Description

I am recommending an investment in the common stock of Lin Media, which is awaiting closing of its merger with Media General in the next few months.   Lin Media has been written up previously on VIC, so I won’t recite too much previously covered territory.  In this write-up, I will focus on the merger and the opportunity to invest in the new company at a compelling valuation.

Investment Thesis

-          Through the shares of Lin Media, an investment in the newly combined company can be purchased today for a sizable discount.  At the merger’s closing, each Lin share will receive $13.22 and 0.7225 shares of Media General (trading at $17.77).  Simply closing of the deal at current share prices for Lin and Media General implies ~9% upside to Lin’s share price, based on the trading price of Media General.  (In the next section, I set forth the mechanics and analysis.)  The date for the shareholder vote is October 6, and, on Wednesday August 20, Media General and Lin announced a small series of divestitures that should clear the way for regulatory approval.  Management is guiding to an early 2015 close, but, with the announced divestitures, a late 2014 closing may be possible.

-          The pro forma company (“New Media General”) should have the ability to generate pro forma FCF per share of ~$2.10 in 2015/2016 (note, this “earnings power” assumes full year of cost savings benefits, which will take some time to phase in, and it averages for a political and non-political year).  At today’s share price for Lin Media, an investor can create the equity of New Media General at an implied multiple 6.3x normalized pro forma free cash flow per share.

-          The combined company will reach ~25% of US households, leaving it considerably below the regulatory cap of 39% with plenty of room to participate in further industry consolidation.  Even with recent FCC actions that discourage the management of multiple big-4 stations in a market, recent acquisitions have shown to be highly accretive.  There are still many small operators who do not capture the same level of retransmission fees as larger operators, and companies such as Lin/Media General can fold them into their retransmission regime through “as-acquired” clauses to immediately step up such rates.

-          Through its prior merger with Young Broadcasting, Media General has identified operating synergies of 2x its original goal.  There is likely upside to the $70 million synergy target for the Lin/Media General once the merger closes.

Merger Mechanics and Valuation

A shareholder in Lin will receive the following, assuming pro-ration, at the deal’s closing:

$13.22 of cash (note: this is undiscounted)
PLUS
.7225 shares of Meg = $12.84 at MEG price of $17.78 per share
Total consideration = $26.06

Current Lin Price = $24.00

Upside = 8.6%

That upside may be interesting on its own as a merger arbitrage matter.  However, I find the longer-term investment even more compelling.  If management executes its business plan and New Media General can demonstrate $2.10 of earnings power (based on normalized FCF), the Media General shares should be more valuable in a year’s time.  At a 12.5x multiple, they would be worth $26.00. 

That means the upside for a Lin shareholder today would be 34%.  Alternatively, an investment in Lin creates a share of New Media General at approximately 6.5x estimated FCF.

Trading Price of Lin Media shares = $24.00
Less: Cash Component (undiscounted) = $(13.22)
Implied Share Component = $10.78
Divided by: Exchange Ratio (adjusted as of 8/20/14) = 0.7225
Implied Price per share of Media General = $14.92

Note that the New Media General will have ~$680 million of NOLs which will make the company a non-tax payer for several years.  I take the present value of these at ~$1.20, net the value from the share price and then fully-tax the company’s free cash flow.  The adjustments and valuation are as follows:

Implied Price per share of Media General = $14.92 [Calculated above]
Less: Present Value of NOL = $1.20 [discounted at ~15%]
Adjusted Implied Share Price = $13.72

Normalized FCF per share (Pro Forma and Fully Taxed) = $2.10
è Implied Adj Share Price to FCF = 6.5x

Note, I derive an estimate of normalized fully-tax pro forma FCF per share from the Merger proxy and adjusted those estimates downward based on (1) updated commentary from both companies’ second quarter earnings calls;  (2) adjusted the loss of the CBS affiliation at Lin’s Indianapolis station which I assume will reduce the company’s EBITDA by ~$15 million.  (I address this further in the following section.); (3) additional growth in reverse compensation to networks; (4) station divestitures and swaps announced since the merger; and (5) fully-taxed, as noted above.

Risks

While believe the valuation and opportunity described above handsomely compensates for the risks, let’s discuss those. 

- Reverse compensation.  On Monday August 11, CBS announced its intention to switch its local affiliate in Indianapolis from Lin’s WISH-TV to Tribune’s WTTV-TV.  The media has widely reported that CBS was aggressively pursuing a better deal on reverse compensation (payments from the affiliate to the network in recognition of growing retransmission fees earned by affiliates) and relocated its affiliate as part of its negotiations.  On Wednesday August 20, Lin and Media General announced a reduction in the Lin deal price by `$110 million related to the loss of the CBS affiliation at WISH-TV.  After studying the situation, I believe this affiliate switch likely represents a special-situation rather than the commencement of a free-for-all of affiliate/network switches.  I will address several points around this topic:

1)   Tribune was uniquely situated in the Indianapolis market with an existing duopoly of a Fox station and a CW (presumably a lower-earning station), where both happened to be full power stations.  This allowed Tribune to move the CW to a “D2” signal (a secondary transmission stream shared with the new CBS station) and offer the primary signal on the channel to CBS.  While I believe this switch allowed CBS to make a very strong statement as it embarks on a series of reverse compensation renewals, it appears to have been an opportunistic switch by CBS/Tribune enabled by these unique circumstances.

2) I believe CBS (and other networks) will seek to maximize reverse compensation by moving to a programming fee because the networks want to pressure affiliates (especially underperforming affiliates) to negotiate for maximum retransmission.  Settling for a % share did not achieve this.  Well-positioned and strongly managed broadcast companies should fare better in this framework, though it will certainly put the onus on them to achieve retransmission rates commensurate with what networks are earning.  Weaker negotiators who are unsuccessful achieving such retransmission fee step-ups will see their retransmission fee margins squeezed significantly (with this perhaps opening a new wave of consolidation).  Ultimately, a strong, healthy affiliate base is in the network’s interest as it bolsters their potential earnings power.  An affiliate system that is in upheaval would not be in a great position to deliver the reverse compensation the networks hope to seek.

3) The industry has seen station switch from time to time, and it is highly instructive to read the history.  Below are some links to news stories that chronicle Nexstar’s  loss of a couple of Fox affiliates in 2011, and then when Fox and Nexstar ended up re-establishing one of the affiliates after realizing the split was serving neither well.  These disputes have happened from time to time over the years (much like franchisee/franchisor relations).  They tend to be relatively isolated and life moves on.  While networks certainly have negotiating power, there is some real disruption that results from switching affiliates that creates some stickiness in the relationship.  (See below to be read in order.)

http://www.nytimes.com/2011/07/04/business/media/04retrans.html?_r=0

http://www.broadcastingcable.com/news/local-tv/fox-nexstar-cut-ties-springfield-mo-and-ft-wayne/42939

http://www.tvnewscheck.com/article/65316/ft-wayne-fox-affiliation-returns-to-wfft

While one cannot be complacent about this issue, I think it is appropriate to consider it in the overall context of the opportunity. 

- Other risks:

• Advertising cyclicality – several companies cited a weak national environment in the second quarter.  (Note the valuation in the write-up is adjusted for an estimate of the annualized impact of this, though most management team’s cited some improvement going into Q3.)
• Declines and fragmentation of television viewership, although hours spent watching television continues to grow and television provides a truly unique mass reach to advertisers.
• Aereo has been resolved but future technical disruption could be possible. 
• Potential for adverse regulatory action

No reliance, no update and use of information. You may not rely on the information set forth in the above write­-up as the basis upon which you make an investment decision. To the extent that you rely on such information, you do so at your own risk. The write-up does not purport to be complete on the topic addressed, and we do not intend to update the information contained therein, even in the event that the information becomes materially inaccurate. Certain information contained in the write-up includes calculations or projections that been prepared internally; use of a different method for preparing such calculations or projections may lead to different results and such differences may be material. We now own the security discussed above, and may decide to buy or sell such securities at any time of our choosing without providing an update.  

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