 63 67 71 75 79 830

20

40

60

80

100

Cox Common Share Price ($)

Payo

ff in

dol

lars

($)


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