John Malone, the visionary cable maverick who built Tele-Communications Inc., has never made a secret of his loathing for government regulation. He alluded to that obsession Wednesday in explaining to Wall Street analysts the merger of his company in a complicated $46-billion transaction with AT&T.;
He told them he worked at the telephone giant early in his career and when he left in 1966, at age 25, he recommended the company figure out a way to reduce its huge tax bill.
Now, Malone has figured out a way to take advantage of that tax rate for himself and Liberty Media Corp., the programming arm of TCI that he will continue to control if the deal is approved by shareholders and regulators.
Malone's top priorities were to retain TCI's valuable programming assets while selling the cable operations and certain related interests to AT&T; without incurring a huge tax on the $5.5 billion in cold hard cash that was part of the purchase price. Generally, a seller of an asset must pay the IRS taxes on the profits, or capital gain, from a sale.
Malone accomplished both his goals by drawing on a relatively obscure financial vehicle called the tracking stock. And their use in the proposed TCI-AT&T; merger is one reason the deal is convoluted, difficult to follow, and disliked by investors in AT&T.;
Tracking stocks are used mostly by large companies with discrete operations that have varying growth rates and risk levels. Companies such as US West and General Motors Corp. have issued such stock to remain attractive to their core investors after buying into new and riskier businesses. For instance, when US West bought into cable, it separated those debt-heavy assets from its prosperous and predictable phone operations by issuing a new stock that tracked only their performance.
Malone is a master of the tracking stock, having created them at TCI to track the performance of its distinct operations such as programming and high-tech ventures.
But his application of the concept in the proposed deal with AT&T; may be the most unusual to date. Under the deal, AT&T; will technically own Liberty Media, but John Malone will control it through the use of the tracking stock.
"It's a new design; we are in unexplored territory," said Robert Bennett, the president of Liberty. "It's unusual to have a tracking stock in which the shareholder controlling the assets is not the corporation of which it is a wholly owned subsidiary."
Better yet, from Malone's point of view if not the taxpaying public's, retaining Liberty as a tracking stock allows it to receive $5.5 billion from AT&T; without paying taxes on it. The payment is for Malone's controlling interest in the @Home online service and a chunk of AT&T; stock received from an earlier deal. The transaction is tax-free because assets can be shifted from one tracking stock to another within a corporation.
Although AT&T; will not have any economic interest in Liberty, Malone said he will make investments that will ultimately help fuel the phone company's new cable and Internet businesses. And in the ultimate nose-thumbing to the government, Malone has struck an agreement with AT&T; under which he can take advantage of the telephone company's heavy taxes and draw upon the IRS to underwrite his future growth.
Under the pact, AT&T; has agreed to pay back to Liberty any taxes it saves the phone giant by investing in startup enterprises that lose money. That would mean that every $100 Liberty invests in a money-losing business would reduce AT&T;'s tax bill by $40 and reduce Liberty's costs to $60.
"Our investments would be subsidized by the IRS, through AT&T;," bragged Bennett.
Malone has made a career of turning money-losing propositions into valuable enterprises. Neither TCI nor @Home makes a penny, though the cable company generates a huge cash flow and both have the promise of breaking even.
In announcing the deal, Malone compared the new Liberty with GE Capital, a vehicle General Electric has used to generate tax losses and shelter income.
Bennett said Liberty would look to invest in businesses with growth potential such as Internet programming startups. Financing the equipment costs such as an advanced set-top boxes needed by the cable industry is another objective of Malone's.
Malone has pushed for the convergence of cable and Silicon Valley, resulting in the advanced set-top box finally being close to a reality. The trouble is it will cost roughly $350 a home, and the cable industry is loath to buy them outright for fear of loading up their already debt-laden balance sheets.
"Cable companies don't need the losses but we do," said Bennett, who said Liberty could help speed the rollout of the boxes and thereby help its programming assets and AT&T;'s ability to charge higher prices for new cable services.
"Investors are going to get another chance to ride the amazing John Malone," said Brian Roberts, chief executive of Comcast Corp., the nation's fourth-largest cable company. "The new structure of Liberty is looking like the best of Warren Buffett and GE Capital."
Liberty is one of two tracking stocks that will result from the deal. In addition to issuing a new tracking stock to existing shareholders of Liberty Media, which owns stakes in cable channels such as QVC, Discovery and BET, AT&T; will create another to track the performance of the cable, online, long-distance and wireless operations of the company, under the banner AT&T; Consumer Services.
The structure is intended to satisfy the risk-oriented investors of TCI, whose value is in the promise of future earnings and today's huge cash flows.
The stock will not reflect the performance of the company's business services group, a predictable dividend-oriented operation that provides networking to 15 million corporate customers worldwide.
But the structure has upset many traditional investors of AT&T; interested in its low-risk predictability. While risk-oriented investors would have a discrete tracking stock to satisfy their needs, the current AT&T; shares would reflect the performance of both the consumer and the corporate businesses, disenfranchising investors looking for stability.
Indeed, some institutional investors are bailing out of AT&T; stock on concern about the extent of future earnings dilution from the acquisition of TCI on the existing stock. AT&T; concedes that earnings will face dilution for up to three years.
AT&T; shares continued to slide on Thursday, losing $1.63 to close at $58.38 on the New York Stock Exchange, bringing the two-day decline to 10.7%. TCI Class A shares lost 50 cents to close at $39.25 on Thursday on Nasdaq.
What's more, major investors in coming weeks expect to give AT&T;'s investment bankers an earful about the proposed structure of the deal. Many of those investors want the planned AT&T-TCI; consumer business unit to be substantially distinct from the rest of AT&T;, so that the cash needs of that business don't weigh down the more profitable corporate-customer lines of AT&T.;
AT&T; is proposing to create a separate tracking stock to represent the consumer unit, just as Liberty would have a tracking stock. But AT&T; has not been specific about how much of the consumer business would effectively be spun out to tracking-stock holders, and how much of an economic interest would be retained by the parent.
"That's still an open question," an AT&T; spokeswoman said.
Tracking stocks typically offer investors a way to bet on the fortunes of a particular corporate unit, while the parent company retains ownership of the unit.
But with the AT&T-TCI; consumer unit unlikely to be a bottom-line earnings story for some time, its effect on the parent AT&T; stock could be a drag near-term.
Thus, "the cleaner the split, the easier it will be for people to treat [the stocks] differently," said Warren Lammert, a portfolio manager at Janus Funds in Denver.
In the meantime, with so many uncertainties surrounding the deal, some investors are opting to simply exit AT&T; stock.
"The sellers are saying, 'Maybe I'll just wait till you're done punching me in the face' " with earnings-dilution concerns before reconsidering the stock, one institutional investor said.
Times staff writer Tom Petruno contributed to this report.