Description

Investment Thesis:

Madison Square Garden (“MSG” or “the Company”) has been the subject of several timely and cogent write-ups on this site over the years. Shares have performed well since they were spun off from Cablevision in 2010, advancing by 178% compared with a 79% increase for the S&P 500. Despite this strong performance, shares currently trade at a 30% discount to my estimate of their intrinsic value. In my view, the valuation disconnect is unwarranted and reflects the following:

• Underappreciated Cash Generating Abilities. The multi-year, $1.1 billion renovation of MSG’s eponymous arena has masked MSG’s free cash flow generating abilities. Beginning in FY 2015 (began July 2014), capex will decline to annual rate of ~$50 million, or less, from an annual average of $316 million (past two years). The upgraded arena generates significantly higher revenue from corporate suites and sponsorships and the full benefits will begin to be realized in FY 2015. Approximately 65% of MSG’s revenues are now derived from multi-year contracts (affiliate fees, corporate sponsorships, suites, etc.) or from sources that have proven resilient historically, such as season ticket sales.
• Further Earnings Improvement at Crown Jewel MSG Media is Being Overlooked. EBITDA margins at the MSG Media segment (48% of total revenues) have increased by 1,600 basis points since the spinoff (51.6% vs. 35.3%). Over the next 2-3 years, below market rate affiliate fee agreements with distributors accounting for ~40% of its Regional Sports Network (RSN) subs will likely come up for renewal. In addition, high-margin advertising revenues are underpenetrated at MSG’s RSNs relative to traditional cable networks, but should experience good growth thanks to viewership gains and the increased attractiveness of sports programming (limited DVR viewing) in today’s fractured media landscape.
• Valuation of Trophy Sports Franchises Not Reflected in Current Market Value. Many investors are reluctant to assign much value to the Company’s sports franchises since a significant amount of their value accrues to the MSG Media segment. I believe this approach understates the true value of these iconic assets. In my view, the Knicks and Rangers could be sold sans media rights for a significant premium to recent Forbes market values.
• Investors Ascribing Minimal Value to MSG’s Real Estate and Air Rights – MSG’s flagship arena, which sits which sits on top of the busiest transportation hub in the country, holds valuable development rights. While “the Street” generally ascribes little value to fallow assets, these rights will likely become increasingly valuable as the area surrounding MSG/Penn Station is upgraded. Real estate developer Vornado owns ~13 properties around Penn Station and recently stated it plans “significant” investment in the area. In May 2014, Marriott announced its intention to build a Renaissance hotel in close proximity to the arena, which should go a long way toward improving property values in the neighborhood.
• Capital Allocation Uncertainties Overblown – “Dolan Discount” Unwarranted.  - Despite the negative Street perception of the Dolan Family, they have implemented a number of shareholder-friendly initiatives at Cablevision, including the spinoffs of MSG and AMC Networks, which have unlocked an enormous amount of shareholder value. While MSG’s recent focus has been on driving future growth via acquisitions/investments, I believe dividends and/or share buybacks will take a more prominent role going forward. The Company’s pristine balance sheet ($77 million of cash and no debt) coupled with its strong cash generating abilities should provide ample flexibility to pursue future growth and to return significant value to shareholders.

Free Cash Flow Poised to Accelerate

MSG will likely generate $300 million (~7% FCF yield) in FY 2015. Over the next 2-3 years FCF should approach $400 million (~9% FCF yield) thanks to built-in rate increases for its contracted revenue streams and the re-pricing of below market rate affiliate contracts as they come up for renewal. It should be noted that FY 2015 will be the first full year the Company will capture all of the benefits of the Garden’s makeover. The arena was closed for ~5 months during each of the preceding 3 years to accommodate the renovation, which was completed in phases. Accordingly, only a portion of the arena’s improved economics have been realized to date. The new state-of-the-art arena will generate meaningful incremental revenues due to the following:

• Improved Corporate Suite Offering – The Garden’s corporate suites are larger, significantly closer to the court/ice/stage and contain more amenities compared with the prior offering. Included in MSG’s portfolio of 96 suites are 20 event level suites that carry a $1 million+ annual price tag and are secured pursuant to multi-year agreements with annual escalators.
• Increased Sponsorship/Advertising – During 2010, JPMorgan Chase became the Company’s marquee advertising partner when it signed a 10-year, $30 million deal (according to accounts from the Sports Business Journal). Subsequently, MSG has added a number of signature level partner agreements with blue chip companies such as Coca-Cola, Anheuser-Busch, Delta Airlines and Lexus. All of these partnerships are believed to be multi-year, multi-million dollar agreements containing annual rate escalators. While MSG does not disclose financial terms, management has previously stated that new sponsorship agreements are larger than previous agreements.

RSNs are MSG’s Crown Jewel with Further Opportunity to Expand Profitability

In my view, the crown jewel of MSG’s business is its two RSNs (MSG and MSG+), which each serve ~8 million subscribers in the New York Metropolitan region. MSG’s RSNs boast a number of attractive attributes including a strong base of recurring revenues (~90% from affiliate fees) and minimal capital intensity with capex averaging just 1.6% of revenues over the past three years. The Company’s RSNs boast superior profitability compared to peers due, in part, to MSG’s ownership of two of the sports teams (NY Knicks and NY Rangers) for which it telecasts programming. MSG Media's EBITDA margins (FY 2013: 52%) are more than double its RSN peers including Fox Sports (~24%), Comcast SportsNet (~24%) and ROOT Sports (~21%). Profitability within the MSG Media segment has expanded markedly in recent years thanks to a 10-year affiliation agreement signed with its former parent just prior to its spinoff accounting for 40% of its RSN subscriber base. Notably, the agreement represented a ~25% step up over the prior deal and also includes a ~7% annual rate escalator. In addition, MSG garnered a similar rate increase from Time Warner Cable (20% of MSG’s RSN subs) when that company’s agreement came up for renewal in 2012. These agreements have significantly enhanced MSG Media’s revenues, profitability and margins. Between 2009 and 2013, segment revenues and AOCF (MSG’s preferred method of EBITDA, which excludes stock-based comp) have increased at an 11% and 23% CAGR, respectively while AOCF margins expanded by over 1,600 basis points to 51.6% from 35.3%.

MSG Media – Summary of AOCF and AOCF Margins ($MM)*

• 2009 - AOCF: $167.4; Margin: 35.3%
• 2010 - AOCF: $231.3; Margin 41.9%
• FY 2011 - AOCF: $228.2; Margin 40.4%
• FY 2012 – AOCF: $258.6; Margin 42.1%
• FY 2013 – AOCF: $349.5; Margin 51.6%

• 9 Mos. FY 2013 - AOCF: $267.7; Margin: 53.4%
• 9 Mos. FY 2014 – AOCF: $259.2; Margin: 48.2%

*Note: MSG transitioned to a June 30^th FY in 2011 therefore 2009 and 2010 results are calendar year results.

While MSG Media segment results have been impressive, multiple items will favorably impact future segment profitability including:

• Re-pricing of Below Market Rate Affiliate Fee Agreements – Affiliate fee agreements with distributors comprising approximately 40% of its RSN subs will likely come up for renewal over the next 2-3 years. These include FiOS (~1.2 million subs for each network), Comcast (~800k subs), DIRECTV (~700k subs) and various distributors/overbuilders (RCN, etc.). Based on my research and analysis, the current affiliate fee market rate for MSG’s RSNs is approximately 10-15% higher than what these distributors are currently paying. Given the strategy to “strategically scatter” its affiliate agreements, coupled with the 2010 and 2012 renewals with Cablevision and Time Warner Cable, respectively, I believe that the other distributors will likely be renegotiating carriage agreements for MSG’s RSNs in the 2014-2016 time frame. What could bode well for MSG is the possibility that the Comcast or DIRECTV affiliate agreement comes up for renewal during the regulatory review of their respective mergers. If this should occur, I would expect the distributor to be a price taker during the renewal process.
• Increased Advertising Revenues – MSG’s RSNs currently generate roughly 10% of their revenue from advertising, which is well below the ~45% amount derived by the average cable network. Notwithstanding the most recent Knicks season, the Knicks and Rangers have registered viewership gains in recent years that should bode well for the attainment of increased high-margin advertising revenues. In addition, the DVR/TiVo-proof nature of live sporting events and the ability of sports programming to deliver large audiences will likely become increasingly attractive to advertisers in today’s fragmented media landscape. According to a recent Nielsen study, viewers watched 97% of sports programming live during 2012, down slightly from 98% in 2008. However, approximately 75% of non-sports programming was viewed live, down sharply from 93% in 2008. I would expect live viewership of non-sports programming to decline further as consumers continue to embrace streaming video services (e.g. Netflix) and penetration of DVRs increase. At present, Leichtman Research estimates that 47% of households have DVRs, leaving plenty of room for further adoption.
• Fuse Divestiture – In July 2014, MSG sold its fledgling Fuse cable network to SiTV for $226 million (MSG is retaining a 15% stake in the combined entity). The divestiture not only strengthens the Company’s already robust balance sheet ($77 million of cash and no debt before divestiture proceeds), but should bolster segment profitability. While the Company does not disclose the results for the Fuse network, management indicated at the time of the 2010 spinoff that the network was not profitable. Since that time, the network has failed to command higher affiliate fees and has invested heavily in original programming to increase its appeal. This poor performance masked the profitability of MSG’s RSNs and created a ~100-200 basis points margin headwind.

Iconic Sports Franchises, Improved Segment Prospects Not Reflected in Current Share Price

In my view, current market value of MSG does not fully reflect the private market value of the Company’s sports franchises or the improving prospects of MSG’s Sports segment (34% of revenues) due to the renovation. The Company’s sports franchises are unique assets that would be impossible to replicate. Wall Street historically has had difficulty ascribing an appropriate value to sports assets and I believe that MSG is no exception. MSG’s sports franchises serve a large, loyal, passionate and affluent fan base in the country’s largest metropolitan market. While recent profitability of the Sports segment has been uninspiring (EBITDA has averaged $27.5 million over past two years; 6% EBITDA margin), the arena upgrade coupled with league media rights agreements should help drive sustained and higher profitability for the segment going forward.

Following the Garden renovation, approximately 80% of the revenue within the Sports segment is now secured under long-term contracts (corporate suites, sponsorship and league revenues) or is derived from sources that have proven to be historically stable such as season ticket sales. The segment’s largest revenue source is ticket sales, which account for approximately 30% of segment revenues. Season tickets, which account for the vast majority of ticket revenues, have been sold out for the Rangers for the past 7 years, while Knicks season tickets have been sold out for the past four years. Notably, for the most recent season, the renewal rate of season tickets for the Knicks and Rangers was 97% and 92%, respectively. The strong season ticket results coupled with the high ticket prices for Knicks (average price of $123 a game, which is highest in the NBA) and Rangers ($233, which ranks 8^th of 30 NHL teams) also helps to reinforce my view of the team’s passionate and affluent fan base.

In addition to the improved arena economics, the Sports segment should also benefit from the robust environment for sports media rights due to league revenue sharing of national broadcast contracts. In 2011, NBC signed a $2 billion, 10-year agreement with the NHL to broadcast games in the U.S. nearly double the amount of the prior contract. Meanwhile, in late 2013 the NHL reached a 12 year, $4.9 billion deal with Rogers Communications for the Canadian broadcast rights that was nearly six times the amount of the current agreement (the new agreement takes commences with the 2014/2015 season). There is also the potential for upside from the NBA’s future media contract. The current NBA league media contract was signed in 2007 and runs through the 2015/2016 season. It should be noted that the current NBA contract was signed in the midst of challenging ratings for the league and before the surge in sports media rights. According to a recent Forbes article, the NBA’s next broadcast deal is expected to be at least double the current yearly average of $930 million that it receives from its current partners including ESPN/ABC and TNT. 

Hidden Assets: Development Rights Offer Significant Long-Term Value

MSG discloses very little information about the development rights that it holds above its flagship arena in Manhattan, which sits above Penn Station, the busiest transportation hub in the country. However, based on my extensive primary research, I believe that these development rights could represent a significant source of long-term value for MSG shareholders – potentially worth nearly $900 million or 20% of MSG’s current market cap. Notably, a recent conversation that I had with an MSG investor relations representative revealed that there is currently no value ascribed to these rights on MSG’s balance sheet (a true hidden asset!). Based on the current dimensions of the property (542.64 feet by 455 feet), which can be located by searching the NYC digital tax map for the property at Block: 781; Lot 9001, and the current zoning for the neighborhood, MSG holds roughly one million square feet of development rights directly above the arena. I estimate that the Company could potentially unlock an additional 2.5 million square feet of air rights/development rights if the area surrounding Penn Station is re-zoned to accommodate a redevelopment of the neighborhood. In 2007, the city proposed re-zoning the area as part of a plan to upgrade Penn Station. While the proposal was not adopted, the station will likely need to be upgraded soon to meet increased passenger volume, which is expected to double over the next 20 years. The Municipal Arts Society of New York City (MASNYC), which a non-profit devoted to intelligent urban planning that is backed by a number of high profile donors including real estate developers Vornado and Forest City Ratner, is leading a charge to build a new Penn Station in order to bolster the city’s competitiveness and ensure long-term economic health. A 2013 article by MASNYC entitled “Unlocking Penn’s Potential” notes: “The district [around Penn Station] is dominated by aging office buildings, and hasn’t had the significant, new Class A construction of the type that has occurred in the nearby Times Square submarket. Given appropriate transit, public space and infrastructure investments, the area could accommodate substantially higher density.” The potential for higher density zoning in the area would be a boon for MSG.

Vornado, which is viewed as an astute and patient long-term real estate investor, has accumulated ~13 properties (7 million square feet) surrounding MSG/Penn Station over the past 20 years and recently stated that it plans “significant” investment in the area. In May 2014, Marriott announced its intention to build a Renaissance hotel in a 38-story tower currently under construction in the neighborhood. It should be noted that Marriott made a similar move during the 1980s when it opened its Marriott Marquis in the troubled Times Square area just before that part of New York City underwent a major resurgence. In my view, these developments should go a long way towards upgrading the neighborhood surrounding the arena and unlocking the value of the Company’s overlooked real estate assets. With the area poised for redevelopment, I would not be surprised if real estate developers become increasingly interested in MSG’s air rights (note: in New York City, air rights are  generally transferrable to nearby properties). The value of air rights in Manhattan has soared in recent years. According to a recent report from Tenantwise Inc., a NY real estate services and advisory company, the average price paid for a square foot of air rights in NYC during 2013 increased by 47% to $305 compared with $207 in 2012 and $244 in 2007, just prior to the 2008/2009 downturn.

Capital Allocation Uncertainties Overblown

MSG has frustrated investors recently by not returning its excess capital to shareholders via dividends or share repurchases. The Company boasts a pristine balance sheet with $77 million of cash (~$250 million pro forma for Fuse sale) and no debt with meaningful free cash flow generation potential on the horizon. Rather than return value to shareholders, management is currently focused on pursuing growth opportunities. MSG invested $120 million (net of tax benefits and loan forgiveness) as part of its 2012 acquisition and subsequent renovation of the LA Forum. Over the past 11 months the Company deployed nearly $200 million for three investments including purchasing a 50% stake in Irving Azoff’s artist management business ($150 million), a JV with Brooklyn Bowl to establish a music venue in Las Vegas ($25 million) and a 50% stake in the Tribeca Film Festival ($22.5 million). While the LA Forum investment makes strategic sense and is located in an underserved entertainment market, the other investments appear somewhat questionable (I’m being kind). I don’t believe the artist management business is a great business, but note that the Company’s prior investment with Azoff proved to be a profitable endeavor (MSG realized a gain when Frontline was sold to Live Nation).

Although shareholders may be uneasy with the investments and potential for sizable future acquisitions, I would note the Dolans, contrary to popular belief, have a successful history of implementing shareholder friendly initiatives. Supporting this view are Cablevision’s spinoffs of MSG and AMC and the family’s robust buyback (albeit ill-timed) and dividend policy at Cablevision. In addition, I believe the Company to be a disciplined acquirer and MSG’s recent proposal to secure development rights for the Nassau Coliseum helps reinforce this view. While MSG agreed to invest more in the project than the winning bidder, the amount of total revenue the Company was willing to share with the county was significantly lower and therefore MSG was not awarded the contract. In addition, the recent sale of the unprofitable Fuse cable network helps further demonstrate my view that the Dolan Family is interested in creating shareholder value by shedding underperforming businesses. While the Company’s current focus on driving growth may irk some investors, management has previously stated that that growing the Company and returning value to shareholders are not mutually exclusive events. In addition, recent comments by MSG CEO Tad Smith provide a reason to be hopeful that shareholder friendly initiatives could be on the horizon. During the Company’s 3Q FY 2014 earnings call held in May 2014, Mr. Smith stated “So for the time being – and only for the time being, our priority is to find new opportunities that enhance our Company’s growth and asset value over the long term.”

Valuation

• Regional Sports Networks – Sports programming has become increasingly valuable in recent years reflecting the DVR-proof nature of the genre. As one media executive stated a few years ago “We know that five, 10 years from now, this might be the only and final appointment-viewing product in the market, other than news. Nobody’s watching the Super Bowl on Monday morning.” Legendary media investor Dr. John Malone stated the following in an August 2014 Wall Street Journal interview regarding Discovery Communications’ interest in the Formula One franchise: “Sports has been elevated as an area of interest in content because of its real-time nature. The industry has a long tradition of paying up for sports and that becomes even more important as other elements of entertainment programming commoditize.”

FOX’s acquisition of a controlling stake in the YES Network during early 2014 at an implied valuation of $3.8 billion provides a good comp for MSG’s RSNs. The valuation translates to $422 per sub (~9 million YES NYC Metro Subs) and nearly 20x EBITDA. The YES network also has approximately 6 million additional national subs, but these subs do not have access Yankees or Nets games so I believe their monthly per sub fees are significantly below the YES Network’s NYC Metro subs. Applying a discounted $300 per sub value to the 8 million MSG RSN subs and $275/sub to the MSG+ RSN subs (fewer Knicks and Rangers games), I derive a value of $4.6 billion (approximates MSG’s current market cap), which implies a 13x multiple based on MSG Media’s 2013 AOCF. I believe that this represents a conservative approach given that the average monthly affiliate fee for MSG’s two networks is at a ~18% discount to the monthly affiliate fee for the YES Network while the per sub value applied to MSG's RSNs represents over a 30% discount to the YES Network comp. The EBITDA multiple implied by the per sub valuation is at the lower end of the range of precedent cable network transactions even though MSG commands superior profitability and meaningfully higher free cash flow conversion vs. cable network properties. (As an aside, I estimate that MSG as a whole will convert over 80% of its EBITDA to free cash flow, which is substantially above the FCF conversion of its media peers including Discovery Communications (~49%), Time Warner (~38%) and Disney (~51%). Looked at on a free cash flow basis, which provides a better comparison, MSG trades at just 15x FCF, representing a nearly 30% discount to the aforementioned peers, which trade at an average of 21x).

• Everything Else For Free – At current levels investors are effectively acquiring MSG’s RSNs at a discounted valuation and receiving all of the Company’s other assets for free. These other assets represent $27 a share in additional value, conservatively valued, or 45% in upside from current levels. The following provides an overview of my valuation for MSG’s other assets:
• Knicks and Rangers – $750 million ($9.59 a share) – While some investors may take issue with assigning a value for MSG’s sports assets beyond the value of the RSNs, I believe that the Knicks and Rangers could be sold without their media rights for a large premium to recent Forbes value. Nevertheless, I have assigned a highly discounted valuation to the most recent Forbes values for the Knicks and Rangers of $1.4 billion and $850 million, respectively. Over the past 10 years, NBA franchises have been acquired (12 precedent transactions) at a roughly 36% premium to the prevailing Forbes value at the time of the transaction. (This premium jumps to 52% if you include the June 2014 proposed deal for the Clippers). During 2011, the Philadelphia 76ers, which ranked 23 of 30 in Forbes recent valuation rankings (the Knicks, rank as the most valuable NBA franchise), were effectively sold without their media rights for a value that approximated the prevailing Forbes value for the team. It is interesting to note that the Yankees, which no longer control the YES Network, still collect a healthy broadcast rights revenue stream. Per the terms of the Yankees’ transaction with Fox, the Yankees currently receive ~$90 million per year for their broadcast rights and this amount is expected to increase at a 5% rate during the 30-year contract term (~$300-$350 million per year in the final years).
• MSG Entertainment – $279 million ($3.57 a share) – I have valued the Entertainment segment at 1x TTM revenue. The segment has been negatively impacted by the Garden’s closure during the renovation, but prospects should improve going forward now that the renovation is complete. The recently acquired and renovated LA Forum should also boost segment prospects in the coming years.
• MSG’s Real Estate – $850 million ($10.87 a share) – I have valued the Company’s two major owned arenas (the Garden and LA Forum) at 50% of their combined renovation costs of ~$1.2 billion. For the Company’s development rights, I have assigned a value of $250 million, which reflects a discounted (relative to recent transactions) $250 value per square foot for the 1 million square feet of development rights that MSG holds under current zoning. I believe this is a conservative approach since I have not applied any value to the 2.5 million square feet of additional development rights that could be unlocked in a potential re-zoning. In addition, the Company owns a number of other real estate assets including the Theater at MSG, a training center in Greenburgh, NY, the Chicago Theater and long-term leases on a number of marquee properties including Radio City Music Hall and the Beacon Theatre that could be a source of additional value, which I have not factored into the valuation.
• Other Investments – $99 Million ($1.26 a share) – MSG has recently invested $198 million for stakes in three separate businesses/ventures including Azoff MSG Entertainment, Brooklyn Bowl Las Vegas and the Tribeca Film Festival. I have valued these stakes at 50% of their original investment. I have not assigned any value to MSG’s 15% stake in the NUVOtv network.
• Cash + 75% of Fuse Cash Proceeds – $246 million ($3.15 a share)
• Less: 2013 Corporate Expenses @ 8x – (-$86 million or -$1.10 a share) 

Risks and Mitigants:

• Capital Allocation Uncertainty – While the Dolan Family has made some questionable capital allocation decisions over the years (Newsday acquisition stands out) they have also demonstrated a commitment to unlock shareholder value with the MSG and AMC Networks spinoffs serving as prime examples.
• Distributor Consolidation – Although Comcast’s proposed acquisition of TWC may create some unease given that both companies are key distributors of MSG’s RSNs (combined subs would be 3.2 million or ~40% of each MSG RSN), I do not believe MSG’s future affiliate fees will be pressured. Comcast is the second largest owner of RSNs (after Fox) and is intimately familiar with the value of live, regional sports programming. It should be noted that Comcast has three RSNs that rank among the 10 most costly regional sports networks in the country.

Catalyst

• Free Cash Flow Acceleration – Significant acceleration of free cash flow following a multi-year, $1 billion+ renovation of MSG’s eponymous arena that masked the Company’s underlying free cash flow generating abilities.
• Re-Pricing of Below Market Rate Affiliate Fee Agreements – Affiliate fee agreements representing 40% of the Company’s subscriber base for its Regional Sports Networks (MSG and MSG+) will likely be renewed at significantly higher rates over the next 2-3 years.
• Optimization of MSG’s Lazy Balance Sheet – Deployment of the Company’s strong free cash flow and overcapitalized balance sheet ($77 million of cash and no debt) toward shareholder friendly initiatives such as dividends, special dividends and share repurchases.
• Increased Manhattan Real Estate Values – Redevelopment of the neighborhood surrounding Penn Station will likely be a boon for real estate values and the Company’s air/development rights located above its flagship arena.
• Phil Jackson – The recent hire of Phil Jackson (13 NBA championships under his belt – 11 as a coach and 2 as a player) as GM of the Knicks should help improve the team’s performance and position them for a championship run.
• Going Private Transaction - The sale of Cablevision or AMC Networks, two Dolan Family controlled assets that are currently attractive acquisition candidates, could provide the Family funding to acquire the rest of MSG.