MSG is an exceptionally high quality real estate and cable asset with almost no macro exposure and a fairly good visibility on earnings growth for the foreseeable future. A number of items have caused some short-term caution amongst investors, namely an ambitious renovation project, higher broadcast costs in an attempt to resuscitate Fuse, the loss of earnings due to the NHL lockout, lower attendance for holiday events in Q4 due to Hurricane Sandy. Fortunately for investors, all of these uncertainties will be removed over the next six months. At that point earnings will begin to approach normalized levels while FCF will hit an inflection point and management is highly likely to embark upon a substantial recapitalization. As a result, the stock will appreciate 30% to $60 over the next year and a half.

Overview

MSG reports in three business segments: Media, Entertainment, and Sports.

Media consists of MSG (broadcasts Rangers, Knicks, Sabres), MSG Plus (broadcasts Devils, Islanders, Red Bulls), and Fuse (music concerts) cable channels. This segment generates more than 90% of the company’s cash flow.

Entertainment consists of Madison Square Garden, Radio City Music Hall, the LA Forum, the Beacon Theatre, the Chicago Theatre, and the Wang Theatre. A substantial portion of revenues is driven by the annual Radio City Christmas Spectacular, which this year will be celebrating its 85^th year in operations

Sports consists of the ownership of the Knicks, Rangers, Liberty (WNBA), and the Connecticut Whale (AHL). While these teams have immense value in the private market, they generate a positive, but very limited amount of income for the company.

In addition, the company has excess cash and zero debt, a small stake in Live Nation (LYV), and owns 50% of the air rights over its real estate.

Spin-off Background

MSG was spun out of Cablevision (CVC) in early 2010. The company traded at a fairly low valuation as management indicated to investors that it was planning on spending the equivalent of half of its market capitalization on an ambitious but necessary renovation of the company’s iconic arena. The Rangers failed to make the playoffs for the first time in four years and the Knicks were completing a decade as one of the worst teams in the NBA. The renovation would require a loss of earnings during the summer months when the arena was shut down, and was viewed as having low to potentially negative returns on capital and the driver behind massively negative FCF for years. The company’s Entertainment segment had gone from generating $50MM in EBITDA pre-recession to bleeding capital. Additionally, management was viewed as likely to embark upon value-destroying projects while obscuring shareholder value. To top it all off, Dish canceled Fuse and the Time Warner contract for MSG was coming up for renewal in 2012 while both leagues had looming CBA expirations.

Results since Spin-off

Fast forward a bit and we now have the #1 NBA team in the East and the #1 ranked NHL team (from last season). Forbes puts the Rangers as the #2 most valuable NHL league and last year put the Knicks at #2 just under the Lakers, giving the Knicks a shot at taking the #1 slot when Forbes revalues the league early next year. The NBA went through a costly lock-out but has since thrived immediately after with increased ratings. Dish has reinstated FUSE and Time Warner after a blackout, and agreed to a long-term contract with MSG on what is believed to be very favorable terms. The renovation of the Garden is now 80% complete with the final, and least risky and least capital intensive, stage slated for this summer. More importantly, the renovation has resulted in material increases in ticket prices and long-term sponsorships, driving a substantial return on capital. Management has cleaned up operations, changed its fiscal year to June to better align with the sports seasons, and delivered strong results, with EPS beating street estimates by 123%, 90% and 38% for the last three quarters. In addition, management has publicly stated that they are exploring both dividends and buybacks as a way of returning capital to shareholders post the renovation. The renovation will be complete this summer in early fiscal 2014, thus in 18 short months when fiscal 2015 starts, investors will be looking at the first normalized year for the business as a public company. While most street models only go out to fiscal 2014, this should change as fiscal 2013 comes to an end in June.

Regional Sports Networks (RSN)

RSN’s are the holy grail of the cable industry. While one can imagine someone making their own cooking show or nature program to compete with established content, one cannot recreate a sports team. For this reason RSNs operate near-monopolies on the right to broadcast within their respective regions. The content they produce has a very loyal fan base, reproduces itself annually, and is one of the few programs available that consumers insist upon watching in real-time, which creates more value for advertisers. As a result, RSN’s generate predictable recurring revenue with huge margins under long-term contracts which carry annual price escalators.

RSN Valuation

A very recent double-digit multiple of EBITDA paid by News Corp to acquire a stake in the YES Network highlights the value of RSNs. Last year, MSG’s RSN value came under question when it was blacked out for Time Warner subscribers as Time Warner balked at the MSG’s 50% rate hike. While on its face investors perceived this to be a ceiling on the pricing power of sports content, Time Warner had an ulterior motive. Prior to the blackout Time Warner committed to a reported multi-billion deal with the Lakers and was trying to suppress the perceived value of sports as it acquired additional content in California. Once Time Warner built its own RSN, it settled with MSG on very favorable times, and is now aggressively demanding higher rates from other cable companies who need its sports content.

MSG Network

While the cash flows of a network can depend on a team’s popularity and performance in the short-run, its long-term value is generally determined by the value of its market. MSG owns the rights to broadcast the two top ranked (at least currently) teams on the East Coast located in the nation’s largest and most valuable market. As a result, the MSG network has 8MM subscribers and generates near 50% EBITDA margins with mid-single-digit price escalators. The business’s cash flows are currently slightly obscured by investments being made in new content for FUSE, which is generating a loss that is rolled into the segment’s accounting. Fortunately, despite its small size, FUSE is still worth $1-3/share to the right owner and management has communicated that if they cannot successfully reignite the channel soon they will explore alternatives. Removing FUSE from the analysis, by fiscal 2015 this network, inclusive of 100% of corporate overhead, should generate EBITDA of $325MM or over $4/share. However, substantial upside could exist, as shown by a recent report from Morgan Stanley, which put the DCF value of this asset, after subtracting 100% of corporate overhead, at the current share price. It should be noted that a traditional private market valuation would be in the mid-teens, implying a much higher value.

Real Estate

MSG also has another valuable asset, which is the iconic Garden itself. The company is now in the third year of a massive $1B transformation project. When the final construction is complete this summer, MSG will be operating one of the most accessible, modern, and iconic venues in the world. Perhaps more importantly, it will be one of the few commercial buildings in Manhattan with zero leverage yet ironically, a combination very dependable and high quality tenants. At this point a number of drivers will occur. First the final round of sponsorship fees will trigger and begin to accrue to the company, second the renovation will add back additional seats to the arena which were removed this year, third the venue will be open and available to book acts over the summer months, and fourth capital expenditures will fall by nearly 90% to approximately a third of annual depreciation resulting in FCF that materially exceeds annual income.

Recapitalization

Combining $1B of minimal-FCF generating sports teams, another $1B of real estate value and a $3B cable network as a public company creates some unique valuation challenges for analysts. Fortunately for investors, while some bonus and accelerated depreciation from the renovation should result in cash taxes lower than reported taxes, the company will still become a substantial tax payer after the summer. Not surprisingly, management has pegged the completion to coincide with them putting an appropriate capital structure on the business, which will allow the company to shield some taxes with interest while effectively monetizing some of its assets.

We're also in the process of analyzing now impacts of stock buybacks and dividends, so that we can come out when we're through the Transformation and be ready to go and do what's smartest as it relates to the health of the company and for our shareholders when the Transformation is done. – CEO Hank Ratner 12/05/12

Given the ability to secure debt with the ownership of its teams and real estate, MSG will be able to borrow a substantial amount of money at extremely low rates. The timing makes sense as a completed Transformation is likely to get a better rate from lenders than one that is almost but not quite complete. While it’s unclear how aggressive management intends to be initially, a recent report published by Macquarie suggested that the company would buy back more than $1.5B or slightly less than half of its current market capitalization.

Valuation

Published estimates for 2015E EBITDA are near $400MM and $200MM in income which assumes > 80% from the Media segment and decent but certainly not aggressive contributions from the Entertainment and Sports segments. Adding back $50MM for the spread between depreciation and actual capital expenditures, $20MM in non-cash stock-based-comp, and some amount for non-cash taxes yields FCF over $275MM or more than $3.50/share. If the company were to borrow $1B at 5% and use the proceeds to buy back 22MM shares of stock and reduce the diluted share count nearly 30% from 78 to 56, FCF would rise by slightly over 10%, or $30MM, and generate FCF of $4.40 share. A price target of $60 would imply 11x EBITDA or slightly higher than a 7% FCF yield. This assumes that all current cash as well as FCF generated in 2013 and 2014 is utilized in the renovation.

Risks

Control Discount. The Dolan family has voting control which has caused a significant control discount to be placed on the company. While it’s a good reason to not expect a sale, the company has been operated in the best interest of shareholders since the spinoff. Additionally, since the end of 2009, more than 50% of the CEO’s compensation has come in the form of stock awards. As of the last proxy, he has beneficial ownership in 1% of the company or just under 0.7MM shares.  

Renovation Overrun. The cost of the renovation has already been bumped once as the core foundation work was completed and the $980MM target has been reiterated as a “contingency” scenario. The company will burn through its existing cash balance by the summer to complete the project but has more than adequate credit availability to make up the difference.

NHL Lockout. While hockey is far less important to earnings than the NBA, the lockout doesn’t help. In the event that they lose the season, both sides currently lose more cash flow permanently than if they fully capitulated to the latest offer from the other side. The analysts who have quantified the impact of a full cancelation have generally gotten to a post-tax loss of income between $0.25-0.75/share. That said, it seems that even if the season is lost, it’s highly likely to assume that eventually the respective parties put dollars over ego and we have an NHL season by fiscal 2015.

Barclay’s Center Competition. A few articles have noted that the new Barclays Center may cannibalize events from the Garden. While quantitatively this is a fairly immaterial negative, most commentary has overlooked the fact that MSG purchased the LA Forum for less than $1/share and will be able to more than make up for the impact by filtering events from the Staples Center, which is even more overbooked than the Garden with three teams (Lakers, Clippers, and Kings) crowding out available dates.