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Short EI Towers (EIT IM) – Concentration Risk Reminder

For those of you who remember the hard-learned lesson of customer concentration risk from LookSmart, the one-time high flying, $4bn Enterprise Value search advertising solutions company, that one day abruptly announced that Microsoft was exiting their JV, and as a consequence, 80% of its revenues would immediately evaporate, I would like to present a very different company that I believe will re-teach the lesson in a similarly dramatic fashion in the near-to-mid-term.  (Today you can find LookSmart looking a little bit less than smart, still trading on the Nasdaq, but with a market capitalization of $9.8mm and $9.2mm of cash, or essentially a zero enterprise value).

Across the ocean, there are interesting parallels that ultimately will, in my view, be the straw that breaks the back of stock market darling EI Towers, that I am compelled to write it up in an effort to convince VIC readers I am worthy of “reactivation”.  It is with a slightly heavy pen that I write this, because as you may notice, I was the author of a very bullish write-up on DMT several years ago, the predecessor Company to EI Towers, and a long-time holder of both shares (for which I profited tremendously and am grateful).  But for the reasons I will outline below, I think it has become “unignorable” that EI is not much more than an ugly pig disguised as every Anglo-Saxon investor’s dream: a long-lived infrastructure asset with industry growth, tremendous contract visibility and the other bells and whistles that get us excited.  However, in this case, the fact that it’s majority shareholder Mediaset (controlled by former Prime Minister Silvio Berlusconi who was recently condemned for fraud and sentenced to prison) from whom it derives 80% of its revenues, will have a massive domino effect for EI Towers.

EI Towers, the result of the merger of DMT and Elettronica Industriale, boasts a portfolio of  predominantly broadcasting towers covering Italy.  The business model is quite similar to the tower businesses in the US, with attractive long-term contracts, significant operating leverage, and a bonus of CPI growth every year serving as a nice inflation hedge. The shares have been viewed predominantly by the Anglo Saxon investment community as a clever way to get access to the unaffordable business model publicly traded tower operators in the US (AMT, CCI and SBAC) which trade at twice the optical valuation of EI Towers. 

But at 11x EBITDA, an EBITDA figure that is comprised 92% of very poor to insolvent payers, the valuation appears VERY bloated.  To put detail to that figure:

1)    Roughly 80% is comprised of EBITDA is comprised of its contract with parent company Mediaset which has been hemorrhaging audience share every year for the last ten years, and has already cut costs to the bone in an effort to offset the 20% step change in revenue (which is accelerating – more on that in a moment) tied to practically irreversible audience share and therefore advertising trends.

2)    Another 12% of EBITDA stemming from small, distressed Italian broadcasters who are largely already bankrupt.  It is worth noting that this year EI Towers allowance for doubtful accounts jumped from €0.6mm to €9.3mm reflecting the reality that roughly half of their small broadcasting customers are unable to make payment; I believe that figure will ultimately increase even further as it represents just over 50% of the struggling independent content provider segment (“With reference to clients with lower credit standing, in particular local television operators and new operators in Wi-Fi and Wi-Max technologies, the real-location of frequencies for the migration to digital broadcasting for the first and the need to invest for the realization of the network for the latter, in an uncertain market scenario, impose on the Group a monitoring of commercial counterparts and a focus on working capital management.” Excerpted from Annual Report)

If we assume I am entirely prescient and all of the above is perfectly accurate, we are paying 138x EBITDA rather than 11x. I am certainly not prescient, but I do believe I can add significant muster to the critical elements of the stated thesis such that the implied sustainable EBITDA is so materially different than the market’s perception, that the risk/reward to the short becomes very apparent and highly compelling.

To highlight the tremendous disconnect between exuberant investor sentiment and EI’s terminal customer concentration risk, not only is EI Towers is trading at all-time highs but recently refinanced all of its maturing bank debt with a 12 times oversubscribed high yield offering at 4% subscribed predominantly by German and French investors (note: as EI is consolidated in Mediaset’s balance sheet, and Mediaset, undergoing its own renegotiations, to be detailed below, forced EI to go to the capital markets to roll-over its maturing bank debt.)

So, Clear that EI has some pretty sizeable issues that the market appears not to be factoring in, but how should we handicap the Mediaset situation given that Mediaset will ultimately be the largest factor in EI hitting the proverbial wall?

Reasons Why Mediaset Terminal Solvency Issues are Closer Than the Investment Community Thinks:

1. Macro Positioning:
   1. Advertising in Italy: While Forecasts all call for television advertising recovery on a country level within the next two years, I think it is important to note that the steep decline in TV directed spend (58% of advertising dollars directed to television in 2010 declined precipitously to 54% in 2012) has in fact been an ongoing eleven year trend suggesting that TV advertising is not in cyclical but in structural decline in Italy.  Without the consolidation of EI, the core business lost LTM €50mm, notwithstanding the fact that 68% of its €450mm cost cutting plan has already been implemented.
   2. Italian Banks and the Berlusconi Boomerang: Italy hates Silvio Berlusconi, convicted of fraud, sentenced to jail, and in the coming weeks, will be evaluated in a hostile Milan tribunal for sex crimes.  Nobody is doing Mediaset any favors these days.  The Company has €1713m of consolidated net debt, optically equivalent to 1.4x 2013E EBITDA. While this looks modest, its leverage would increase to 6.5x EBITDA post programming amortization.  The trick however is that its covenants were set at 3x EBITDA allowing Mediaset to capitalize content cash costs rather than expense them.  This extremely favorable treatment is entirely characteristic of the manner in which Mediaset was preferentialyl treated due to its affiliation with Prime Minister Berlusconi.  But now, not only do I believe it is not helpful, but that it is extremely hurtful.  Renegotiations will be austere at best and “tricks” will not be tolerated but heavily scrutinized.  Very likely, banks will require reimbursement rather than renegotiate and extend maturities, sending Mediaset to the capital markets to refinance itself (Mediaset recently sought board authorization for a €500mm bond issue indicating .  A third of debt comes due within 12 months while all debt becomes due by 2017.  Italian banks have tightened the purse strings immeasurably as their own cost to finance themselves has exploded (Unicredit, the Italian bellwether CDS trades at c. 1400). It is therefore likely that Mediaset is positioning itself to be “shut out” by banks when its €579mm of debt comes due next year).  Today, Mediaset enjoys an average cost of borrowing of 2.4%.  Most of that is tied to a rising Euribor.  But importantly, Mediaset will now need to plead its case for funding on a pan-european stage where it is unclear whether investors will require a higher yield out of pure emotion – finally after years of pupeteering Italy’s laws and policies for his own personal gain, now his empire must come hat in hand and ask for capital, or rather the bleak fundamental picture the group cant avoid but paint to the institutional community will dominate where their new cost of funds is re-struck.  Hibu, which is considered from a credit standpoint to be most analogous, is paying roughly 7% on a blended basis.  If Mediaset gets away with being judged purely on fundamentals, it will see an increase of €80mm per annum of incremental interest expense, assuming no inflation.  I think this assumption is conservative for the short case.
   3. Mediaset positioning in Italy: Now that Berlusconi has proven that he is not invincible, walls are coming down rapidly in Italy.  Foreign entrants like AMC and Scripps Group with relevant and exciting content highly suitable for the Italian market have been sitting on the sidelines waiting for the political landscape to debilitate Mediaset and provide a less hostile opportunity to enter (while advertising trends are indeed poor, the pie is c. €8bn.  A private study conducted showed that credible content assigned to an important LCN (literally the number on your remote control) could raise as much as €100mm annually – today LCN 9 is being used to play music on the radio, and is for sale).  I expect to see new content from abroad start to explode in Italy as the government prepares to give away 3 new nationally licensed multiplexes (spectrum rights) to new entrants. 
   4. Berlusconi is “Down For The Count” – How Will This Impact Mediaset Revenues?

Importantly, in regulated sectors, companies have been statistically proven to allocate significantly more advertising dollars to Mediaset than other advertising outlets in exchange for favor and standing that the government can provide (Source: Stanford University – Influence For Sale : Evidence From The Italian Advertising Market by Stefano DellaVigna).  Telecommunications companies score the highest for biasing their spend toward Berlusconi during periods coinciding with him holding office.  This makes sense because telecom operators depend upon scarce spectrum grants and tariff regulation.  Pharmaceutical spend was second most biased, with automobiles ranking third (note that Italy has heavily subsidized consumer purchases of Fiat automobiles for the last 25 years).

In conclusion, the fundamental health of Mediaset is inextricably tied to the public image of Silvio Berlusconi, and his ability to influence law, regulation and commerce.  Despite Berlusconi’s political dominance in the past several years (with brief fractures), the fundamental macroeconomic shift away from TV advertising spend to other channels such as digital/online, coupled by the measured inferiority of Mediaset produced content and consequent market-share loss (particularly to SkyItalia or NewsCorp) suggests that things are likely to get materially worse for Mediaset with the former Prime Minister’s fraud conviction.  While Stanford predicts a structural 30% decline in Mediaset advertising for periods during which Berlusconi is not an elected official, they do not attempt to estimate the impact of the effective impeachment and conviction on advertising spend.  Additionally, as much as 15% of annual advertising spend on TV is government-related and had a correlation of .91 of having been directed toward Mediaset during Berlusconi periods of power; I believe fair to say that erodes entirely.  Coupled with exponentially increasing debt costs, Mediaset appears set for a proper death spiral. 

As always, when people stop assuming Mediaset will always be fine because it always has been fine in the past despite its fundamental woes, is when people will acknowledge the second derivative effects.  Clearly, with 80% of its revenues at high margins tied to Mediaset, EI will encounter grave difficulties.  Furthermore with very limited capacity to take on debt to diversify away from Mediaset through acquisition, and a dearth of acquisition targets (captive tower portfolios of telecom operators are far too large and competitive for EI to consider), there does not appear to be a remedy to EI’s predicament.  On the flip side, what is the risk to shorting the stock at a moment in time where the market is blind to these risks? In my view quite low.  I therefore recommend a medium-term short position in EI Towers.  The probability of a LookSmart repeat appears high, while the risks to the upside appear quite limited, independent of management initiative.  EI is simply stuck. 

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