Description

I am recommending a long investment in Hemisphere Media Group (“HMTV” or the “Company”).  I believe the set-up dynamics for an investment in HMTV are very favorable.  I have followed this company since its IPO and have owned the stock several times including last year as a core-sized long but reduced my exposure because of the devastating hurricanes—Irma and Maria--that hit Puerto Rico and consequently created much uncertainty, short-term challenges to the Company’s WAPA business in Puerto Rico, and ultimately a lower price for re-investment.  Based on evidence of the recovery of video consumption in Puerto Rico and the strong performance of HMTV’s other businesses, I made HMTV a core-sized long again, and based on my targeted upside potential of ~40% in two years or less, I wanted to share my perspective for being long HMTV with the VIC community.

The recommendation for being long has been made previously on VIC by three members:  last year on August 30^that $13 by jwilliam903, on December 28^thin 2015 at $13.92 by porz6, and on March 19^thin 2014 at $11.25 by tml2106.  I encourage anyone interested in HMTV to read those VIC submissions for great historical context and I will try not to be too repetitive with regards to what those members shared.

When management reported Q2’17 on August 4, 2017, they reiterated an intent to achieve EBITDA guidance for that year.  At that time, I estimated 2017 EBITDA of ~$66M.  Results during the first half of 2017 were generally positive but Hurricanes Irma and Maria, which hit Puerto Rico on September 6^thand 20^th, caused management to withdraw its 2017 guidance. Management wrote in their press release on September 29, 2017, “As a result of the extraordinary scope and power of Hurricane Maria, there has been disruption to our business in Puerto Rico…Beyond physical damage, the extraordinary situation in Puerto Rico will adversely affect WAPA’s business in the coming months.”  

The fact that management withdrew its outlook was not too much of a surprise to the market as the stock’s reaction (a 2% decline) was more than recouped on the following trading day.  However, the market did step aside for several months that followed the initial hurricane as evidenced by more than 25% of underperformance relative to the Russell 2000 from September 5, 2017 through the end of April this year.  But since the end of April, HMTV’s performance has been roughly double relative to the Russell 2000 and HMTV is now up over 17% YTD.  The setbacks to WAPA from the hurricanes will soon be an anniversary event and the Company’s headline results will demonstrate substantial growth.  In fact, based on management’s recent outlook, EBITDA during the second half could grow by 55-63% versus the second half of 2017.       

There is of course no mention of either the names Irma or Maria in any 10K from the Company that preceded 2017 but in the 2017 10K, Irma gets mentioned sixteen times and Maria twenty-eight times so I believe it’s important to briefly review those two hurricanes and their impact to HMTV.  On September 6, 2017, Hurricane Irma impacted more than 70% of the homes in Puerto Rico losing power.  After Maria hit two weeks later, Puerto Rico’s electrical grid was wiped out and the majority of the island’s residents were left without potable water.  Even two months after the storms, the majority of the population lacked electricity. The electricity outage following Hurricane Maria was the worst in U.S. history and the second-largest in the world. The financial toll of recovery from the hurricanes was estimated at ~$95B by the island’s governor.  Moreover, as has been well-documented, Puerto Rico was already confronting financial hardship with a recession since 2006.

Restoration of vital services in Puerto Rico has been a difficult process. Although no two natural disasters will be alike in their impact nor recovery to those communities incurring the effects of “Mother Nature,” I reviewed numerous reports and spoke to several experts to deduce that most impacted communities will experience a surge in economic recovery pursuant to a natural disaster.  And although the circumstances in Puerto Rico are obviously different, I envision the island will enjoy a positive impact that will also accrue to the benefit of HMTV relative to expectations.

After the initial disruptions that are caused by widespread destruction, local and regional economies typically get a boost from natural disasters. In the case of Houston struck last year by Hurricane Harvey, economists have estimated over $100B in federal assistance and insurance payouts benefitted the Houston area following that storm.  In a Labor and Population research study conducted by the RAND Corporation that considered the aggregate labor force patterns for all individuals age 25-64 in the Hurricane Katrina-affected states, the researchers found relatively short-term negative labor market consequences followed by eventual recovery. During the decade that would follow Katrina, the federal government spent ~$120B on recovery-related projects, which incidentally is over 3x the annual budget of Louisiana.  

With only a few exceptions, areas hit by hurricanes in the past twenty years had job growth rates that exceeded the U.S. average within twelve months. This is also being evidenced in Puerto Rico where employment grew from July of last year by 2.4% versus the overall U.S. by 1.6%.  Furthermore, as described by HMTV’s CEO during the most recent earnings call, “Puerto Rico registered its lowest unemployment rate in five decades…and despite population losses the absolute number of employed as a percentage is now at its highest level since 2013.”  Unemployment in Puerto Rico is still quite high on an absolute basis, at 9.1%, but WAPA’s strong performance, which preceded the hurricanes, was when the number of employed was lower.  During mid-August, the governor said that the employment data shows the island is reaching a turning point toward economic growth.

There’s little argument that the Federal government did not effectively respond to the devastation wrought by Hurricanes Maria and Irma.  Much has been written regarding the challenges at FEMA and its disbursement of approved funding to address the Puerto Rican recovery. For instance, Frontline reported about FEMA’s inability to deliver tarps for temporary roofing that left many Puerto Ricans unnecessarily exposed without adequate shelter for months.  Nevertheless, capital is flowing to the island and this should have a positive near-term impact to the economy in Puerto Rico.  The Department of Housing and Urban Development (“HUD”) gave Puerto Rico the biggest disaster recovery grant in the agency’s history.  During April, HUD approved over $20B to assist Puerto Rico, more than twice the island’s general budget.  Almost 40% of an expected $8B of insurance proceeds have been delivered to the island and $6B in Federal funds have been disbursed.  Another $50B of funding is anticipated during the next six years.

Puerto Rico’s challenges from the hurricanes and pre-storm economic woes are far from solved but there are some positive data points evidencing a recovery. Though its power grid remains fragile, on August 14^th, the Puerto Rico Electric Power Authority announced it had finally reconnected all 1.5M customers to the grid.  Using sales tax revenues as a proxy of economic activity, it’s notable that sales tax revenues have exceeded pre-storm figures each month since March.  Based on airline passenger data through April, ~200,000 people left Puerto Rico after the storm, and 72,000 have since returned to the island, thereby yielding a net migration of 128,000 which is a lower number than previously estimated. The net migration is even lower based on data from 500,000 smartphones analyzed by Teralytics in partnership with a major undisclosed wireless carrier.  As described during the recent earnings call by HMTV’s CEO, “the market approached normalized levels of business, a recovery pace which accelerated over the course of the quarter...all of these metrics point to a promising recovery and future of Puerto Rico.”  However, for the recovery to be sustainable, it will be crucial that the disagreements between the Puerto Rican government and the Oversight Board be resolved to facilitate implementation of requisite structural reforms. 

Not surprisingly, after the hurricanes, the TV ad market in Puerto Rico suffered tremendous declines but the magnitude of the deterioration moderated significantly each quarter and HMTV management believes the market will be “normalized” by the end of 2018.  During Q4’17, the year-over-year decline was 70% which improved in Q1’18 to a decline of 38%, and most recently in Q2’18 to an advertising market approaching the prior year level.  There was some benefit from the World Cup though so adjusted for that, the market was down approximately mid-single digits.  Further evidencing the recovery of video consumption in Puerto Rico is the fact that Liberty’s cable system is now almost fully restored and they delivered their first quarter of net additions since the hurricanes last year. There is no doubt that the advertising market has improved and although it’s not yet clear whether the market will return to pre-storm levels on a sustainable basis, management noted “strong momentum heading into the second half of the year.”  The improvements in the TV ad market have closely tracked the restoration of power in Puerto Rico but as HMTV’s management has emphasized, it is of critical importance that a permanent solution be agreed upon to address the rebuilding of the power grid.  

As those following HMTV know, this management team executed a turnaround at WAPA and the improvements at the network have proved sustainable as evidenced by the Company’s uninterrupted nine-year streak as the ratings leader in Puerto Rico.  During prime time, WAPA has been delivering a 50% share in the 18-49 demographic.  It has not been an area of focus on any of the earnings calls because the challenges from the hurricanes overshadowed the change but it’s worth noting that the previous President of WAPA, Jose Ramos, retired at the end of November and was replaced by Javier Maynulet who joined HMTV with more than twenty years of both financial and operating experience in media including having most recently served as the CFO of Univision Networks and previously the CFO of Telemundo Media.  I understand that although Jose is highly-regarded and continues to be a consultant to HMTV including assisting with the strategy at Canal Uno, the management change is an upgrade.  

The first risk factor described by the Company in its 10K is that “service providers could discontinue or refrain from carrying our Networks, decide not to renew their distribution agreements or renew on less favorable terms, which could substantially reduce the number of viewers and harm our business and operating results.”  The balance of power game between content and distribution is nothing new but for HMTV’s WAPA it was the first time ever that a distributor could not reach a retransmission agreement with WAPA and therefore the network and its sports network WAPA Deportes went dark to DirecTV subscribers for six weeks starting May 5th. It was reported that DirecTV would not agree to WAPA’s asking price of nearly double its current fees.  HMTV’s CEO said, “WAPA requested a fair amount, which is much less than any American cable network charges for smaller audiences, and DirecTV refused to pay for it.  In fact, we requested the same as we did for the rest of the cable and satellite providers on the island.”  

As the ratings leader for nine consecutive years and having a primetime household rating that is 4x higher than CBS, the most highly-rated English-language U.S. broadcast network, and higher than the combined ratings of all the U.S. broadcast networks combined, HMTV’s management team was confident with their position to drive towards a higher subscriber fee.  On June 14^th, the Company and DirecTV announced a new multi-year retransmission consent agreement.  Management said, “We are very pleased with the terms of our new agreement, which represent a substantial fee increase.”  I estimate that being dark for those six weeks cost the Company approximately $500,000 of profit during the second quarter.  This simplistic estimate excludes any advertising impact and assumes the previous subscriber fee was just $.75 across 400,000 subscribers. Every $.25 of increase is $1.2M of additional revenue which is essentially all profit.  Based on the reports that HMTV was seeking nearly double its fee, I would not be surprised if the agreement generates $2M of incremental EBITDA next year.

I have focused my write-up on the issues in Puerto Rico because I believe the set-back from the hurricanes created an overhang that has only recently been removed and these issues were obviously not addressed in previous write-ups which were posted before the incidents.  I don’t want to repeat too much of the substance pertaining to the other critical parts of the business but briefly describe below the other components of the HMTV portfolio.

·      Cinelatino: the leading Spanish-language cable movie network with over 20M subscribers across the U.S., Latin America, and Canada.  Cinelatino is the second highest-rated Spanish language cable network in the U.S. 

·      WAPA America: distributed to 4.4M subscribers, excluding digital basic subs, WAPA America is primarily targeted to Puerto Ricans and other Caribbean Hispanics living in the U.S. with over sixty hours of news and entertainment programming produced by WAPA.  It is notable that this network grew substantially pursuant to the hurricanes as cable systems realized there was increased demand.  The increased viewership drove double-digit advertising growth.

·      Pasiones: distributed to over 20M subscribers across Latin America and the U.S., this network is focused on programming the most popular telenovelas and serialized dramas.  Ratings strength has recently been evidenced by growth of 11% during Q1 and 42% during Q2.

·      Centroamerica TV:  distributed to 4.3M subscribers in the U.S., this network targets the third largest U.S. Hispanic group which is also the fastest growing segment of the U.S. Hispanic population.  Ratings strength has recently been evidenced by growth of 18% during Q1 and 38% during Q2. The strength during Q2 is particularly impressive against the strong competition from the World Cup.

·      Television Dominicana:  distributed to 2M subscribers in the U.S., this network targets the fourth largest U.S. Hispanic group.  During the latter part of June, this network received carriage on U-verse which has yet to impact HMTV’s financial performance but management cited will be a positive impact in the low six figures.

There is likely to be much value ultimately generated from HMTV’s investment strategy which includes Canal Uno, PANTAYA, and REMEZCLA.  I later describe my simplistic and conservative approach to valuing these investments and therefore won’t try to frame the upside potential of each (there are others who have framed their perspective in the previous VIC posting) but I am confident that my baseline of just $65M will be exceeded and is therefore potential upside to my return target of 40%.

With regards to Canal Uno, HMTV owns 40% of this broadcast television network in Colombia.  Management envisions a double-digit share by year-end and is already generating 15% during certain day parts with an overall 9% share.  A key component of any investment is management execution and HMTV’s management is seizing the opportunity in Colombia to orchestrate a turnaround similar to what they did at Telemundo and at WAPA.  Each market is obviously different but those experiences from previous playbooks enhances the probability of a successful outcome with Canal Uno.  Furthermore, Canal Uno can be very successful for shareholders without becoming number one in the market like HMTV’s management was able to effectuate with WAPA within two years.  Among the items that management has already identified as being a relatively easy improvement is the fact that commercial breaks in Colombia historically run for over ten minutes.  Management has already begun to modify the implement a 3-4 minute commercial break which of course enhances the quality of the viewing experience for the audience.

With regards to HMTV’s investment in PANTAYA, the leading Spanish-language OTT service in the U.S., although we know little with regards to the number of subscribers and financial performance (though I am hopeful that clarity of both the business and financial performance will improve over time for each of the Company’s investments), it is notable that PANTAYA occupies the 10^thand 12^thhighest grossing entertainment apps on Apple and Android.  It is therefore not surprising that both HMTV and Lionsgate have communicated they are pleased with the rapid growth of PANTAYA thus far.  The demographic trends are favorable for the PANTAYA offering and this investment could emerge to be valuable over time.  Although I am not one to value businesses solely on their revenue growth potential, this market is enamored with growth stories and there is optionality for how the market might value PANTAYA as more clarity regarding subscribers and growth develops.        

Using 2016 as the baseline, revenue grew during the previous three years at a 15% CAGR and EBITDA grew at a 19% CAGR.  Revenue generated from subscriber and retransmission fees comprised 53% of revenue.  Subscriber growth continues to be strong as HMTV’s networks appeal to the fastest growing demographic across the U.S. and both Cinelatino and Pasiones remain underpenetrated in Latin America.  In the U.S. where cord cutting remains an ongoing challenge confronting numerous cable networks, HMTV’s networks continue to grow and remain underpenetrated by ~7M relative to the number of Hispanic pay TV subscribers.  The other area of growth is advertising and the Company’s cable networks have demonstrated double-digit growth potential.  The aggregate media spend targeted at U.S. Hispanics significantly under-indexes the buying power of this growing demographic. U.S. Hispanic cable advertising is expected to grow at 9%.  During discussions with several Hispanic media agencies, I heard that their advertising clients are increasingly focused on targeting the Hispanic population. One agency executive said that Hemisphere is in the “sweet spot” with their programming offerings.  In Puerto Rico, in addition to the setback from power outages and the migration that impacted the subscriber universe there, another adverse effect was the suspension of ratings data by Nielsen until May. Since advertising is now able to conform to historical ratings, this is another boost to the advertising potential relative to the six months that followed the hurricanes.  

The Board’s confidence in the longer-term prospects for the Company did not fade as the Company repurchased $5.7M of stock during September of last year at an average price of $12.62 and continued the repurchase program during Q4’17 with the repurchase of 2.3% of outstanding shares at an average price of $11.79 for ~$11.2M.  Having spent ~$23.5M of its previous $25M June 2017 buyback plan, management announced a new $25M buyback plan on August 15^th and the CEO said, “This new authorization highlights the Board and management team’s continued confidence in our unique portfolio and business outlook, our strong cash flow generation and our focus on returning capital to shareholders.”

On the surface, if one is simply screening for potential “value”, HMTV appears expensive.  Based on the Company’s adjusted LTM EBITDA and EBIT, the stock is trading at over 14x EBITDA and ~22x EBIT.  However, the primary reason for this high multiple is that LTM performance captures the dislocation that HMTV suffered from the unprecedented hurricanes last September in Puerto Rico.  During the second half of 2017, the Company’s EBITDA declined by over 40% from the second half of 2016.  Historically, the fourth quarter has been the Company’s strongest but EBITDA during Q4 in 2017 declined by 66.5% on a revenue decline that exceeded 39%.  During the first half of 2018, EBITDA declined by 17% and some of that decline can also be ascribed to the six weeks when WAPA went dark to DirecTV subscribers.  Investors can now anticipate strong growth from that negotiation.  

The other reason that the multiple looks expensive is there is “hidden asset value” based on some investments management has made which inherently adds to the calculation of enterprise value from the funding of such investments but currently without EBITDA ascribed to those investments when calculating the EBIDA and EBIT multiples.  Those investments which are currently incurring losses do get a favorable adjustment to EBITDA and I believe this is an appropriate addback, but a simple valuation framework based on multiples doesn’t capture any potential value for those investments.  I assume those investments in Canal Uno, PANTAYA, and REMEZCLA are worth just $65M which is essentially the capital spent in 2017 and this year to fund them.  To be clear, I am confident in the management team and both their ability to allocate capital and to effectively implement a business plan for those investments.  I think there is substantial value creation potential from Canal Uno and PANTAYA and therefore the $65M should be interpreted as being very conservative.

The other detail that is worth noting is an expectation for both insurance proceeds from both P&C and business interruption policies by year-end. I anticipate at least $15M of proceeds and adjust cash accordingly.  Net/net, adjusting for the $65m of investment value and the $15M of insurance proceeds, the LTM EBITDA multiple is ~12.5x and the LTM EBIT multiple is ~19x.  This is more reasonable to me given the quality of businesses and growth prospects but I am not advocating a core long at that multiple.  

Based on management’s recent EBITDA outlook of a mid-teen percentage increase in EBITDA for this year versus 2017, I assume 12-15% growth which implies ~$57M-$59M of EBITDA this year.  Note that HMTV generated $58.1M of EBITDA in 2015 and given the growth across the non-WAPA businesses and the “normalization” being exhibited at WAPA, I do not interpret management’s outlook as a stretch target.  Moreover, I think it’s likely that financial performance gets back to at least the 2016 level in 2019 and especially since we know there is additional EBITDA from the acquisition of SNAP Global as well as further improvements at WAPA based on the retransmission fee increase and a recovering Puerto Rico.  For modeling purposes, I assume that EBITDA grows this year by 14% to $58.4M and by 10% in 2019 to $64.3M.  In 2020, when WAPA will benefit from political advertising in Puerto Rico, I think it’s reasonable to again assume 10% EBITDA growth.  Note that political advertising was $6M in 2012 but dropped off substantially in 2016 to just $2.6M.  In 2021, I assume EBITDA grows by 8%.  During the years 2015-2017, FCF conversion (as a percentage of EBITDA) was 38-64% (the higher end of the range occurred in 2015).  For simplistic framing purposes, I assume FCF conversion is 40%.  Based on a multiple of 10x 2021 EBITDA and making the adjustments for insurance proceeds, a conservative investment value that ascribes nothing more than what has been invested, and FCF generation from performance, one can envision a potential $20 target in two years.  Each multiple of EBITDA is ~$2 of value.  

From a downside perspective, it is notable that the stock has provided lower entry points numerous times and that’s not too surprising for a relatively illiquid stock but I think $11.50 per share (or 7.5x 2019E EBITDA) would provide significant fundamental support and the Board’s willingness to be more aggressive repurchasing shares.  As others have opined, there is ultimately a likely premium paid for control of HMTV and so the notion of this quality platform trading much below 7.5x EBITDA would not likely endure for too long.  Based on the assumptions and framework I have shared, at $13.70, the stock is trading at 9.8x 2018E EBITDA and 8.9x 2019E EBITDA.

There are of course numerous risk considerations and the 10K is comprehensive with a discussion of such issues but I will highlight a few notable risks. Based on what I have shared in regards to the impact from Hurricanes Irma and Maria, the risk of another such occurrence is an obvious risk and would be more so if a significant storm were to strike the island soon while Puerto Ricans are transitioning towards recovery.  Another risk of course is with regards to the magnitude of recovery and structural reforms in Puerto Rico that sustain an improving economy relative to the recession that has challenged the island for several years.  Austerity measures that might be necessary for structural reform for longer-term improvement could challenge the television ad market in the shorter-term.  If the migration pattern of the population were to accelerate, that would be a headwind. As with any programmer, the risks associated with distribution and cord cutting exist.  The mitigating factor with regards to cord cutting is that HMTV’s U.S. cable networks have been growing and should benefit from the “skinny bundle” based on the highly-targeted appeal to the growing Hispanic population in the U.S.  If management continues to pursue an investment strategy predicated on joint ventures which comes with an increasing magnitude of debt that is not as easily serviced by FCF generated from those joint ventures coupled with an increased complexity of the business, this could challenge the equity with an ongoing discount based on a lack of clarity pertaining to the “value” of such investments. I am confident that this management team and Board understands this delicate issue.  One approach for mitigating the perceived discount is to offer the investment community more clarity pertaining to the potential value of the Company’s existing investments and this is among the catalysts I also highlight below.  Since advertising has been an attractive growth driver but can be inherently cyclical, this is another issue for consideration.    

Catalyst

·      Second half EBITDA growth will be significant; the reported headline growth could attract the passive-driven investment base

·      Ongoing growth of Hispanic TV households and pay TV subscribers provides an attractive growth opportunity for HMTV’s cable networks

·      WAPA’s growth resumes based on the recent favorable renegotiation of the retransmission agreement with DIRECTV, and from overall market growth stimulated by proceeds coming to Puerto Rico from both the Federal government and insurance proceeds 

·      Increased advertising monetization at Cinelatino and WAPA America

·      Cinelatino and Pasiones grow penetration in Latin America from ~30%

·      More clarity pertaining to the value drivers of investments such as Canal Uno and PANTAYA