Description

*NOTE ON THE FINANCIAL TABLE: All numbers above include the new debt and new earnings power from the August acquisition of Quincy’s TV stations and the coming December acquisition of Meredith’s TV stations.  The debt amounts and leverage numbers treat Gray’s $650m of preferred stock as debt, and the cash earnings numbers deduct the $52m of preferred dividends.

This month I have been supplementing my long-time core position in Nexstar Media, for which I posted a VIC write-up two months ago, by purchasing a new position in Gray Television, another TV station stock.  I am buying Gray now for the same reason I re-bought Nexstar in 2017 (after foolishly selling in 2013): a transformative acquisition for which traders give no stock-price credit until the increased earnings start actually coming in and the debt starts getting paid down.  Traders do give credit over time, and the stock should over time retain its old multiples on the higher earnings levels while net debt rapidly falls.  Acquisitions like these are the primary way that TV station businesses create shareholder value over time. I have seen this movie before, and it ends well.

In August Gray completed a $545m acquisition (net of divestitures) of Quincy’s TV stations.  Before year-end it will close a $2755m acquisition (net of divestitures) of all Meredith’s TV stations.  From average 2019-2020 pro forma numbers, these acquisitions will boost Gray’s revenues by 40% and boost its cash earnings power by 50%.  Using management’s guidance, which I believe is conservative, the stock is trading at 3.3x average 2022-2023 cash earnings to common shares (i.e., deducting the preferred stock dividends) and 7x average EV/EBITDA.  For comparison, Nexstar is now at about 5.3x average 2022-2023 cash earnings and 7.5x average EV/EBITDA.

The downside of Gray vs. Nexstar is that Gray will be at peak debt leverage following its two acquisitions, while Nexstar has already had two years to pay down debt following its 2019 Tribune acquisition.  Using either management’s calculations under its senior credit facility (using trailing 8-quarter pro forma EBITDA) or my own calculations (using 2022-2023 average EBITDA and counting the preferred stock as debt), Gray’s leverage immediately after the Meredith closing will be 5.4x, versus roughly 3.6x for Nexstar.  Gray will devote all its cash flow for the next ~two years to debt paydown, while Nexstar makes large value-creating stock buybacks.  In the interim, Gray has more risk if the business deteriorates or if short-term rates rise materially and quickly.

I do not believe either of those two risks are likely to occur.  My Nexstar write-up includes a detailed explanation of why TV station businesses have been growing and will keep growing revenues and earnings, despite the well-known declines in linear pay-TV subscribers, and why TV stations now have a small fraction of the economic cyclicality they had in 2008-2009.  It also discusses the interest rate risk.  You should read the Nexstar write-up for those details.

In short: Gray is about to become a TV station stock on steroids, as I happily lived through with Nexstar in 2017-2019 (Media General acquisition) and again in 2019-2021 (Tribune acquisition).  If you like TV station stocks, you should love Gray, and if you don’t like TV station stocks, you should hate Gray.  That’s it, that’s the entire investment thesis.

Here are a few more details worth calling out:

Strength in political advertising

The two largest growth drivers TV stations' revenues and profits for the past 10-20 years have been retransmission fees and political ads.  Retransmission fee growth will likely slow materially within a few years.  Political ad growth shows no sign of slowing.  Gray will benefit by more than its peers from this continued growth because its revenues skew more to political ads, thanks to its station footprint’s heavy weighting in battleground states and contestable districts and (I am half-guessing) a smaller-metro mix that inherently weights more to political ads and less to commercial ads.  Political ads made up 18% of Gray’s total 2020 revenues, versus 11% for Nexstar.

Conservative guidance

Management has already guided to average 2022-2023 free cash flow of $600-625m.  That range should prove conservative, thanks to political advertising.  Political ad revenue in 2020 for the pro forma combined business was $652m.  Their cash flow guidance embeds 2022 political ad revenues of “only” $525m, 80% of the 2020 number.  Although non-presidential years typically have lower spending than presidential years in a vacuum, the trend of higher spending in all elections has been so strong that 2022 political ad revenues look likely to come very close to 2020.  Gray’s 2020-to-2022 fall off should be modestly higher than Nexstar’s, because Gray has a heavier Georgia mix that benefited from the insane special-election spending last November and December -- but still.  They should come close.  Management already said they are “cautiously optimistic that we'll be raising the political guide.”  Matching 2020 here would mean an extra $127m of political ad revenue.  Some of those dollars would displace commercial ads, but on the other side, all that extra demand drives pricing higher on all the ads, both political and commercial.  It probably isn’t a bad SWAG to say that all the extra political ad revenue would be extra total revenue, and that all the extra revenue is extra pretax profit.  Taxed at 28%, that’s $91m extra free cash flow, or $46m average across the two-year cycle -- 7% more than the top end of management’s guidance.

Debt market appears to like the acquisitions

To fund its acquisitions, Gray has already closed the sale of $1300m of 5.375% senior notes due 2031.  This fixed rate on a ten-year maturity, starting with peak leverage, compares favorably to Nexstar’s 4.75% eight-year notes issued in late 2020, a year after it had been paying down debt and just before its blowout 2020 presidential-election quarter.  Gray is funding the remainder of the acquisition costs with a $1500m increase in its term loans (Libor + 200/225bps, with 12/31/2020 rates of 2.4% and 2.7%) and an increase from $300m to $500m in its revolver capacity.  The blended cost of its new debt is 4.15%, compared to Nexstar’s current total blended rate of 3.61% with much lower leverage.

Auto ads will be back in 2022...

You probably already know about how shortages in certain types of semiconductors have been severely constraining automakers’ production quantities.  Combined with the boom in consumer demand for all types of goods, including autos, the supply crunch has shrunk auto dealer inventories to all-time lows.  Because dealers don’t have much inventory to sell and can sell what they have at unusually high prices, they aren’t spending on advertising.  Gray management said on its 3Q call that this year's 1Q-3Q auto ad revenues are down 30% compared to 2019.  That represents a big hit to total revenues, because typically autos are a TV station’s #1 ad vertical, accounting for more than 20% of commercial ad sales.  I saw somewhere else -- either from Gray or another TV station company, I don’t remember which -- that the auto drag on total 2021 revenues has been 7%.

I follow both the semiconductor market and the auto market, and the latest word from most of those players is that the auto semiconductor crisis is now past its peak.  Shortages will taper off for a full year before disappearing.  That means auto inventories should start rebuilding and auto advertising will rebound in 2022.

...while sports betting keeps exploding

As I discussed in the Nexstar write-up, TV stations have been making up a decent chunk of the auto ad deficit with a new monster boom in sports betting ads, driven by more and more states legalizing online betting and the betting itself expanding from final game scores to multiple in-game outcomes.  Gray said on the 3Q call that its 2021 sports betting revenues will be up 250% over 2020, which lines up with what the other station chains have been saying.

This growth pace should continue in 2022.  Only 18 states have legalized online sports betting so far, with many of those legalizations taking effect in roughly the last year.  It takes time for the betting activity to ramp up, and the newer states haven’t yet lapped their launch dates.  Another three states have legalizations pending, and another 11 could conceivably legalize in 2022.

When you combine the recovery in auto with another triple-digit growth year for sports betting and another surge in political spending, you’re looking at a great year for TV ad revenues.

Subscriber attrition has already slowed as predicted

Nexstar has been saying for a few quarters that its retransmission-fee subscriber counts have been falling 5% YoY, but the declines were expected to slow (which makes sense given 2020 Covid-panic acceleration of cancellations.  Gray’s management just said that its 2Q subscriber count -- the subscriber reporting lags by a quarter -- was flat YoY, at least for its “big four” (ABC/CBS/NBC/Fox) viewers.  I don’t know how much that “big four” qualification is worth, but probably not much.

The stock’s likely path forward

I expect that, two years from now, Gray’s earnings multiple will have crept back up to where Nexstar’s is today, from 3.3x to 5.3x.  That’s 60% upside just from the multiple expansion.  Revenues and EBITDA should keep growing, which will boost the stock value further.  Interest expense will fall materially as they pay down debt, which will boost the stock value further yet.  And of course, I believe a 5.3x multiple is well below fair value.  At that point Gray can start serious buybacks and create yet more value, such that you can continue holding the stock and get above-market returns out into the future even without further multiple expansion. (It can't buy many more stations, because Meredith puts it at 36% national share versus the FCC's 39% cap.)

Catalyst

Close the Meredith acquisition, earn what they say they'll earn, pay down debt, then start buybacks.