Thanks, Mike.(Comcast, MediaOne merger)

Negotiations to outflank AT&T lead to Comcast's $60 billion purchase of Media One

Thank AT&T's Michael Armstrong for unintentionally bringing Comcast Corp. and MediaOne Group Inc. together.

The two cable operators started out merely looking to plot against the AT&T chairman in his push to lure cable partners into a critical new phone venture. But those early talks sparked a vastly more expansive deal--one that set price records in the cable industry and likely will create the nation's second-largest MSO.

By acquiring MediaOne for $60 billion, Comcast will control a portfolio of cable systems serving 11 million subscribers with major concentrations in markets including Miami, suburban Boston, suburban Washington and Detroit. As Comcast president Brian Roberts sees it, the additional clusters and national reach will make it easier to offer advanced services such as high-speed Internet, digital cable and telephone.

But just as importantly, the stock-swap acquisition is a straight financial play. Roberts is taking advantage of the soaring value of Comcast shares, which is just as outsized as the price he is paying for MediaOne shares. Also, Comcast expects to substantially improve MediaOne's relatively inefficiently managed cable operations, whose 38% cash-flow margin falls far below Comcast's 48% margin.

Comcast readily acknowledges that combining the operations will generate $500 million-$700 million in lower expenses --in part by cutting 5% of the two companies' 34,000 workers.

The deal offers what Time Warner Inc. Gerald Levin characterized as a "psychodrama" over MediaOne's relationship with that company through its 26% ownership of Time Warner Entertainment. MediaOne Chairman Charles Lillis and Levin have long had a fractious relationship, but Time Warner suddenly finds itself with new leverage over its partner.

Levin last week was conciliatory, saying he was "a happy partner" with Comcast and didn't plan to use certain elements of the TWE partnership agreement to impede the MediaOne deal or squeeze concessions regarding TWE.

The deal could change Comcast as well. MediaOne has been fairly aggressive in deploying new technology, pushing hard on offering Internet and telephone services on its systems. The MSO has long been what Roberts characterized as "a close follower," preferring not to heavily invest capital until revenues are clearly in sight.

The company currently has no cable telephone operations and MediaOne's push could influence that position. However, Comcast management may wait until technology issues that could make telephone service much cheaper are sorted out.

Roberts said that subscribers and investors should expect Comcast to be in all those new businesses.

"This company is, in my opinion, a super-cap, growth, pure play broadband company," he said.

Lillis agreed, saying, "Neither of us would be able to do that as an individual company as well as we can do it together."

Lillis is to be vice chairman of the combined operation, but Roberts and his father, Chairman Ralph Roberts, are clearly in charge.

Roberts bragged that the merger gives Comcast strong local system clusters: half of the two companies' system portfolios overlap.

But the deal doesn't really create much in the way of new "superclusters." For example, MediaOne is already dominant in Boston, Atlanta and Miami. Comcast is big in Baltimore.

"They filled in the holes beautifully in Sacramento and Detroit, but in the top 30 markets I didn't see anything," said Bear, Stearns & Co. analyst Ray Katz.

Lillis and Roberts said that once their phone-venture talks shifted into a merger dance, it took less than three weeks to actually cut a deal.

Initially, the two cable operators had linked last December with Cox Communications Inc. to team up against AT&T as the long-distance carrier pushed to cut joint ventures with MSOs. The goal: to create a cable platform for telephone traffic.

AT&T got there part of the way by acquiring Tele-Communications Inc.'s 10.7 million-subscriber cable operation. But it needs alliances with many other cable operators to create a truly national telephone network to bypass onerous access charges levied by local phone monopolies.

The three MSOs watched Time Warner secure cash payments that could exceed $5 billion in exchange for allowing AT&T to run phone traffic over the MSOs' 11.9 million cable subscribers. By negotiating jointly, the three MSOs figured their combined 15 million subscribers would give them at least as much leverage at Time Warner.

The Cox agreement is still alive. But it was in those discussions that Roberts and Lillis say they realized they should do a bigger deal. As they studied how to present the combined systems for AT&T's consideration, Roberts decided to push for a merger. "I remember calling Chuck after one of those meetings and saying, "We've got to get married'," Roberts said.

Lillis has long been seen as a short-termer, with many industry executives believing that MediaOne--which was spun off from former telco parent U.S. West Inc.-would cash in quickly.

But MediaOne executives insisted that Lillis has for months spent his energy trying to buy, not sell. He approached Cox and Adelphia Communications Corp., but neither wanted to sell.

The numbers are staggering. The $60 billion price is $10 billion more than AT&T paid for Tele-Communications Inc. last month, largely because MediaOne has major non-cable investments. Analysts pegged the deal between 17 and 22 times cash flow, depending on the analysis. One year ago, major system groups sold for just 11 times cash flow.

But Comcast executives look at it a bit differently. Their stock has quadrupled in the two years since Microsoft Corp. seized investor attention by shelling out $1 billion for the company to jump-start deployment of advanced services. An adviser to Comcast said that rise has left the company trading at 17 times cash flow. "If you look at the cost savings, that's the same as the MediaOne valuation."

By using hugely "appreciated" currency--he disagreed at the suggested adjective "overinflated"-to buy MediaOne's equally "appreciated" stock, the deal is a wash for Comcast's shareholders. "Now we grow the business," the adviser said.

                              Comcast's Clusters  Market              Subs Mkt. [*] Market               Subs Mkt. [*]                    (000)    share                     (000)    share Miami                861      87% Washington            632      47% Springfield          157      79% Knoxville             140      46% Richmond, Va.        213      74% Minneapolis           331      44% Atlanta              804      70% Los Angeles           837      26% Fresno               183      70% Philadelphia          538      26% Jacksonville, Fla.   254      68% Hartford, Conn.       190      24% Sacramento           486      67% Indianapolis          150      24% Boston             1,067      63% West Florida          291      20% Baltimore            399      62% New York/New Jersey   689      15%   (*.)Percentage of cable homes in market Source: Comcast