Description

I apologize for not posting this earlier. The stock is up a bit from where I think this is a no brainer (anything <$10), but this name is quite volatile so I think it's a good one to have queued up.

Overview

For the past year and a half we’ve been very involved in the local TV broadcasting space. At one point or another we have owned just about every name in the sector. In 2013 you simply could not go wrong owning any one of these companies. The combination of improving fundamentals, refi’s that cut borrowing costs by +40%, significant financial and operational leverage and an extremely robust M&A market made for more multi-baggers than we will likely see in our portfolio for a long time to come. At the end of the year, we found much of the space trading near our view of intrinsic value. We liked the long term story (growing retransmission revenue, political spend in a secular uptrend and a long runway of consolidation), but at 10x pro forma EBITDA and low double digit free cash flow yields most of that seemed priced in. However, after a +35% sell off in response to changes in TV station ownership rules, we think there are some great bargains. Of these bargains, we think Gray Television is the easiest to own and that it offers the cleanest pathway to +45% upside.

Earlier this month Gray announced that they had restructured their acquisition of Hoak Media, all government approvals had been received and the transaction should close in the second quarter. While the purchase was modified so that stations which either involved or created duopolies (effective ownership of two stations in the same market) were excluded from the current transaction, these stations comprised less than 20% of the deal and the multiple for the purchased stations remained unchanged at 6.8x 13/14 pro forma EBITDA. This transaction is meaningfully accretive and was the reason the stock ran from $8 to +$15 last fall. We estimate that GTN will generate +$3.50/share in free cash flow over the next two years, or +37% of the company’s total market cap. We think that given the quality of the company’s assets (#1 and #2 stations in college towns and state capitols where local news matters), organic growth prospects (mid-single digit earnings growth) and highly compelling consolidation economics, the intrinsic value today is somewhere between $14.50 (9.5x 14/15 EBITDA) and $18.00 (10% free cash flow yield). As we move closer to 2016, which will be a huge year for political advertising, GTN will have the balance sheet flexibility for more acquisitions. By the end of 2016, we think the stock could approach $20 per share.

The Business

Rather than regurgitate, I’d just suggest taking a look at their IR presentation here (http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NTM2NDI0fENoaWxkSUQ9MjI0NjE5fFR5cGU9MQ==&t=1). God invented them for a reason.

Why the Opportunity Exists

The first 100 days of the year have been a terrible time to be a broadcaster stock. In January the space sold off 15-25% following the announcement that the Supreme Court would hear broadcasters’ appeal of the Second Circuit’s ruling that upheld Aereo’s business model as legal. In February and March the sector added another 10-20% to the selloff when reports started circulating that the FCC would be changing ownership rules specifically related to “sidecar” arrangements for stations owned by the same company in a single market (referred to in the industry as a duopoly). We view the Aereo risk as purely a headline issue (i.e., having little if any impact on the actual business), and we view the ownership changes as having a real, but manageable impact.

We are happy to discuss Aereo in the thread, but it’s really not something we are worried about right now. This is a complex legal issue (that’s why it’s at the Supreme Court), and we have no illusions about our ability to forecast the court’s decision. That being said, we think there is very good chance that the Court sides with the broadcasters (okay, maybe that was like starting off a discussion with “no offense”).

In early March the DOJ filed a brief with the Supreme Court requesting that the Court side with the broadcasters. Shortly after the filing, the Solicitor General asked to be allowed to argue his view against Aereo before the Supreme Court. The Solicitor General backs the winner around 90% of the time (fact check: http://lawdigitalcommons.bc.edu/cgi/viewcontent.cgi?article=3129&context=bclr). Furthermore, while it’s probably a fool’s errand to try and read tea leaves on how the Supreme Court justices will side (especially with this being a fairly non-partisan issue), in 2009 Justice Kagan (then Solicitor General) signed a brief (http://cyber.law.harvard.edu/~jpalfrey/SGBrief.pdf) that called the Second Circuit’s reasoning for the Cablevision case that is used to support Aereo’s claims as “problematic.” Also, anecdotally, Ruth Bader Ginsburg’s daughter, Jane Ginsburg, is a vocal supporter of strong copyright law and referred to the Second Circuit’s ruling in favor of Aereo as an “April Fool’s prank” (http://www.mediainstitute.org/IPI/2013/042313.php). Our due diligence suggests that RBG likes her daughter. Lastly, Alito recently “un-recused” himself from the case, hopefully giving the broadcasters another ally and taking the “tie goes to the lower court” scenario off the table.

At any rate, even if the Supreme Court rules against the broadcasters we believe that there will be a legislative response aimed at updating copyright laws to reflect the current technological environment. Also, we just don’t think Aereo is that much of a competitive threat (i.e. we don’t think it will materially affect Gray’s cash flows).

We are far more interested in the decisions coming out of the FCC. There are a number of theories for why the FCC has taken what feels like an unnecessarily aggressive stance towards regulating local TV broadcasters (they include jockeying for spectrum, cable cronyism, the Free Press camp’s opposition to media consolidation, etc.). Whatever the reason, Chairman Tom Wheeler has made it very clear that he plans to spend his time at the helm ensuring that broadcasters follow the letter of the FCC’s ownership rules, and even augmenting broadcaster restrictions when possible.

In the March 31^st Commission meeting the commissioners voted on two measures affecting local broadcasters. The first prohibits two “Big 4” stations from coordinating their negotiations for retransmission fees (monthly per subscriber fees that the cable/satellite co’s pay to local affiliate owners or the networks themselves owners). You can read more about this decision here: http://www.fcc.gov/document/fcc-strengthens-retransmission-consent-rules. The second, and more significant, is a move that will make joint sales agreements (JSAs) “attributable” when the agreement involves one station selling more than 15% of another station’s advertising time.

There are several drivers of value creation when two broadcasters combine. Corporate G&A is pretty much eliminated and there are some potentially meaningful revenue synergies (acquired stations can have their retrans rates stepped up to those of the acquirer and combining stations improves bargaining power). However, another significant value driver occurs when the combination results in two stations being owned in one market, referred to as a duopoly. Current media ownership rules effectively prohibit owning two stations in the same market outright. The industry has come up with a number of work arounds whereby an “unrelated” entity acquires the second station and then engages in a number of agreements that more or less combine operations under one roof and transfers economic ownership of the second station to the acquiring entity. The standard arrangement involves the establishment of a JSA’s and shared services agreement (SSA). In short, the JSA involves one station selling ad space on behalf of another and the SSA involves sharing any number of expenses. The current proposal from the FCC more or less calls for the unwinding of JSAs and may require some additional disclosures regarding what is involved in the SSA down the road. While we don’t know what these agreements will look like in the end, I think it is reasonable to assume that duopolies will still exist, they will just be less cost effective and the FCC will take its sweet time in approving the creation of new duopolies.

So now you are likely asking, “How many of these duopolies does Gray Television have?” They only have one. It’s very small (<2% of revenue) and they only have an SSA in place (no JSA). Given the current ownership rules they will not need to unwind this relationship. One of the knocks on Gray has been that they were slow to embrace consolidation – either as a buyer or seller. Unlike Nexstar (we also own), which is run with a private equity mindset, Gray has always been focused on operating high quality news stations first, and M&A fourteenth (that’s a joke). At least that’s how it was until last fall when they created an entity (Excalibur) that would enable the creation of duopolies. In August they completed their first acquisition using this sidecar entity (very nominal in size) and in November they used Excalibur to facilitate the acquisition of Hoak. While we believe that Gray will eventually close on the duopoly stations, perhaps using a very limited JSA and a beefed up SSA to achieve synergies, it’s worth noting that even though the duopolies are not part of the package that is set to close this quarter, the acquisition is still quite significant (increases EBITDA by +20%) and being completed at a highly accretive multiple (6.8x pro forma EBITDA when the space trades at 9-10x).

While it took longer than it should have, management finally seems to “get it” when it comes to the consolidation opportunity. Whether by design or accident, we think that Gray will be able to largely sidestep the regulatory hurdles that currently face its peers (namely Sinclair and Nexstar) and that they will be able to cleanly execute on additional consolidation once the Hoak assets are integrated and Gray is able to pay down some debt (they’ll be around 5.5x debt/EBITDA after Hoak). We estimate that there are around 400 Big 4 stations that are not currently owned by the publicly traded consolidators. Considering that Gray’s 73 affiliates gives them reach into only 7.3% of households (FCC limits ownership at 39% of households), we believe the runway is quite long. Perhaps most interestingly, we also expect that the consolidation math (acquire for <7x EBITDA, trade at +9x EBITDA) will remain largely unchanged and may even improve thanks to diminished competition for deals (limiting duopolies cuts more pieces of the pie and Sinclair and Tribune are hitting household ownership limits).

Valuation and Return Expectations

This may be a little late to introduce into the discussion, but we like (or at least don’t dislike outright) the local broadcaster business even outside of the consolidation story. While we think that the discussion of what television will look like ten years from now is quite interesting, we think discussion of the next three to five years is much less so. Around 87% of US households currently subscribe to pay TV. Cord cutting is real (2013 posted a 0.2% decline in pay TV households), but revenue growth on a per household basis should well exceed this headwind for the foreseeable future. While we accept that Gray will not be immune to broader industry trends, we do think their focus on smaller markets should give them “better than average” audience captivity. Gray’s revenue is about 50% local advertising, 15% national advertising, 10% political advertising and just under 20% retransmission revenue. Growth from each of these revenue buckets ranges from flat (national ads) to GDP plus a few points (local ads) to double digits (political and retransmission revenues). Furthermore, as retransmission fees become a more significant component of revenue, the stability of the business improves significantly. While our model has several line items and inputs, we think same station EBITDA should grow at least in the mid single digit rates and warrant valuations around 9x EBITDA (around 10% unlevered pre-tax cash flow, but there are significant NOLs) on an “organic” basis. We think the acquisition runway is worth at least half to a full turn of EBITDA in the valuation.

We value Gray using recently announced M&A multiples for publicly traded peers (MEG is acquiring LIN at 9.5x 14/15 EBITDA, we think Gray is worth more) and by estimating free cash flow generation, its use and the company’s ability to create additional value for equity holders. By these approaches, we think the equity is worth between $14.50 and $18.00.

Risks

Additional ownership restrictions, downturn in the economy resulting in lowered ad spend, significant increase in cable cord cutting

Catalyst