The story of Tele-Communications, Inc. (TCI) is one of the most fascinating tales of shareholder wealth creation that you’ll hear. It is also the story of the rise of one of the most renowned owner-operators, John C. Malone.
If one would have invested $100 into TCI in 1973 when John Malone joined the company as CEO and mimicked the participation of Malone in all spin-offs and splits that occurred until TCI was acquired by AT&T in 1999, said person’s investment would have appreciated to $181,200.
Much like the history of the cable industry in general, the origin and early history of Tele-Communications, Inc. is nothing but fascinating. It’s founder, Bob Magness, was a cotton seed salesman as well as a cattle rancher. In a chance encounter in 1956, Magness gave two men a ride, who were stranded while installing a community antenna system.
At the time, there were three national television broadcasting networks in the US, NBC, ABC and CBS. However, as they were broadcasted Over the Air, many areas were out of reach for the broadcasts. Sensing the immense consumer need, entrepreneurial minds in those areas, started setting up antennas in high grounds where they could receive the broadcasts and then selling services whereby they would draw cables from the antennas, all the way to the customers home.
Wasting no time, Bob Magness sold his cattle, took out a mortgage on his home and borrowed $2,500 from his father and invested the proceeds into building a system in Memphis, Tennessee. After working tirelessly on the system for two years, laying the cables himself, while his wife manned the office, Magness sold the Memphis cable network.
Tele-Communications, Inc. (TCI)
A short while later, he was already invested in what would become TCI. Moving his family to Bozeman, Montana, Magness became the main investor and operator of 6 cable systems, through two companies under overlapping ownership: Community Television Inc. and Western Microwave Inc.
In 1968, the two companies merged under the name Tele-Communications, Inc. and in 1970 the company went public. At the time of the IPO, the company had grown from 12,000 subscribers in 1958 to close to 100,000 subscribers.
Investing in antennas and laying cables to customer’s homes requires capital expenditures and from the beginning, the cable industry has been reliant on funding through debt issuance. Cable subscriptions provided stable cash flows but growth required consumption of significant capital.
By 1972, Bob Magness was exhausted. Creditors had become uneasy with the burgeoning debt load of the company and he realized that he might not be as well suited to the role of a CEO of a public company. It was time to find someone who could.
Enter John Malone
In 1967 John Malone stood in front of the AT&T boards and presented a mathematical economic treatise of his, somewhat prophetically named Profit Maximization in a Regulated Firm.
A few years earlier, after graduating with honours from both electrical engineering and economics from Yale, Malone had pragmatically looked for opportunities where he would be able to continue his studies while getting paid. He found that opportunity at AT&T’s Bell Labs. By the time he presented to the AT&T board, he had already earned a Master’s and Doctorate’s degrees in Operational Research and Computer Science.
According to Malone, after the presentation, the Chairman of AT&T put his arm around his shoulder and said “son, this was great, it gives you a lot to think about. But let me give you one word of advice. If there is anything you do in your career that changes the course of the Bell system, you will have really done something”. Realizing then and there, that AT&T was not the fast pace environment that he was looking for, Malone started looking for his next job.
After a two year stint with management consulting firm McKinsey & Company, Malone accepted a job proposal at one of his clients at McKinsey and went to work for General Instruments. There, he got his first brush with the cable industry. After losing a fight for the vacant CEO position of GI, Malone moved to a subsidiary of GI, Jerrold Electronics. At Jerrod, he first met up with Bob Magness.
Cable Center Oral History with Tryg Myhren:
Jerrod was at the time, one of the biggest technical equipment suppliers to the growing cable industry. Malone has joked that, at the time when he arrived, Jerrod’s accounts receivable to the cable companies was bigger than the cable industry’s entire market cap. What Jerrod was actually doing, was factoring the receivables to various financial discount houses.
There is a funny story about the time the first time Malone met Bob Magness. Jerrod was by then the third-biggest owner of cable systems in the US and Magness was interested in acquiring them. The only problem was that he was severely cash-strapped.
When Malone told Moses Shapiro, the Chairman of General Instruments at the time, about TCI’s interest in acquiring Jerrod’s cable systems as well as his opinion that they could most likely squeeze a higher price out of “this guy Magness”, Shapiro retorted: “Yeah, but I don’t want any Portuguese Escudos. I want coin of the Realm…Cash.”
On April Fool’s Day in 1973, John Malone started working for TCI. Malone had already turned down two jobs while working at Jerrald’s but after a few months of courtship, Malone came aboard as President and CEO of the company. He took a 50% pay cut and committed himself to invest a significant amount of his net worth in TCI stock.
Keeping the Boat Afloat
By no means was John Malone dealt a good hand when he was handed the reigns at TCI. Bankers and other creditors upped the ante in their efforts to collect and the TCI stock started to slide as the cable industry had overextended and sentiment on the grew more pessimistic.
According to Malone, things got pretty close during those years. Malone has joked that in the first two years at TCI, he spent half of his time in New York “getting beat up by the banks” and the other half of his time, meeting with city officials and reneging on commitments TCI had committed to for cable licences.
Throughout 1973-1977, TCI was literally “borrowing from Peter to pay to Paul” and implemented every measure to keep operating licenses while evading a liquidity event with creditors. The industry, in general, was suffering from its dependency on the national broadcasters for content as the regulatory framework gave the broadcasters little flexibility to provide their own programming content.
The turning point came with a combination of wins that hit the industry almost simultaneously. A loosing up by regulators, granting the cable companies more freedom to produce content, a permission to by the regulators for cable companies to use smaller receivers and the arrival of HBO to the scene, all worked in favour of the cable industry.
After this inflexion point, with TCI in a much better financial position and an improved operating environment for cable companies in general, what followed was more than 20 years of continuous wealth creation for TCI shareholders.
Over the course of that period, Malone developed business strategies along with financial engineering tactics, aimed at squeezing out every basis point of return that he seemingly could for its owners. Tactics and plays that Malone implemented at TCI, have later been repeated by him in other ventures, such as the Liberty companies, Charter Communications, Discovery Entertainment and Qurate.
To some extent, Malone had bet on the right employer. Bob Magness was not particularly interested in short-term earnings and since he held the majority of votes, TCI was undoubtedly freer than the average public company to sacrifice short-term earnings for long-term wealth creation.
As a result, TCI never paid dividends during its entire existence and redeployed all its cash flows back into the business. What follows is a short summary of the main strategies used by John Malone in his quest for long-term wealth creation at TCI:
1. Scale Economics
From the get-go, it was clear that the cable industry had inherent scale advantages. Being big would give the operator power to enjoy greater unit economics from buying programming than smaller counterparts as well as equipment.
In that sense, Malone was in favour of horizontal acquisitions. His argument was that in horizontal acquisitions, the synergies he could get were material. You could reasonably estimate the direct savings you could squeeze out by combining two cable systems, especially in terms of overhead costs.
2. Prizefighter Strategy
In its effort to build scale, TCI deliberately avoided bigger cities and focused on rural areas and tertiary cities, where there was much less competition for cable licenses and city officials had lower expectations in terms of commitments required to those licenses.
Once TCI had the resources to do so, it made it its mission to consolidate a fragmented industry. At a certain point, TCI was doing on as much as one acquisition per day on average.
This approach was incredibly savvy. There were many instances of parties overbidding for cable licences in large cities and in most cases the victors would suffer the Winner’s Curse by overpaying for the contracts.
3. Strategic High Ground
Although Malone preferred to scale horizontally, it did not stop him from investing vertically as well. Vertical investments, however, followed a totally different logic. Whereas investments in cable systems were aimed at lowering unit costs and leveraged by debt to minimize cash outlay, investments elsewhere in the value chain were normally part of a negotiation process.
Once TCI reached a certain scale, their bargaining power over networks and other content providers grew. For a cable network to operate profitably, it needed to reach around 10 million homes. This meant that a big cable operator such as TCI could basically make or break a new network.
TCI used its bargaining power to negotiate for shares in the networks. This was often done in collaboration with other cable operators, as even though the cable companies were competitors, they each controlled their own areas and hardly ever competed directly within a given area. The only exceptions were if they were competing for licenses or acquisitions of cable systems.
4. Tracking Stocks and Spin-offs
Malone reintroduced the use of tracking stocks for public companies. A tracking stock tracks the performance of specific assets within a corporate entity, even though the assets being tracked, share the same balance sheet.
The use of tracking stocks gives shareholders the option of selecting assets within the company and is useful if the underlying operating economics of the separate units vary to some extent. During the acquisition of TCI by AT&T, Malone argued for AT&T to adopt a tracking stock structure.
While AT&T stockholders measured AT&T by its earnings and dividend rate, TCI had never reported positive earnings, never paid out any dividends and was not likely to do so in the future. A tracking stock would allow investors to measure and analyse each tracking stock by its own underlying operating characteristics while enjoying the benefits of a combined balance sheet.
Often, the creation of a tracking stock was the prelude of a spin-off. A spin-off allows a company to distribute shares of the spun-off entity to its shareholders in a tax-exempt manner. Malone has used spin-offs repeatedly throughout his career.
5. Tax Efficiency
Malone’s tax mantra was that the government was your partner and as such, you should do everything to keep it in the partnership as long as seemingly possible. For a long time, Wall Street analysts did not understand the cable companies. Despite years of growth, the company never seemed to report profits in its financial reports.
Malone used every means available to defer tax payments:
- The cable systems were depreciated faster than the capital expenditures required to maintain them. This meant that even if the operations where generating free cash flow, the reported earnings where negative.
- Interest payments are deduced as costs on the income statement. As the capital structure of the cable companies was debt-heavy this worked to lower net profits.
- If the TCI wanted to dispose of assets with would do so in a tax-efficient manner, for example through tax-exempt spin-offs to shareholders or by using them as currency in asset swaps for assets the company desired.
- Tacking equity from content suppliers instead of recognizing revenue from distribution agreements.
A Fundamental Finance Prototype
In many ways, the TCI story is the story of what it means to be a Fundamental Finance oriented investor. The behaviour of TCI and its operators, Magness and Malone, showed all the characteristics that you would want to see from an operator. Not only did they operate the company well, they created wealth through various ways of allocating capital profitably.
Malone and Magness never really cared about showing positive earnings to shareholders. Their focus laid solemnly on designing ways by which they would maximise the wealth of TCI’s shareholders. This meant allocating capital in a tax efficient way to the channels where they would reap the highest returns.
They focused on cash flows as opposed to accounted earnings as an owner-operator of a private company would do. In addition to this, they utilized all levers available to them to create value. By not limiting themselves to operational matters, they used financing, acquisitions and disposals to opportunistically manage the companies capital.