Description

Recommendation: Short Diamond Sports 6.6% ’27 unsecured bonds at 95c. Base case price target of 80c with a chance at insolvency

Company Description: Diamond Sports is the RSN (Regional Sports Network) subsidiary of Sinclair Broadcast Group (NYSE:SBGI), created by the August 2019 acquisition the 21 FOX regional sports network brands that Sinclair bought from Disney (required by the DOJ to close the 21st Century Fox acquisition). RSNs are regional cable networks that pay sports rights fees to regional MLB/NBA/NHL teams for the rights to produce & broadcast games in their local market. RSNs generate revenue from affiliate fees from the pay-TV distributors (MVPDs e.g. Comcast, DirecTV, DISH, Charter) to put that channel in their bundle. Diamond holds sports rights from 43 professional teams (e.g. St Louis Cardinals, Cleveland Cavaliers, Detroit Redwings) and has 3x the number of subscribers (74M) as the 2nd largest RSN programmer (NBC Sports Nets).

Capitalization & Corporate Structure (Diamond debt is non-recourse)

Thesis: When Sinclair announced the acquisition of the FOX RSNs in May 2019, LTM EBITDA was $1.5bn (implying a 6.3x multiple), and the $10.6bn acquisition was financed with $8.2bn of debt (5.4x gross leverage, unsecured layer of 4.2x-5.4x) or ~80% loan-to-value. We believe Sinclair top-ticked the RSN business. In the last 8 months DISH Network (12% of Affiliate Revenue) dropped carriage of Diamond’s networks, while subscriber declines have accelerated from 1-2% to 4-6%. We believe Diamond 2020 EBITDA is now $960M (down 40%), which implies 8.9x gross leverage (unsecureds 6.9x-8.9x) and 8.5x net leverage, far through the TEV which we think in today’s environment is less than the 6.3x Sinclair paid. The unsecured bonds are out-of-the-money, yet trade at 95c and at a 7% yield. Based on other comparable TMT names that trade at high LTV, we think these bonds will de-rate to a 10% yield or ~80 cents as the market understands the magnitude of the EBITDA rebase and the worse than expected organic EBITDA trajectory.

1.       Dish Network dropped carriage of Diamond on 7/26/19, and we believe Dish is most likely gone for good. The Dish blackout happened during the peak of baseball season in Aug/Sept which has the vast majority of viewership (pre-playoffs). Importantly, Dish 3Q19 results showed little to no impact on subscriber churn, which highlights the poor value of RSNs

a.        RSNs are the most expensive channels in the Pay TV bundle ($/sub/month) even though only ~15% of households survey as being avid viewers. As cord cutting has accelerated, distributors such as DISH have made tough choices on what channels to carry vs. drop to remain profitable

b.       Given the live event nature of sports, passionate sports fans who care about the RSNs have already churned off DISH. A renewal would not make economic sense, given the remaining DISH customer base is likely ambivalent to local sports. DISH CEO Charlie Ergen’s comments on dropping Diamond are in Exhibit 5

c.        Sinclair Management recently told investors and gave forward guidance assuming DISH is off permanently. DISH is worth $415M of Diamond EBITDA or 26% of EBITDA

2.       We have a differentiated view on Diamond’s organic growth trajectory, which we think the market misunderstands. We believe organic EBITDA will decline at a negative HSD CAGR, contrary to management guidance of flat to LSD growth when Sinclair marketed the deal to creditors

a.        Industry-wide cord-cutting has accelerated by 200bps in 2H’19. For reference, 2018 pay-TV sub declines (including the benefit of virtual MVPDs e.g. YouTube TV, Sling) was -1%, and we believe -4% is the new-normal at best

b.       Diamond sub-declines will be worse than the overall industry because RSN channels are ‘tiered,’ which means Diamond also loses subscribers when one downgrades from a premium to basic package and drops expensive sports channels. This is known as “cord-shaving,” as Diamond still loses a sub although that sub remains a pay-TV customer

                                                   i.      This phenomenon is best exemplified by MSG Networks, the only publically traded RSN and rights-holder to the NY Knicks & NY Rangers, which has seen sub losses accelerate to -6.5% in CY2Q, -7% in 3Q, and -8% in 4Q

c.        On the expense side, the vast majority of costs are long-term (10-year +) sports rights contracts with built-in escalators. Given the low underlying operating cost of the RSN business and little to no variable costs, the RSN business model benefits from enormous operating leverage in good times, but accelerates EBITDA declines in bad times, as programming cost grow and no costs can be cut

3.       Another blackout, if only optically / temporary, could be the straw that breaks the camel’s back. The next major renewal will be Comcast in summer 2020

a.        We estimate Comcast represents 13% of affiliate revenue or ~$450M, which has full flow-through to EBITDA given no variable costs. Note: in Nov-2018, AT&T received an effective 12% step-down in affiliate fees (~$100M reduction to EBITDA). A similar step-down from Comcast would be a $50M hit to EBITDA

b.       RSNs are notorious in the media industry for being the worst return on investment of all networks, given exorbitant subscriber fees with very little viewership. Data suggest only 10-20% of households watch local sports, as the vast majority of subscribers do not care (note: local sports are very different from national sports e.g. NFL, world series, NBA playoffs etc). The legacy RSN business model has been to get people who don’t watch sports to subsidize those who do

Why does this opportunity exist?

1.       Lack of sellside coverage – No credit analysts have initiated / covered Diamond or published on the name since the DISH drop

2.       Poor disclosures that “hide the ball” with regards to RSN underlying EBITDA and FCF generation

3.       Despite Diamond’s existential risk, secular decline, and EBITDA re-base, creditors argue that Diamond still generates positive FCF. While true, FCF/Debt is < 5% now and at serious risk, while LTV is > 100%, so we believe the bonds are mispriced

Price Targets: Our base case is a 10% yield or 80 cents (16% downside). In the upside case, there is an additional distributor drop (Comcast renewal in summer 2020) and the bonds could be severely impaired as Diamond would revert to significantly negative FCF. In the downside case, the bonds could trade back to 104, which is where they were before DISH dropped carriage (+9% from here)

Catalysts: 1) More financial disclosure helps credit analysts get up to speed, 2) Diamond pays down Preferred Equity before debt, 3) sellside EBITDA estimates continue to decline, 4) cord-cutting worsens, 5) DISH stays blacked out, 6) poor renewals with other major MVPDs e.g. Comcast, 7) recession

Risks

1.       DISH comes back, similar to DISH re-engaging with Univision in 2018

a.        Mitigant: By dropping Diamond, DISH just saved $400M of EBITDA with little incremental sub loss. A new deal would have to come at a significant discount, as Ergen is incentivized to harvest FCF to invest in wireless. We believe such discount would be too difficult for Sinclair to stomach given most favored nation (MFN) agreements. Experts suggest DISH would most likely stay blacked out until retrans is up for renewal (we think Aug ’21)

2.       Successful “maintain the status-quo” renewal with MVPDs e.g. Comcast as SBGI retrans agreement is up Aug ’20

3.       Cord-cutting decelerates and improves i.e. 2019 was an abnormally bad year

4.       Diamond cuts costs and finds ancillary revenue streams e.g. political advertising, sports betting, OTT

Exhibit 1: EBITDA Bridge & Organic Growth

Note: most analysts haven’t caught the ~$60M cash management fee that Diamond pays to Sinclair for corp overhead costs, which we believe is a bogus add-back to EBITDA. There is also an additional “incentive fee paid to Sinclair for successful MVPD renewals,” which we believe could be payments to Sinclair for leveraging retrans and shielding the RSNs, another way to potentially siphon value from Diamond to Sinclair. Lastly, management/IR does not provide any details on how the tax shield is allocated between Sinclair and Diamond; we believe Diamond may need to pay Sinclair to use such tax shield

Exhibit 2: Industry Pay-TV Subscriber Declines

We went from a world with -3.5% traditional / -1% net (incl vMVPD), to now -7% / -4.5%. We assume the heavy DirecTV losses in 2H’19 were one-time and get lapped in the following year, such that cord-cutting normalizes, though that may not be the case

Exhibit 3: Charlie Ergen (DISH CEO) comments on dropping the Fox RSNs

DISH 3Q’19 Earnings Call (11/7/19)

Question (Analyst): When you look at the drop of the RSNs, I think you've sort of shocked the world, only losing 66,000 subs. Back of the envelope math, it looks like you just saved [$400M] annually, and you're only going to lose $20-plus million of EBITDA. It seems like a fantastic trade. I'm sure you'll lose some more subscribers as baseball season comes back, but this seems like it was a truly amazing decision. Am I missing anything? Or is this sort of, are you teaching the rest of the industry that RSNs aren't needed anymore?

CEO Answer:

·         The regional sports were mispriced. In regional sports, there's different zones and people in the cities tend to pay more for regional sports than people in the rural areas [note: DISH customers skew rural]

·         The biggest complication was that Disney themselves didn't extend [our RSN] contract. So we lost our best and highest value regional sports customers because the months of August and September are the highest viewed months for regional sports by a long shot. So to be down during that period of time, (Disney) thought that was negotiating leverage against us, but they actually did the illogical thing because we lost our best customers, and so therefore we couldn't pay as much money to put regional sports back up again.

·         We'd rather have regional sports, but we're not going to subsidize regional sports. And so there's economics that may not work for them (Sinclair), and we know what the economics are for us. We actually analyze stuff. We actually look at how our customers value regional sports. if everybody has regional sports and we don't -- and trust me, the vast, vast, vast majority of our customers don't watch a single second of regional sports in our network-- then that's an advantage for us if that's the strategy we have to go down because we won't have to increase prices to our consumers.

·         Even regional sports teams themselves will probably stream directly.

DISH 2Q’19 Earnings Call (7/30/19)

Regarding RSN drop

·         We offered a 30-day extension. And we have tried fairly hard. And frankly, I think we said it in the past, the model is broken. We've got real data. We've got real viewership. And it's an expensive gamut for us. So frankly, I and my team have made a recommendation to [Charlie Ergen]…the RSNs are just not a good deal. So the recommendation is actually to leave those RSNs off the service long term.

Catalyst

1) More financial disclosure helps credit analysts get up to speed, 2) Diamond pays down Preferred Equity before debt, 3) sellside EBITDA estimates continue to decline, 4) cord-cutting worsens, 5) DISH stays blacked out, 6) poor renewals with other major MVPDs e.g. Comcast, 7) recession