PARAMOUNT COMMUNICATIONS/VIACOM CASE STUDY

In Sept. 1993, Viacom agreed to purchase Paramount Communications for stock and cash. Viacom, a media conglomerate controlled by Sumner Redstone, was the owner of cable services like MTV, Nickelodeon, and Showtime, cable systems, broadcast stations, and television and production divisions. In what appeared to most analysts to be a good fit with Viacom, a combination with Paramount would contribute a leading producer and distributor of motion picture and television programming, a book publisher (Simon and Schuster), more cable channels, more television stations, and two sports teams. Particularly attractive to Viacom was Paramount’s’ extensive library of past movie and television hits as well as access to the future output of Paramount’s film and television studios.

Viacom was competing in this merger against Barry Diller of Fox Network and QVC Home Shopping service. Viacom, in an effort to strengthen its offer, Viacom merged with Blockbuster Entertainment. That merger was scheduled to close shortly after the successful acquisition of Paramount.

At the time Viacom was able to purchase, for cash, 50.1 percent of Paramount’s shares outstanding. Although the contest was over the opportunity to profit from the merger had only begun.

What wasn’t so formal was the method of payment for the remaining 49.9 percent of Paramount. While cash was the sole from of payment for purchasing the first half of Paramount’s stock, practically everything except cash, was the form of payment for the second half of the merger—known as the back end of the merger. The back-end payment for each share of Paramount consisted of:

• Viacom common stock

• Exchangeable subordinated debentures of Viacom

• Securities known as contingent value rights or (“CVR” one for each share of Viacom stock received in the merger),

• Three-year warrants to purchase Viacom common stock at $60 per share, and

• Five-year warrants to purchase Viacom common stock at $70 per share.

The vast majority of Paramount shareholders were interested in owning the shares of an entertainment conglomerate or the stock of a takeover candidate. While the Viacom common stock might have been of interest to some of these shareholders, the exchangeable debentures, the CVR and the two types of warrants were going to be sold—without looking at the proxy document and without regard to their true value (They sell without economic reason).

The Viacom stock issued to the public as part of the merger consideration would nearly triple the supply of Viacom stock in public hands.

What is all this stuff? It was answered in “Paramount Merger Consideration”.

Combining the purchase of one share of Viacom common stock with the purchase of one CVR created a unique investment opportunity. The CVR was a security issued by Viacom to help guarantee the value of the back-end securities that Paramount shareholders were to receive in the merger. It was probably this guarantee of value by Viacom that was responsible for its victory in the bidding war over Paramount.

The CVRs worked this way: If Viacom common stock traded below $48 one year after the completion of the Paramount merger, Viacom would make up the difference through a payment to holders of the CVRs. (E.g., if Viacom stock traded at $44 on the one-year anniversary of the merger’s close, Viacom would pay $4 for each CVR; if Viacom traded at $38 Viacom would pay $10 for each CVR.

By purchasing one CVR for each share of Viacom he owned, an investor could ensure that the combined value of the two securities would be at least $48 in one year. If Viacom traded higher than $48 –let’s say to $55— then, although the CVR would be worthless, the combined value of the two securities would be $55, even better than the guaranteed $48 price. Since, shortly after the merger was completed, one CVR and one share of Viacom stock could be purchased for a combined price of $37, a guaranteed price of $48 in one year looked pretty good—a 30% annual return with little risk and no upside limitation.

Viacom limited the payout on the CVRs to a maximum of $12; even so, Viacom stock could fall to $25 before an investor who bought both the CVR and Viacom stock for a combined $37 would lose money. For another, Viacom could extend the payment date of the CVR—but only in exchange for a payout larger than $12. I simply read the page in the proxy that told me how they worked. However, I did have an advantage in all this. It pays to check out merger securities!

The five year warrants to buy Viacom stock at $70 per share, looked particularly interesting. These warrants gave the holder the right to buy Viacom stock at $70 per share for a period of five years. Since Viacom stock was trading at about $32 per share in July 1994, the right to buy Viacom stock at $70 didn’t look too enticing. On the other hand, with this type of situation, I like to think about the old story of the peasant who is brought before the king and sentenced to death. A lot can happen in a year.

The five year warrants gave the holder the right to buy Viacom stock at any time during the next five years for $70. In the case of an ordinary warrant, this could mean that the warrant holder was entitled to receive one share of Viacom common stock in exchange for $70 in cash. The $70 could be paid in cash—and there was nothing unusual about that. However, the $70 could also be paid with $70 in face value of one of the other Paramount merger securities. Which merger security? The exchangeable subordinated debentures I mentioned earlier—item #2 on our list.

Shortly after the Paramount merger was completed, these merger securities were trading at 60% of their face value. This meant I could buy $70 of face value of these securities for only $42 (60% of $70). I would effectively have the right to buy Viacom stock not for $70, but only $42 worth of merger securities. I would have this right for five years. Viacom was at $32. The right to buy stock at $42 for five years was a lot more valuable than the right to buy stock at $70. If I hadn’t read the portion of the proxy covering merger securities, there was no way I could have known this opportunity existed.

Buying both the warrants and debentures was a winning trade.

Remember to read the proxy of merger securities. (end of book section) PARAMOUNT – Page 12.

This is the back-story to the example in the book, (You Can Be a Stock Market Genius). The Paramount situation was a hostile battle for control of Paramount back in 1994. What eventually happened was two sides bidding for Paramount and they ran out of money, so they threw out pieces of paper. Different rounds. The

winner of Viacom--they would buy half your stock in a tender offer 51% for cash and then give you all that stuff that they didn’t have on the back end. Part of the deal happened in cash, then give you paper on the back end.

It really was one of the most complicated deals ever. They didn’t have value to give. The front end was done —Viacom bought 51% of Paramount for cash—then you had the clean up 3 or 4 months later. This proxy came out in 1994. This was no longer on the front page. Look on page 12—this is what you were getting in the pack end of that deal.

.93065 of a share of a leveraged company (Viacom B Stock). Viacom bought a company bigger than itself.

Viacom traded at $28 5/8 before this battle it was at $34 and change. The stock gets pummeled because they are issuing millions of shares of stock and they overpaid, the winners curse.

Then you get $17.50 of 8% subordinated debentures of Viacom. They are exchangeable and subordinated.

There is plenty to trade here.

.93 for a contingent value right (CVR)

.53 of a three-year warrant. The difference between a warrant and an option? They work the same way, but

with a warrant the money upon exercise goes back to the company. The stock has to double within3 years.

.3 of a five-year warrant.

When issued trade: if the event occurs.

CVR: $48 & mkt. price. At $28. Not >$12. If $26 ---$48 = $12. $51 second date. $55 third date.

If you are a mutual fund—you don’t want the junk on the back end. There will be selling—so this presents an opportunity. I will describe what a CVR is. It is an interesting security. This is complicated stuff. What is this CVR?

Well if you looked at the table of contents of the proxy—so you go and read what a CVR is. Turn to page 13 or 14. The basic jist is: listen, if our stock is not at $48, but at such a time—two years out—we will pay you the difference of the market price and $48. But they will not pay you more than a maximum of $12. So at $36, the CVR will be paid off at $12 and if Viacom is at $40, then ($48-$40) $8 will be paid to the CVR holder. CVR guarantees the $48 price unless below $36.

We can extend the CVR, then it is at $51, then next at $55.00. Such an amount of $12 can be paid at the discretion of Viacom. What does that mean? This means you will get 85 cents to 95 cents on the dollar. Wall Street speak means that they will screw you in the end. A euphemism.

So when you do your margin of safety analysis you need to account for the haircut.

Then again, this presents an opportunity of buying Viacom and if you are bullish on Viacom and this CVR is trading at $3, then for $31 5/8 you will have some security. Let’s say you buy 1.5 CVRs for every share you buy of Viacom, then at $33 you have the upside above $33 but the downside is covered. This was unique to this deal but every deal has unique aspects.