Emmis Communications Corporation (“Emmis” or the “Company,” NASDAQ: EMMS) is a small capitalization media company that derives the overwhelming majority of its revenues and cash flows from its ownership and operation of 18 radio stations in major markets (New York, Los Angeles, St. Louis, Austin, Indianapolis and Terre Haute). The Company also owns various publishing assets, including Texas Monthly, which generate significant revenues but limited income. Over the last few months the Company has undertaken actions which have dramatically reduced its indebtedness and increased its value through a controversial restructuring of its preferred stock and highly accretive asset monetizations. We believe the stock is worth almost $5 per share in a mid case scenario, and we see a low end value of $2.77 and a high end potential of $6.74 per share. Management, and most notably the CEO and controlling shareholder Jeff Smulyan, were buying stock aggressively near these prices prior to the announcement of 2 positive catalysts (sale of a Los Angeles station and a positive ruling in the preferred litigation) during the last half of August; insiders have been restricted since the end of the latest quarter on August 31st, and the market has amazingly not rewarded the stock at all for the 2 aforementioned positive events. We believe an investment in Emmis common stock at these levels provides the opportunity to capture significant upside with limited downside given the insider purchases (which will most likely resume) and an imminent catalyst from a capital structure refinancing.

 

The actions taken by Emmis to drive value creation can be separated into two buckets: (i) dealing with its preferred shares and (ii) completing significant asset sales to pay down debt. The flurry of corporate events over the last few months has made it extremely difficult for investors to piece together a true picture of the Company’s current capital structure and value. We have laid out a summary of the events and our thoughts on valuation below.

 

In April 2010 Emmis CEO and controlling shareholder Jeff Smulyan launched his second attempt to take Emmis private by partnering with Alden Global Capital (“Alden”) to make a $2.40 per share bid for the Company. The deal was contingent upon completing an exchange offer for Emmis’ preferred stock whereby holders would agree to swap the 6.25%, $50 liquidation value preferred stock for $30 in a new 12% subordinated note. The exchange would also cancel all outstanding unpaid dividends on the preferred stock. This exchange was necessary because the preferred stock included a right to have the stock redeemed by the Company at the $50 liquidation preference (plus unpaid dividends) in the event of a going private transaction in which Mr. Smulyan participated, and the buyers were not able or willing to do so. The offer was terminated on September 8, 2010, when Emmis failed to receive the required 66.7% consent from preferred shareholders; a group of preferred holders had filed a 13-D on July 9th stating their intention to block the deal. The Smulyan/Alden offer valued the Company at a total enterprise value of roughly $557 million.  

 

Emmis Begins Purchasing the Preferred at Significant Discounts
Following the collapse of the 2010 go private transaction, Emmis’ board “determined that it would be in the best interests of Emmis and the holders of our Common Stock to commence a program that would provide Emmis with flexibility to amend the terms of the Preferred Stock, if it so chose, whereby Emmis would enter into total return swaps with respect to certain outstanding shares of Preferred Stock and/or purchase shares of Preferred Stock and to acquire the right to vote, or to direct the vote, of shares of Preferred Stock, through voting agreements or otherwise.”  In other words, Emmis embarked on a strategy to accumulate the voting rights of 66.7% of the preferred in order to amend its terms and create shareholder value. In order to finance these acquisitions, on November 10, 2011, Emmis entered into a note purchase agreement with Zell Credit Opportunities Master Fund, L.P. (“Zell”) whereby Emmis could borrow money at a PIK rate of 22.95%. The potential value creation justified the expensive interest rate. On November 15, 2011, Emmis repurchased 645,504 shares of preferred stock (448,754 under total return swaps) at $15.25 per share, and on November 22, 2011, Emmis purchased 1,035,925 shares of preferred on total return swaps at a price of $15.75 per share. These total return swaps included the sellers entering into agreements to vote their shares in accordance with the written instructions of Emmis. Emmis made additional purchases of preferred stock on December 30, 2011, and January 20, 2012, and after purchasing and retiring those shares, the 1,484,679 preferred shares owned by Emmis under swaps represented 61.3% of the total outstanding preferred shares.

 

Reissuance of Preferred to the ESOP 

Emmis was still short of the 66.7% threshold needed to amend the preferred stock’s certificate of designation, and the overwhelming majority of non-Emmis preferred holders entered into a lock-up agreement on December 12, 2011, whereby they each agreed not to sell their preferred stock to the Company. Therefore, the Company needed to find a new way to gain positive control of the class, and the board decided to re-issue 400,000 shares of previously purchased and retired preferred stock to a newly formed 2012 Retention Plan Trust (approved by the board on March 8, 2012 and by shareholders on April 2, 2012). The 2012 Retention Plan Trust entered into a voting and transfer restriction agreement with Emmis, and with these shares Emmis gained voting control of 1,884,679 preferred shares which represented more the 66.7% of the class.

 

Preferred Motion for an Injunction and Subsequent Shareholder Vote
Once Emmis gained control of 66.7% of the preferred shares’ votes, the Company pushed forward with seven proposed amendments to the preferred stock’s certificate of designation: (i) cancelling the accumulated and unpaid dividends (roughly $12.12 per share), (ii) change the preferred from cumulative to non-cumulative and make dividends only payable if declared by the board, (iii) cancel restrictions on paying dividends to or repurchasing common shares, (iv) remove the change of control put on transactions which involved Mr. Smulyan, (v) remove the conversion price adjustments on a change of control, (vi) remove the ability to vote as a separate class on certain corporate events and (vii) giving the preferred the right to receive only consideration paid to common holders on an as converted basis in the event of a merger. Emmis filed a complaint in Marion County Superior Court in Indianapolis, Indiana seeking declaratory judgment that the amendments and its actions were valid and permissible under Indiana law. The locked-up group of preferred holders filed a lawsuit in US District Court for the Southern District of Indiana seeking to enjoin Emmis from holding a special meeting to approve the amendments. Emmis agreed to stay the state court action and move its motion to federal court, and the Company agreed to delay the shareholder meeting until after a hearing and ruling on the lock-up group’s motion for injunctive relief.

A hearing on the motion for a preliminary injunction was held on July 31st and August 1st, and the court indicated it would issue a ruling by the end of August; consequently, Emmis agreed to adjourn its shareholder meeting until September 4th. On August 31st the court issued a detailed ruling that denied the lock-up group’s motion for a preliminary injunction because the plaintiffs (the locked-up group) failed to prove a likelihood of succeeding on any of its arguments and the lack of irreparable harm. Press reports after the ruling was issued focused on the lack of irreparable harm as being the main driver of the decision; however, nothing could be further from the truth. The decision spends 2 pages at the very end on irreparable harm, concluding “that any damage Plaintiffs are likely to suffer in the absence of injunctive relief is not irreparable and can be adequately compensated for by an award of monetary damages, should they ultimately prevail after a full assessment of the evidence pursuant to controlling legal principles.”  However, the ruling spends over 30 pages dismissing each of the plaintiffs’ 12 arguments by concluding on each that “Plaintiffs have failed to establish that they have a reasonable likelihood” 3 of winning. It is our conclusion, based on the ruling, that the locked-up group is unlikely to prevail in a future trial for monetary damages based on the court’s assessment of its arguments, and one of the group’s members seems to agree. Corre Opportunities Fund, one of the members of the group, purchased 692,259 shares of common the day the ruling was announced at an average price of $2.229. 

Following the court’s denial of the locked-up group’s request for a preliminary injunction, Emmis held a special shareholder meeting on September 4, 2012, at which the amendments to the preferred stock’s certificate of designation were approved. While the federal case remains open, it is unclear how aggressively a group with roughly $10 million of invested capital will pursue an expensive, 24 month legal battle. For our analysis, we consider the remaining preferred stock on an as-converted basis.

 

LMA Agreement with Disney for WRKS in New York
On April 26, 2012, Emmis entered into a local programming and marketing agreement (“LMA”) with New York AM Radio, LLC, a subsidiary of Disney Enterprises, Inc., under which Disney agreed to pay Emmis an annual fee to provide programming on the station. Disney wanted to move ESPN Radio onto FM in New York City, and the LMA contract with Emmis has a life of 12 years and calls for an annual payment of $8,435,000 in the first year increasing 3.5% each subsequent year. Emmis retained the license for WRKS and contributed that license and the LMA agreement into a financing subsidiary, and Emmis securitized the cash flow payments under the LMA and received $75 million in net proceeds which were used to reduce indebtedness. At the termination of the LMA and the repayment of the securitized borrowings in 2024, the license for the station will revert to Emmis and Disney will no longer have the right to program the station (absent an extension). The proceeds from this transaction were used to pay down debt, and that paydown is reflected in the Company’s latest 10-Q.

 

On April 3, 2009, Emmis and Grupo Radio Centro, S.A.B. de C.V. (“GRC”) entered into a seven year LMA under which GRC provided programming for KXOS-FM in Los Angeles. At the same time, Emmis and GRC entered into a put and call agreement (“Put-Call Agreement”) under which GRC had the right to purchase the station for $110 million at any time during the term of the LMA and Emmis had the right to require GRC to purchase the station for the same amount at the end of the term of the LMA (April 2016). On April 13, 2012, Emmis and GRC amended the Put-Call Agreement to give GRC the right to purchase the Station for $85.5 million provided that the purchase closed on or before March 27, 2013, and that the closing occur on or before the thirtieth day after FCC approval of the transfer of the station’s main FCC license. Clearly, Emmis and GRC had worked out a deal that was beneficial to both sides, and the hurdles to completion were FCC approval and financing.

On June 22, 2012, the FCC approved the license transfer, but GRC needed more time to raise the required financing. Emmis agreed to give GRC until August 8, 2012, to complete the purchase (through a second amendment to the Put-Call Agreement); however, GRC was unable to raise the financing by that date and, while GRC continued to talk to financing parties, Emmis allowed the second amendment to terminate and the purchase price reverted back to $110 million. 

A couple weeks later, GRC was able to round up the financing, and on August 23, 2012, Emmis completed the sale of the station pursuant to the Put-Call Agreement. Emmis received gross proceeds from the sale of $85.5 million, incurred approximately $1.9 million in transaction expenses and tax obligations, retained $4 million for working capital purposes, and used the remaining $79.6 million to repay indebtedness under Emmis’ senior credit facility. The sources and uses are detailed below.
 

Sources and Uses from LA Sale
Sources				Uses
Asset Sale		$85.5		Transaction Fees			$1.9
				Cash Retained on Balance Sheet			4.0
				Repay TL B			34.2
				Repay Ext Term Loan B			42.8
				Ext Term Loan B Term Fee			2.6
Total Sources		85.5		Total Uses			85.5

Sale of Country Sampler and Smart Retailer Magazines
On October 1, 2012, Emmis completed the sale of Country Sampler and Smart Retailer magazines to DRG Holdings for $8.7 million and used the $8.5 million in net proceeds to pay down debt. The sources and uses are detailed below.
 

Sources and Uses from Publishing Sale
Sources				Uses
Asset Sale		$8.7		Transaction Fees			$0.2
				Repay TL B			3.7
				Repay Ext Term Loan B			4.6
				Ext Term Loan B Term Fee			0.3
Total Sources		8.7		Total Uses			8.7

 

Pro forma for the asset sales, the Company’s debt load is now below $90 million, including pre-payment penalties. The Company is reportedly working on a refinancing with would dramatically lower interest costs. We believe an announcement of a refinancing is imminent and will reduce the interest rate to below 7%, based on market feedback and color.

Pro Forma Capitalization
			5/31/12 10-Q	LA Sale	PF after LA	Publish Sale	PF after Pub
Cash			$10.5	$4.0	$14.5		$14.5
Revolver			0.0		0.0		0.0
Term Loan B			61.7	(34.2)	27.4	(3.7)	23.8
Extended Term Loan B			77.2	(42.8)	34.3	(4.6)	29.8
Total Secured Debt			138.8		61.8		53.6
Zell Sr. Unsecured Notes			35.8		35.8		35.8
Total Debt			174.6		97.6		89.4
Ext Term B Exit Fee		6.0%					1.8
Zell Make-whole							8.5
Total Debt and Exit Fees							$99.7
Net Debt							$85.2

 
Valuation Analysis

 

Third Party Valuation Markers
Before looking at our own sum of the parts analysis, we looked at the valuation based on 3 relevant valuation markers: a BIA Capital Strategies, LLC (“BIA”) valuation from April 2010, a Moelis & Company (“Moelis”) valuation performed at the same time and the value of Jeff Smulyan’s take private offer in 2010. The BIA valuation “showed the Company’s total asset value to exceed $620 million,”  and Moelis “ascribed a potential value of $608.9 million to Emmis following a ‘take private’ transaction.”5 The BIA and Moelis valuations are mentioned in the locked-up group’s complaint against Emmis. The valuation of the Smulyan take private offer comes from the Morgan Stanley fairness opinion. These values are then reduced by (i) $130 million to reflect the gross purchase price of the three stations sold to Merlin Media on September 1, 2011, (ii) $85 million for the sale of the WRKS and related IP, (iii) $85.5 million for the sale of KXOS and (iv) $8.7 million for the sale of Country Sampler and Smart Retailer magazines. We ignore the value of the Company’s preferred and common interests in Merlin (which have been written down) and treat the remaining preferred on an as-converted basis. The value range is $3.78 - $5.25 per share.
 
Sum of the Parts Valuation
For our sum of the parts valuation, we first tackle the Company’s radio stations. The Morgan Stanley fairness opinion used a range of 6.5 – 8x broadcast cash flow to value the station assets; we use a range of 6-8x and a stick station valuation of $300 million (roughly $5.50 per Covered POP). We start with LTM BCF of $43.0 million from the Company’s supplemental financial disclosures on its website and back out $7 million of BCF from KXOS (now sold) and $4.5 million of BCF representing the 49% minority interest in the Austin stations. This gives us a pro forma BCF of $31.5 million. We value the publishing assets at between 0.2x and 0.33x revenues. LTM revenues from the publishing business, pro forma for the recent asset sale, are roughly $75 million. Based on our own checks, we think Texas Monthly alone could be worth more than $25 million, and the assets the Company just sold traded at 1x revenue, but we want to be conservative. The final asset we value, only in upside cases, is the Company’s litigation in international courts against the Hungarian government. The Hungarian government seized a radio license from the Company and cost them a station that produced roughly $10 million in annual BCF. While it is difficult to get great color on this, it appears the Company found success in Hungarian courts so the government retroactively changed the law to make its actions legal. The Company is not pursuing the Company in international court. Our valuation range is $2.77 - $6.74 per share.

 

SOTP Valuation
			Low	Mid	High
LTM Station EBITDA			43.0	43.0
Less: BCF from LA Station Sold			(7.0)	(7.0)
Less: 49% of Austin BCF Owned by Partner			(4.5)	(4.5)
Remaining Station BCF			31.5	31.5
BCF Multiple			6.0x	8.0x
Value of Stations			189.2	252.3	300.0
Publishing			15.0	20.0	25.0
Cash on Hand			14.5	14.5	14.5
Hungarian Litigation			0.0	25.0	50.0
Total Asset Value			218.7	311.8	389.5
Less: Debt			(99.7)	(99.7)	(99.7)
Avaiable to Common			119.1	212.1	289.8
Common Shares			43.0	43.0	43.0
Price per Share			$2.77	$4.93	$6.74

Conclusion
We believe Emmis stock has significant upside and extremely imminent catalysts. The Company will report an August 31 balance sheet which shows the debt paydown from the KXOS sale, and we also believe it will announce a refinancing in the near term. Post a refinancing, the Company should have fixed charges of $9 million or less, allowing it to generate free cash flow of roughly $11 - $13 million, or 25-30c per share. We believe that Jeff Smulyan will continue to buy stock, and post a refinancing the Company may begin paying a dividend or buying back equity as well. Finally, although he said during the preferred litigation that he had no plans to take the Company private, the removal of the change of control put which only applied if Jeff Smulyan was part of the buying group leads us to believe that another go private attempt is likely. At these prices you can buy in at a price almost 50% below the implied valuation of the last attempted buyout.