Description

Crown Media Holdings (CRWN) owns the Hallmark Channel (86 million subscribers) and the Hallmark Movie Channel (15 million subscribers, going to 25 million by the end of the year). The Hallmark Channel is the only Top 25 basic cable channel that is still independently owned; a media conglomerate controls every other one. It makes very little business sense for Hallmark to be independently owned (more on that later), so we expect a sale of the company within two to three years. To that end, we note that the CEO's compensation package encourages a sale. In the event of a sale, recent comps suggest a price ranging from two to six times the current stock price. In the meantime, the company is beginning to deleverage, and given its debt-heavy capital structure, the stock could more than double in the next two years from debt reduction alone.

The Hallmark Channel was formed about a decade ago as part of a partnership between a Christian programming group and Hallmark Cards. The Christian group still owns some shares, but the company is controlled by Hallmark Cards, which owns 63% of the stock through a holding company, and the overwhelming majority of the debt. Other major holders include JP Morgan and Liberty Media. Today, the channel targets women age 25-54 with a mix of original programming, television series reruns, and movies. As one might expect from the brand name, Hallmark Channel features programs with family-friendly, uplifting, wholesome themes. Unlike many basic and premium cable channels that compete for mindshare and viewership with original series (like Mad Men on AMC, or Rescue Me on FX) the Hallmark Channel devotes its original programming resources to one- and two-part movies and miniseries. Typically aired on Saturday night, when there is little or no high quality original programming aired by broadcast or cable competitors, Crown's movies define the brand and drive repeat viewership, with much less financial risk than investing in a series. The company licenses and broadcasts just under 30 movies each year, at a cost of about $1.5 million each. Over time, the number of movies should grow as CRWN is able to afford the investment in more original, high quality programming.

With 86 million subscribers, growing to 88 million by the end of the year, the Hallmark Channel is almost fully distributed in the United States. Top cable channels like Discovery and ESPN reach about 98 million homes. For several years now, the Hallmark Channel has ranked around #8 in primetime ratings, and around #11 in total day ratings, despite the fact that its top ten competitors have between five and ten million more subs than does Hallmark. The channel ranks highly in ad effectiveness, and is number one among all channels, broadcast or cable, for length of tune. The Hallmark Movie Channel has 15 million subs today, with plans to hit 25 million by the end of the year. The big leap in subs will occur whenever DirecTV launches its newest satellite. Unlike the Hallmark Channel, which is carried on basic or analog tiers, the Movie Channel is typically carried on digital tiers as part of premium content packages. The Movie Channel is most often sold as part of a "family tier" to cable, satellite and phone company IPTV subscribers. Crown licenses all content to be aired on both channels, allowing them to operate the Movie Channel at an incremental cost of less than $1 million a year.

Revenue has grown just under 20% a year since 2004, despite the loss of the company's license fee revenue stream from its film library, which was sold to RHI Entertainment (RHIE) a few years ago. In 2008, 20% of revenue of revenue was generated from subscriber fees, up from 7% in 2004. Since the Movie Channel does not generate subscriber fees we can take the $14.48 million in 4Q08 subscription revenue, apply it to the 86 million subs at the end of the year, and estimate that the company is being paid 5.6 cents per subscriber. Advertising revenue grew in 2008 but fell slightly in the fourth quarter of the year, due to the softness in the economy. Scatter pricing for advertising on the Hallmark Channel has held up well.

  

Crown Media Income Statement	2004	2005	2006	2007	2008
Subscriber fees	9874	18746	24869	27812	57153
Advertising Revenue	104481	143780	172950	205666	222967
Advertising by Hallmark Cards	1846	2335	1240	508	429
Film asset license fees	22035	21693	1815	--	--
Sublicense fees and other revenue	--	10830	305	378	1245
Total revenue, net	138236	197384	201179	234364	281794
Programming costs
Hallmark Cards affiliates	12	74	74	82	798
Non-affiliates	89866	120503	152119	164287	139900
Amortization of film assets	28905	51619	14739	-5220	-745
Impairment of film assets	22003	25542	225832	--	176
Subscriber acquisition fee amortization	26020	35928	31044	30996	--
Amortization of capital lease	96	1158	1157	1158	1158
Other costs of services	10939	20448	11273	11222	12492
Total cost of services	177841	255272	436238	202525	153779
SG&A	52209	55138	43968	61452	46605
Marketing Expense	16477	24160	16021	19733	19603
D&A	6306	4471	2865	1656	1932
Gain on sale of film assets	-	-	-8238	-	-
Income/loss from operations before interest expense	-114597	-141657	-289675	-51002	59875
Interest expense, net	-60179	-73880	-98728	-108144	-100157
Los before disc. operations and accounting change	-174776	-215537	-388403	-159146	-40282
Loss from disc. operations, net of tax	-142030	-10683	-	-	-
Loss/gain from sale of disc. operations, net of tax	-	-6538	1530	114	3064
Loss before accounting change	-316806	-232758	-386873	-159032	-37218
Accounting change	-	-	-2099	-	-
Net loss	-316806	-232758	-388972	-159032	-37218
FX adjustment	1421	-3434	-	-	-
Comprehensive loss	-315385	-236192	-388972	-159032	-37218
Shares	104533	104619	104788	104038	104776
Loss per share	-3.03	-2.22	-3.71	-1.53	-0.36

On the fourth quarter conference call, management indicated that the Movie Channel did $7 million in revenue for the year. Thus, we can estimate annual advertising revenue per subscriber for the two channels, recognizing that the exercise will be imperfect due to the Movie Channel's chunky growth pattern, as it added several million subs at a time more than once over the course of the year.

Channel	Total ad revenue = $222,967,000	Subs (millions)	Ad revenue per sub
Hallmark Channel	$215,967,000	86	$2.51
Movie Channel	$7,000,000	15	$0.47

Similarly, we can estimate subscription revenue per subscriber.

Channel	Affiliate fees	Subs (millions)	Affiliate revenue per sub
Hallmark Channel	$57,153,000	86	$0.66
Movie Channel	$0	15	$0.00

Comparing these numbers to those of other pure play cable networks shows the growth opportunity in front of Hallmark.

Network	Ad revenue	Subs (millions)	Ad revenue per sub
Scripps Network Interactive	$1,005,330,000	354	$2.84
Discovery Communications (US only)	$1,058,000,000	708	$1.49

Network	Affiliate fees	Subs (millions)	Affiliate revenue per sub
Scripps Network Interactive	$277,370,000	354	$0.78
Discovery Communications (US only)	$1,396,000,000	708	$1.97

In reality, there is more room for Hallmark to increase fees than these charts would indicate. The charts aggregate subscription and advertising fees for all the networks owned by these two conglomerates. That said, the Discovery Channel clearly gets more affiliate and advertising revenue per subscriber than Planet Green or the Science Channel, just as HGTV earns more than other Scripps properties like the DIY Channel. The Hallmark Channel, with its high viewership, is much more akin to the flagship channels owned by Scripps and Discovery than it is to the smaller, less profitable channels in those portfolios.

According to MultiChannel News, Scripps has begun negotiations with many of their distribution partners for the fees on the Food Network and HGTV. Citing SNL Kagan, a research firm, Multichannel News estimates that the Food Network generates eight cents a month in affiliate fees, while HGTV generates eleven cents. Industry speculation cited in the article suggests that HGTV's new fee could reach 25 cents per subscriber at the tail end of deals signed in 2009. Notably, both Food Network and HGTV charged zero fees until 2004. Given that the Hallmark Channel targets a similar demographic and receives more viewers than either HGTV or Food, there should be an opportunity for Crown to charge higher fees in a few years, when the current distribution agreements expire.

Capital Structure
 
The company has a highly levered capital structure. There are four notes outstanding held by Hallmark Cards and affiliates, a credit line with JP Morgan, and the common stock:

Crown Media Holdings	Capital Structure (in millions)
Senior secured note @ 10.5%	$686
Three junior notes @ LIBOR + 5.0%	$340
JP Morgan Credit Facility	$269
105MM shares at $2.28	$239
Total	$1.294 billion

The JP Morgan credit facility has been paid down from over $130 million a few years ago, and the company expects its value to fall further over the next year as the company uses ongoing cash generation to reduce debt and put some cash on the balance sheet for the first time in years. Other than this credit facility, the rest of CRWN's debt is held entirely by Hallmark Cards. Until November 2008, Hallmark had been allowing Crown to accrue the interest payments, adding them back to the principal of the loans. In November 2008, the two companies decided that CRWN's cash flows were sufficient to allow the company to begin making interest payments, adding up to about $22 million a year, on the three variable rate notes. Those payments have now begun.

The remaining senior secured 10.5% note matures in March 2010 and has an interest waiver agreement from Hallmark in place until March 2010 as well. You could argue that the stock price reflects the market's perception of near-term refinancing risk, but since CRWN went down to current prices along with every other company in America in February, it's unclear whether investors are focused on this concern. That said, for investors considering CRWN, the risk profile is meaningfully different from that of other companies with similar levels of leverage. In this case, it's Hallmark Cards, not a reeling bank or a CDO, that holds the debt. Hallmark founded Crown Media, owns about 63% of the stock, controls voting stock and the board, and has waived interest and extended maturity on the debt for well over five years as Crown has grown. Now that Crown generates enough cash flow to pay interest on the floating rate notes, it has begun doing so. Within a year to a year and a half, Crown should generate enough cash flow to comfortably pay cash interest on the senior secured note. It seems illogical to us to imagine Hallmark, a highly profitable company, abandoning Crown Media just as it's about to make the transition to being a company that can stand on its own two feet.

Hallmark can get liquidity on its investment in Crown Media in one of two ways. First, Crown can be sold to a major media company (see below), which would assume or pay off the debt and purchase the equity. However, we think it's likely that Hallmark achieves liquidity via a two-step transaction. First, sometime in 2010 or 2011, Crown Media should be able to refinance its Hallmark notes into a single credit facility with a third party lender. Just as Hallmark has guaranteed the JP Morgan line of credit since its inception, we would expect Hallmark to guarantee a third party credit facility in order to keep the interest rate owed by Crown manageable. As the majority equity holder, Hallmark would then have interests perfectly aligned with shareholders to maximize the value of the stock.

Regardless of how Hallmark achieves liquidity in its CRWN investment, the company's interest is to maximize the enterprise value of CRWN. We believe their interests are closely aligned with those of outside shareholders. 

Acquisition Rationale and Pricing

Before we explain why Crown Media should be sold to another media company, we should first explain why we believe it will be sold at some point in the future. The CEO, Henry Schlieff, previously grew the Court TV (now Tru TV) channel for Time Warner and Liberty Media, as Chief Operating Officer in the late 90s and then CEO from 1999-2006. After Time Warner bought out Liberty's interest in Court TV, Crown Media recruited him as their CEO. His compensation agreement calls for a salary of just over $1 million, a cash bonus, plus restricted stock units and stock appreciation rights that will be worthless until the stock price passes $9.43. However, he is also eligible for a transaction bonus as described below:

In the event of a change in control of the Company during the first year of employment, Mr. Schleiff will receive a transaction bonus of $6,000,000; provided that he stays with the Company or a successor company for 6 months. The transaction bonus will be increased by $1,000,000 for each succeeding year Mr. Schleiff remains employed with the Company prior to a change in control through the fourth year of the term, up to a maximum of $9,000,000.

We believe that the compensation agreement strongly suggests that the board views a sale of the company as the best way to generate long-term value. What's more, the company will be much more valuable in the hands of a true multi-channel operator than it could ever be on its own. A major media company could eliminate virtually all of the SG&A, and would have the leverage to demand affiliate fees between fifteen and twenty-five cents per month from cable and satellite companies. A new owner might also choose to pay upfront fees to cable operators for marketing support and subscriber acquisition for the Hallmark Movie Channel, in exchange for affiliate fees on that network. Even assuming no subscriber fees at the Movie Channel, the following brief model shows the earnings power of the business in the hands of a major media conglomerate:

Crown @ full earnings power
		Per sub	Total (millions)
Hallmark Channel	88,000,000
up slightly from $2.50 today	Ad Revenue	2.75	$242
15 cents/month	Sub Revenue	1.80	158
	Total		$400
Hallmark Movie Channel	25,000,000
up substantially from $0.47 today	Ad Revenue	$1.50	$37.5
	Sub Revenue	0	$0
	Total		$37.5
	Total Revenue		$437.5
Less	Programming costs		$154
Less	Marketing Expense		20
	EBIT		$263.5
	SG&A avoided		$60

Since these projections are post-synergy and post-price increases, they should have a low multiple attached to them.

Shares (in millions)	105
Net Debt (in millions)	1080
EBIT to an acquirer (in millions)	$264
Multiple	4	6	8	10
Equity value per share	-$0.21	$4.83	$9.87	$14.91

Happily, there are a lot of comparable transactions in the last decade to help us value Crown Media. Recently, cable companies have been acquired for $12 to $65 per subscriber and for EBITDA multiples above 20X, reflecting the opportunity for the same kinds of synergies and revenue increases described above. Significant variation exists, based on the maturity of the channel (number of subs), the structure of distribution agreements, and the quality of the channel's demographic reach and segmentation.

Comparable acquisitions
price and sub data in millions
Target	Year	Buyer	Seller	Value	Subs	Cash flow	Price per sub	Price to Cash Flow
Court TV (half interest)	2006	Time Warner	Liberty Media	$1470	86	N/A	$17.09	--
Sundance	2008	Cablevision	NBC, CBS, Robert Redford	$496	30	$175	$16.53	24.80
Fox Family Channel	2001	Disney	Fox/Saban	$5300	81	$150	$65.43	35.33
Weather Channel	2008	NBC, Blackstone, Bain	Landmark Comm.	$3500	85	$175	$41.18	20.00
Bravo	2002	NBC	Cablevision	$1250	68	--	$18.38	--
Oxygen Media	2007	NBC	Oxygen Media	$875	74	--	$11.82	--
Classic Sports (ESPN Classic)	1997	ESPN	Classic Sports	$175	10	--	$17.50	--
College Sports TV	2005	CBS	College Sports TV	$325	15	--	$21.67	--
Comedy Central (half interest)	2003	Viacom	Time Warner	$2460	82	--	$30.00	--

The average price per sub of these deals was $26.62, and the mean was $18.38. There are a number of reasons to suggest a valuation in the middle to high end of this range in any transaction involving the Hallmark Channel:

• A primetime rank of 8 and a total day rank of 11, consistent over the last three years.
• Hallmark Channel is already fully distributed, and Hallmark Movie Channel will have 25 million subs by year-end, more than some of the "emerging" networks in this chart.
• Very low subscriber fees in current deals (just under 6 cents per month in 2008) that can easily be tripled as part of a package negotiation by a media conglomerate. No subscriber fees @ Hallmark Movie Channel offer even more headroom for growth.
• Highly desirable demographic (women 25-54) drawn to uplifting content. Plays well everywhere between NY and LA but not in the major coastal markets.
• Stable advertiser base anchored by pharmaceutical and consumer packaged goods companies.
• Deals done before 2004 may not be good comps because industry affiliate fees were much lower than. Affiliate fees only go up over time, giving cable channels stable, rising, high quality, recurring revenues.

The company is currently valued at $15 per subscriber at the Hallmark Channel, ascribing no value to the 25 million subscribers at the Movie Channel by year-end. Assuming the following subscriber numbers and per-subscriber valuations in 2009, the company could be sold for a substantial premium to the current price.

Shares: 105,000,000
Net Debt: $1,080,000,000

Hallmark Channel subs: 88,000,000 (end of 2009)

Hallmark Movie Channel subs: 25,000,000 (end of 2009)

2009	Hallmark Channel Price Per Sub
		8	10	12	15	17	20	25	30	35
Movie	8	-1.68	0.00	1.68	4.19	5.87	8.38	12.57	16.76	20.95
Channel	10	-1.20	0.48	2.15	4.67	6.34	8.86	13.05	17.24	21.43
Price	12	-0.72	0.95	2.63	5.14	6.82	9.33	13.52	17.71	21.90
Per	14	-0.25	1.43	3.10	5.62	7.30	9.81	14.00	18.19	22.38
Sub	16	0.23	1.90	3.58	6.10	7.77	10.29	14.48	18.67	22.86
	18	0.70	2.38	4.06	6.57	8.25	10.76	14.95	19.14	23.33
	20	1.18	2.86	4.53	7.05	8.72	11.24	15.43	19.62	23.81

If a sale doesn't occur until the end of 2012, we make the following assumptions about acquisition prices.

Shares: 105,000,000
Net Debt: $980,000,000
Hallmark Channel subs: 93,000,000
Movie Subs: 42,000,000

 

2012	Hallmark Channel Price Per Sub
		8	10	12	15	17	20	25	30	35
Movie	8	0.95	2.72	4.50	7.15	8.92	11.58	16.01	20.44	24.87
Channel	10	1.75	3.52	5.30	7.95	9.72	12.38	16.81	21.24	25.67
Price	12	2.55	4.32	6.10	8.75	10.52	13.18	17.61	22.04	26.47
Per	14	3.35	5.12	6.90	9.55	11.32	13.98	18.41	22.84	27.27
Sub	16	4.15	5.92	7.70	10.35	12.12	14.78	19.21	23.64	28.07
	18	4.95	6.72	8.50	11.15	12.92	15.58	20.01	24.44	28.87
	20	5.75	7.52	9.30	11.95	13.72	16.38	20.81	25.24	29.67

Readers can make their own judgments about the appropriate price per subscriber at which Hallmark will be sold, and when a sale might take place. Even if we value Hallmark Channel far below the median and average prices of the last few years, and value the Movie Channel below any precedent transaction, the stock appears undervalued today. For a highly levered company like Crown, there appears to be a strong margin of safety, thanks to company's affiliation with Hallmark, the high ratings of the Hallmark Channel, and the strong growth in cash flow and revenue that should continue over time.

 

Catalyst

Sale of the company to a larger media company.

Deleveraging over time.

Completion of a credit agreement with a disinterested third party lender.