Sometimes, the easiest way to end a dogfight is to shoot one of the dogs. Today, proprietary TV viewing and programming technologies developer Gemstar International(Nasdaq: GMST) proved that point by agreeing to acquire TV Guide Inc.(Nasdaq: TVGIA) for $9.2 billion in stock and assumed debt. The move simultaneously wipes out years of patent litigation between the two companies while creating what could potentially evolve into an out-and-out monopoly in the emerging electronic program guide (EPG) arena.
To say the deal is a shock is an understatement, considering the history between the two companies. The litigation component is so old that it can be traced back to businesses with completely different names. StarSight Telecast (since acquired by Gemstar) originally sued United Video Satellite Group (now TV Guide). After the case was thrown out, TV Guide countersued with a patent infringement gripe of its own. Analysts had expected a short-term boost for both stocks upon a settlement; no one, it seems, expected the legal wrangling to give way to a friendly merger.
Making a merger an even more far-fetched possibility was the fact that TV Guide, in its former incarnation as United Video Satellite, had tried to acquire Gemstar for $2.8 billion in cash just last year. Gemstar eventually balked at the deal. Obviously, Gemstar's management knew that they were onto something good, as the company's market capitalization has zoomed to $9.4 billion from $2.1 billion in the 14 months since the TV Guide blow-off. Gemstar also gets to laugh last by turning the former acquirer into the acquisition target and by taking a majority 55% stake in the new company, which will do business as TV Guide International.
Gemstar's sky-high valuation took a hit today, however, as investors feared that the deal's steep price tag and some of TV Guide's business units will dilute Gemstar's future financial results and lean business model. However, the cash flow monster that will emerge from the combination looks impressive.
For investors smitten by firms with substantial "operating leverage," Gemstar is a dream come true. In fiscal 1999, the company reported an incredible net margin of 44% -- roughly equal to that of market margin darling Microsoft (Nasdaq: MSFT). Since the company's main business is licensing its VCR Plus+ and Gemstar Guide technology, traditional inventoriable costs are nonexistent. The main expense is selling and marketing, which represented 20% of revenues last year. General and administrative expenses were a low 13%, mostly because the company only has 200 or so employees and a ridiculously puny $2.7 million in net property and equipment on its balance sheet.
Shareholders' equity as a percentage of total assets is 73%, with accounts payable and deferred revenues and taxes the only major liability accounts. Return on average equity was 35% with zero leverage. Operating cash flow of $65 million, which was roughly equivalent to net income for the period, was mostly plowed back into $60.8 million in share repurchases.
Capital expenditures were a paltry $527,000, so this business is far from capital intensive. Compare that to TV Guide, which spent $3.4 million in cap ex last quarter alone, and it's easy to see why people are worried that today's news will end up packing on unwanted pounds to Gemstar's svelte business.
However, the opportunity for a full-scale monopoly in EPG could prove to be well worth the risk. TV Guide's strong ties to the cable industry will complement Gemstar's leading position in everything else, from TV and VCR makers to broadcasters to satellite programmers. It's not too far-fetched to imagine the combined company's EPG one day becoming a must-have portal for enabling interactive TV, with outrageous margins from dual licensing and advertising revenue streams. Investors wondering where TV is heading should tune in and take a closer look.
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