The Viacom offer has Wall Street abuzz. Is CBS worth more?


Now that the initial hype over the CBS Corp./Viacom Inc. merger has subsided, the second-guessing has begun. Will the merger overcome regulatory hurdles? Will Phyllis Redstone's pending $3 billion divorce suit against husband Sumner, chairman of Viacom, effectively cripple the deal? Most ominously, will another suitor for CBS emerge? The stock market is signaling its doubts. Both stocks have fallen in price, while CBS trades at a premium to the value of Viacom's offer.

But whatever the outcome, the prospect of this landmark deal between two media giants sheds light on one of the most remarkable corporate transformations of the past decade, and offers a peek at what the emerging new-media giants may look like.

At this point, CBS bears almost as little resemblance to the "Tiffany Network" as the network did to the old Westinghouse Electric Corp., which bought CBS in 1995. As CFO, first under Michael Jordan and now under Mel Karmazin, Fredric G. Reynolds has presided over both the shift from struggling industrial powerhouse to traditional media company, and the more recent shift -- far from complete -- to omnichannel new-media behemoth.

It is a process Reynolds, presumptive CFO of Viacom, has embraced. (Analysts harbor no doubt that Reynolds would be the CFO, and that longtime Viacom CFO George Smith would be out of a job, simply because Karmazin's authority over operations is a condition of the agreement.)

When CFO magazine first caught up with Reynolds, he had just moved to Westinghouse at the behest of then-CEO Jordan. Not a likely move, on the face of it. After leaving the accounting firm of Touche Ross in 1979, Reynolds oversaw the finances of Burger King International when it was owned by Pillsbury. In 1981, he went to PepsiCo, where he served as CFO of Kentucky Fried Chicken, Pepsi-Cola International, Frito-Lay, and Pizza Hut.

Challenging assignments all, but they could not compare with what he faced at Westinghouse when he joined the company in 1994. After 13 years at PepsiCo, Reynolds had taken over the finances of a company that had yet to recover from a disastrous series of diversification forays following the long decline of its power- generation business.

Reynolds proceeded simultaneously to oversee the integration of CBS's assets and the divestiture of almost all of the old Westinghouse assets. And he did so without forgoing good prices for the likes of The Knoll Group, a loss-plagued office-furniture maker; or Electronic Systems Group, a defense electronics unit. In the space of roughly three years, the source of 95 percent of the company's revenues had changed.

Reynolds, says Merrill Lynch analyst Jessica Reif Cohen, "is a careful, thoughtful CFO." That view is echoed by Peter Bardwick, CFO of MarketWatch.com, in which CBS recently acquired an equity stake. Reynolds is "extremely bright and analytical," says Bardwick. And he notes that although Reynolds has worked only a few years in the media business, "he instantly gets the value of audiences." What's more, his cool, cerebral manner may serve as a foil to Karmazin's aggressive, hard-charging approach.

Still, it's one thing to turn an industrial laggard into a media power when there's nowhere to go but up. It's quite another to take a media conglomerate with such old- fashioned properties as radio stations, billboards, and "The Price is Right" into the uncertain economics of the emerging Web.

All Channels Go

If the viacom deal goes as planned, Reynolds insists investors will be pleased. "We have highly complementary assets with very little overlap," he says. "We're very strong in distribution, and [Viacom has] great content." Characterizing the proposed merger as a "dream" for CBS ever since Westinghouse bought the company in November 1995, Reynolds observes, "Sometimes dreams come true." (CBS had been forced by the Federal Communications Commission in 1970 to divest the cable programming assets that were the original business of Viacom.)

None of this has been lost on Wall Street analysts. Cohen of Merrill Lynch expects cash flow to rise by 15 to 20 percent annually for the foreseeable future, thanks to revenue as well as cost synergies. As a result, she projects the stock of the combined entity to rise about 25 percent in the next 12 months.

A little lost in the excitement, though, is the fact that the Viacom deal represents just an acceleration of the strategy that Karmazin, with Reynolds at his side, has been pursuing for quite a while. Following the last of the Westinghouse divestitures, Reynolds and Karmazin have made one acquisition after another designed to extend CBS's reach, not only geographically but also in terms of demographics and type of medium.

First came the acquisition of Infinity Broadcasting Corp. in 1996, which upped CBS's radio reach from 39 stations to 79. The purchase of American Radio Systems the following year brought the total to 160. More recently, CBS announced an $8.7 billion deal for Outdoor Systems Inc., a leader in outdoor advertising. Billboards may be unglamorous and decidedly low-tech, but by turning CBS into the nation's largest owner of outdoor advertising, the acquisition will help the company reach all possible customers. Hollywood studios, he points out, spend a lot of money advertising their movies and programs on billboards. What's more, billboard slots fetch premium rates because of legal limits on their size and location. Extending CBS's reach to media besides radio and TV also helps CBS sell packages of advertising. "I should be able to get more of your ad dollars," says Reynolds, "because I satisfy all the audiences you want to reach with your product."

With network, cable, radio, print, billboard, and Internet interests, the pre-Viacom CBS could be said to be in the business of selling air and space in all venues (except possibly sky-writers).

This broad reach gives CBS an enviable ability to cross-promote. CBS radio stations, for instance, promote CBS programming, while billboards advertise Web sites in which CBS has an interest.

Unlike its peers (for instance, The Walt Disney Co.), CBS has focused much of its heaviest investment on businesses that require little ongoing spending. "For every incremental dollar of revenue in either radio or TV stations, about 80 cents goes to the bottom line," notes Reynolds. "Your variable costs are very few."

In fact, the "Tiffany Network" itself now represents only 10 percent of CBS's cash flow, even before the acquisition of Outdoor Systems, and that proportion will dwindle if the Viacom deals goes through.

Making A Megaportal

As for the Internet, CBS hasn't exactly had its head in the sand. To date, it has acquired stakes in some 13 Internet companies, including MarketWatch.com, SportsLine USA, Medscape, and Office.com, and plans to acquire more. In fact, the most prominent item on the wall in Reynolds's office besides a TV set is a chart that diagrams which Internet companies do what. Created by a Wall Street investment firm, the chart, Reynolds says, has quickly fallen out of date.

Reynolds says he has looked at more than 140 such companies for investment opportunities. How does he separate the wheat from the chaff?

"You have to first buy into the business plan," he says. "But that's the easiest step, because they're usually going after existing markets, [but] going after them through a different medium. Then you ask, What's the leadership? What's the vision? because they all have the same models. The question is, How are they going to get there?"

Beyond that, however, traditional yardsticks don't apply. Says Reynolds, "There is no way to value them other than to look to see who their partners are, particularly venture capitalists, and what values they come in with [when putting up] hard cash."

But given its broad reach into other media, CBS may have turned the apparent obstacle of high Internet valuations into a strategic advantage. So far, CBS has stuck to private companies and paid for them not with cash or stock, but with advertising time and space, thereby avoiding the huge premiums that Internet stocks fetch even after their recent sell-off. The latest CBS investment, a portal called Iwon.com, is the first that CBS controls outright. But as with its other Internet investments, CBS is paying for it with radio and TV advertising.

Reynolds also helped engineer a deal with America Online Inc. in 1995, whereby AOL agreed to provide Internet access to CBS programming. The relationship deepened a few weeks after CBS announced the merger with Viacom in early September, when MarketWatch.com agreed to provide business and financial news through several of AOL's most popular sites in return for $21 million in cash and advertising.

Meanwhile, because Internet companies are all spending heavily on advertising in other media, CBS is positioned to profit handsomely from the emergence of the Internet, even as it invests in it.


The merger with Viacom would eventually create, says Reynolds, a "mega-portal" linking an array of Web offerings and other media. The combination represents a vast span of media. These include the top-rated broadcast network, massive TV syndication power, the second- biggest radio group in the United States, the four leading cable music networks, the cable programming networks of Showtime and Nickelodeon, the Paramount movie studio, Blockbuster video, and assorted outdoor advertising and Internet investments. Together, Viacom and CBS would be the largest media company in terms of total ad revenues. "Size is important," says Reynolds; without it, he says, it would be difficult to have "the financial wherewithal to bring the best content to the viewers and make sure our shareholders are rewarded."

Adds Cohen of Merrill Lynch: "The new company creates industry-leading strength in both content and distribution across virtually all media segments."

Reynolds plans to exploit that strength in two basic ways. For one thing, the additional reach provided by Viacom will enhance the CBS strategy of packaging different kinds of media for what Reynolds calls "one-stop shopping" for advertisers. "We can reach every person you want," notes Reynolds. "Where else can you build brands more efficiently?"

The deal also can't help but add to the two companies' ability to cross-promote. "Imagine our 163 radio stations driving people into MTV," says Reynolds, without even a hint of a parental shudder.

Now, too, the CBS network could serve as a ready outlet for Paramount movies and TV shows. But Reynolds is quick to note that CBS, unlike Disney's ABC, won't favor its own studio content. "With our very strong distribution, it's nice to have more content through the studio," he says. "But it's not going to be exclusive. The studio is going to be agnostic. It's going to sell its product to the highest bidder."

Is The Price Right?

Investors seem to be wondering whether CBS can say the same about itself. Why? Notwithstanding Reynolds's description of the deal as a merger of equals, CBS shareholders would be ceding control to Redstone, and CBS's assets may be worth more than he has offered for them.

The deal calls for a swap of 1.085 shares of Viacom for every share of CBS's, and offers no premium for CBS's shares.

"The price [of the deal] is on the low end," concedes Richard Read, an analyst for Credit Lyonnais Securities. But, says Read, CBS shareholders "are receiving currency with recognizable intrinsic value," thanks to Viacom's "huge amounts of cash flow." As a result, he adds, "there's no ground swell" of shareholder opposition to the deal.

For his part, Reynolds contends that "the valuation was easy. We said this was a merger of equals, so there [couldn't] be a big premium." If there had been, he notes, the value of the shares of the group that offered the premium would have been diluted. To head off that possibility, he says, "we wanted to do something that was relatively close to market."

Reynolds is the first to concede that the deal is a long way from done, but insists that, apart from the widely anticipated regulatory hurdles, this is the inevitable result of putting together two "hugely successful" companies. The most difficult issue to negotiate, he says, "was how we were going to operate the company. We both have seen our market value increase significantly. So we didn't need to do this merger. Eventually, Sumner Redstone saw that one plus one could equal four, and certainly Mel was convinced of that."

----------------------------------------------- --------------------------------- Shadow Of A Doubt
While the stocks of Viacom and CBS have fallen in price since the companies announced their merger, CBS's chief financial officer, Fredric G. Reynolds, has another cause for concern. A look at the way the stocks are trading in relation to each other suggests that investors seem to foresee a bidding war for CBS, with USA Networks, Seagram's, and Sony the most likely participants. America Online is a possibility, as well.

Granted, analysts may be trading rumors to produce arbitrage opportunities, but there's evidence that investors are taking such reports seriously. As this issue of CFO went to press, CBS's stock was trading at a premium to the value of Viacom's offer. In other words, investors were bidding up CBS's shares on the expectation that a higher offer for the company might be imminent.

If investors didn't think a counteroffer for CBS was likely, its stock would be trading at a discount to Viacom's bid, reflecting the regulatory hurdles to the deal, says Tom Burnett, a director at Merger Insight, a New York­based institutional research service. Those hurdles range from the deal's potential rejection by the Federal Communications Commission (FCC) or the Justice Department, to approval conditioned on asset sales.

For one thing, CBS's 16 stations, combined with Viacom's 19, would represent roughly 41 percent of the nation's TV stations, while federal rules prohibit more than 35 percent in the hands of a single owner. What's more, the American Association of Advertising Agencies wants the Justice Department to block the deal on anticompetitive grounds. In any case, analysts estimate that the extent of such a discount would be about $3 or $4 per share.

Viacom chairman Sumner M. Redstone and CBS chief executive officer Mel Karmazin have put in place a $1 billion breakup fee to ward off other bidders. But this fee would add no more than about $1.50 a share to a new bid.

Complicating matters is the fact that Redstone has been sued for divorce by his wife, Phyllis, for $3 billion, which would be the largest divorce settlement in history. Redstone claims that his interest in Viacom is structured in such a way as to avoid the reach of a court ruling in her favor. But investors evidently are taking that claim with a large grain of salt, as divorce courts have ignored trusts and other arrangements for keeping assets out of the hands of estranged spouses. All in all, Burnett says, "I'm not comfortable" with assurances from Viacom that the divorce suit poses no threat to the deal.

As a result, lawyers in a brief for a suit against the company say shareholders "will not receive their fair proportion of the value of CBS's assets and businesses, and have been and will be prevented from obtaining a fair price for their shares." These shareholders, at least, want CBS to solicit other bids.

Some analysts contend that CBS may be vulnerable to a bid by America Online, which offers shareholders loads of E-commerce opportunities, and a stock with a much higher multiple of revenue than either Viacom's or CBS's. With $1 billion in ad revenues for the 12 months that ended last June 30, AOL already trails only ABC, CBS, and Time Inc.

Since credit analysts are untroubled by debt levels and other obstacles to a deal, bidders aren't likely to be fazed either, especially when facing the possibility that Viacom's bid will come undone as a result of the divorce suit against Redstone. While CBS may be the acquirer of Viacom for tax purposes, Viacom is the acquirer of CBS in a legal sense. Reason: Redstone would control 67 percent of the new entity, just as he controls 67 percent of Viacom, because CBS shareholders would be getting nonvoting shares in return for their stock.

If, however, his wife succeeds in winning half of his assets, as her suit is intended to do, his ownership stake would be cut to a third, and her third would potentially be available to another bidder. So the divorce could be a deal breaker, even if Redstone were prepared to offer much more for CBS than he already has.

----------------------------------------------- --------------------------------- What It's Worth
The stock of CBS seems undervalued for at least two reasons. First, CBS still has roughly $1 billion in net operating tax-loss carryforwards, otherwise known as net operating losses (NOLs), from discontinued operations. Known as Westinghouse until 1997, the company only recently completed its disposal of troubled industrial businesses, and the losses from those discontinued operations can be used to shelter income that other businesses produce, thereby boosting aftertax profits.

Then there are the broadcast licenses of CBS's 16 television stations. These are likely to become significantly more valuable than they currently seem, if the Financial Accounting Standards Board adopts its proposed new rules for business combinations. Under the proposal, companies would no longer have to amortize the value of intangible assets for which they can identify cash flow, if they can show they have indefinite lives. That would eliminate the annual hit to earnings that such amortization currently produces.

How big a hit does that represent for CBS? The company doesn't disclose the amount of amortization attributable to its broadcast licenses. But in 1998, for instance, CBS's total depreciation and amortization amounted to $571 million, and a look at its balance sheet suggests that broadcast licenses represented roughly a quarter of that. Had the company been able to avoid a hit of that size, the company's operating profit would have risen by half. And all things being equal, CBS would have reported a net profit for the year instead of a $21 million loss.

Granted, experts contend it will be difficult for companies to identify cash flows from intangible assets of any kind, much less those that they claim have risen in value. But FASB itself singled out broadcast licenses as an example that would qualify for such treatment. And the reasons for that are clear. The broadcast spectrum itself is finite, while the license to use it does not expire. "It's an asset that cannot be duplicated, and is infinite-lived," notes Barry Hyman, an analyst for Ehrenkrantz King Nussbaum Inc., a New York investment firm. To be sure, analysts value media companies like Viacom and CBS not on earnings per share, but on earnings before interest, taxes, depreciation, and amortization (EBITDA). And the value of CBS's NOLs and broadcast licenses doesn't affect EBITDA. But surely the company would get more credit from shareholders for reporting actual earnings, and both the NOLs and FASB's proposed balance-sheet treatment of broadcast licenses could help produce those.

Of course, it's possible that the potential benefits of CBS's NOLs and broadcast licenses are already reflected in CBS's stock price. But at least one analyst considers that unlikely. One reason: Investors may assume that Viacom cannot use CBS's NOLs. The Internal Revenue Service has a complicated set of rules designed to prevent companies from "trafficking" in these tax credits. Under these rules, a company cannot use the NOLs of an acquired company against its own income.

But the rules wouldn't apply in this deal. Reason: CBS shareholders would end up with the greater amount of the combined companies' total market value, so for tax purposes, CBS is considered Viacom's acquirer. If the merger goes through, "CBS has acquired more income to apply those NOLs against," notes Robert Willens, a tax and accounting expert with Lehman Bro-thers Inc. As for the licenses, Willens notes that FASB's proposal is most likely at least a year away from enactment. But while investors are unlikely to be taking that into account at this point either, they can be expected to if and when the new rules come closer to becoming a reality.


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