3/22/2022 Written Case

Analysis

Submitted By-
BJ21124 | Adarsh Nethwewala
BJ21136 | Chinmayi Lanka
BJ21150 | Mohak Khare
BJ21157 | Pallavi Mehrotra
BJ21177 | Utkarsh Gupta
CASE BACKGROUND
Cox Communications Inc. a spin off Cox Enterprise Inc., a newspaper company, started its
operation in the cable business in 1995. The company recorded a net income of $1,271 million
in fiscal year 1999 with the number of subscribers exceeding 3.7 million. To enjoy cost
leadership advantage (as most of the costs were fixed in nature), the companies utilised the
strategies of acquisitions and mergers in the cables and communications industry. On similar
lines, Cox Communications had agreed to acquire the cable systems of Media General along
with a few AT&T properties and merge with the TCA cable. This was primarily done for the
purpose of availing the benefits of economies of scale coupled with increasing the company’s
presence as a cable operator by boosting its subscriber base. It was estimated that Cox would
expand its customer base to 5.5 million covering almost 18 states through these acquisitions.
In addition to the above, Cox Communications was also looking to acquire Gannet Co’s cable
properties. This purchase would cost the company an additional $2.7 billion ($5000 for every
additional customer against market average of $4000 per customer) over the $7 billion that it
incurred for its previous acquisitions. Like Cox, Gannet Co. was also a large newspaper company
which later diversified into the cable industry. Since the other companies in the industry were
also competing for the same acquisition, Cox Communications was likely to incur high costs for
winning the bid. But with these costs, Cox Communications would be able to expand its
customer base by bringing in 522,000 customers (indicating a 60% growth in its subscriber
base). Moreover, it would also contribute towards economies in scale as the geographical reach
of the subscriber base of Gannet was well fit with that of Cox Communications. Hence, for the
growth of the company and its subscriber base, the company had to decide on the ways to be
adopted for financing the acquisition of Gannet along with the other acquisitions.
As per our analysis, the firm should go for a combination of equity and debt financing, coupled
with the availing of benefits of Merrill Lynch’s FELINE PRIDES hybrid securities.

PROBLEM STATEMENT
The main problem before Cox Communications was to arrive at the most optimum way for
funding its future expenditures (including its strategic acquisitions) and the acquisition of
Gannet Co. for which it would be required to pay $2.7 billion to win the bid. Cox
Communications had to decide on an appropriate mix of both short-term and long-term funds
which would help in fulfilling both the shareholders and the company’s needs. The company
had to chose from different methods of financing, which included the issue of common stock,
borrowing debt, issuing of hybrid securities or by the sale of its strategic assets. During the
evaluation, Clement and entire team of analysts had to ensure that the company was able to
maintain its leverage ratio at below 5 coupled with ensuring that the majority control of the
company remained with the Cox Family.
ANALYSIS
The company would not be able to generate the necessary funds required for the expenditure
internally and would need to raise funds from external sources as well. Cox would require $2.67
billion ($2.023 billion for the cash part of TCA, $1.4 billion for the Media General acquisition as
reduced by $700 million that Cox would obtain as a part of the AT&T deal) for the purpose of
funding a portion of its acquisitions. It was also expected to have capital expenditures ranging
between $983 million to $759 million between 1999 and 2003. Along with this, the Gannet
acquisition would cost Cox Communications an additional $2.7 billion. Hence, as per these
calculations, Cox Communications would be requiring $7.5 billion (short-term) between 1999-
2000 for the purpose of financing its transactions. In addition to the above, long-term financing
of roughly $2.7 billion would be needed between 2001-2003.
In trying to raise these funds, the company must ensure that it is maintaining its investment
grade rating coupled with maintaining a majority control of the Cox family in the company
(which stood at 67%). The management was not willing to allow the leverage ratio to go beyond
5 (to maintain its investment grade rating). A favourable rating would allow the company to
raise additional funds in the future as the industry is highly dependent on mergers and
acquisitions for maintenance of cost leadership.

EVALUATION OF ALTERNATIVES
Cox Communications has the options to go for either equity financing or debt borrowing for the
purpose of financing its expenditure to achieve the desired growth. Equity financing would not
have any additional impact on the cash flow generated by the company as no fixed cost would
be incurred by them unlike in the case of debt financing wherein the company faces interest
burden (apart from principal repayment). If the company goes for equity financing, it would be
required to sell shares for the purpose of raising capital, an action which can dilute the
company’s ownership control. Given that the company wants to ensure that a majority control
remains with the Cox family, equity mode of financing can prove to be a costly affair (as in the
event of an acquisition, the share of the Cox family would be reduced because of the dilution of
ownership). It can also affect the availability of sources of finance in the future, wherein if the
company is required to raise additional funds, the option of going for equity mode of financing
would not be available since the Cox family may not be willing to dilute its ownership any
further.
In the case of debt financing, the company would be incurring the burden of making the
payment of both the principal as well as the interest amount (even though it would bring in the
benefits of interest tax shield). Moreover, too much debt can raise the leverage ratio of the
company to exorbitant levels, which can severely impact the investor’s confidence in the
company forcing them to sell of their shareholding which can severely reduce the stock price
coupled with limiting financial flexibility. A high leverage ratio would not be acceptable to the
management as it is seeking to ensure that the same does not go beyond 5. However, in the
case of debt financing, the company would not be diluting its shareholding thus ensuring
adequate control. Hence, in the event of a takeover wherein the acquiring company can take
over the shareholding of external stakeholders (tender offers), debt financing would prove to
be much more beneficial. The firm can also avail the benefit of trading on equity wherein it
would be using borrowed capital to finance its operations rather than going for owned funds.
Merrill Lynch had introduced an equity linked hybrid product going by the name of FELINE
Income PRIDES. This comprised the elements of both debt as well as equity. Each unit of it
involved an obligation for the investor to purchase of fixed dollar amount of Cox’s Class A
Common Stock in 3 years along with preferred equity. While the preferred equity was tax-
deductible, the common stock was like equity (financial treatment purposes) as it involved the
obligation for the holder to purchase equity in the future. This provided a good option for Cox
to reduce the amount of debt load faced by the company while ensuring it was not diluting its
equity stake to such an extent that the control of the company was being compromised. It also
ensured flexibility as the option of going for debt/equity financing in the future should be
available to the firm in the event of requiring additional funds.
Apart from the above, Cox Communications could also opt for the sale of non-strategic assets.
While this would not impact the debt or equity capital of the company, the firm could lose out
on assets that could potentially become strategic to its operation in the near future. It can also
impact its revenue generating capacity.

RECOMMENDATIONS
Based on the above analysis, it seems that neither of the method in isolation would be
appropriate for Cox Communications. If it wants to meet its criteria of ensuring control over the
company while not letting the leverage ratio fall below 5, it must go for a mix of equity and debt
financing along with the option available for hybrid securities. This would not only ensure
adequate control in the hands of the firm, but also provide the benefit of tax shield for interest
and tax-deductible expenditure through preferred equity. It would also help in ensuring
flexibility in the options available for future fund-raising activities, where neither of the
methods have been exhausted by the firm.