Media General, Inc. (MEG; $1.2 billion market cap currently; $1.8 billion pro forma), a local broadcaster with 31 network-affiliated TV stations in 28 markets covering approximately 14% of the U.S. population. We have followed the broadcasting industry and MEG for several years and see the company as being underappreciated by the market in an environment in which investors have soured on the industry.

Equity investors adored TV broadcasters in 2013 as M&A activity was pronounced, core local and national advertising demand was sound, and many operators continued to report solid gains in retransmission consent payments from cable and satellite operators. This year is a different story as M&A activity has tapered and national advertising revenue trends have been sluggish. Investor anxiety arose earlier in the year from the threat posed by an upstart new video service provider called Aereo (the broadcasting industry prevailed in the courts), from proposed changes by the FCC to the rules surrounding certain business arrangements that had facilitated M&A (nothing has been finalized), and most recently from a presumed balance of power shift in favor of the national networks whom the local affiliates contract with for programming. More specifically, CBS has taken the lead among the four major networks in negotiating compensation arrangements with affiliates (often called reverse comp or reverse retrans), and investors have perceived that CBS is extracting much more of the economics for itself than the conventional wisdom expected, potentially leading to declines in net retrans for affiliates.

Our take is that there is little doubt that the cost of doing business for CBS affiliates is going up. CBS (and the other networks) have a right to seek fair value for their programming, and the affiliates must do an effective job of getting paid fair value for their signal from cable and satellite operators, as well as creating other revenue streams such as digital. However, with the CBS contracts being five years long, the affiliates a) create certainty around a fixed level of expense for a while, and b) can have multiple opportunities within that window to raise the level of retransmission consent payments from multichannel distributors. So our assessment is that investors have become too conservative in their forecasts for net retrans, a profit stream that we think certain affiliates (like MEG) can continue to grow.

MEG was a struggling company with a weak balance sheet until closing a set of transactions with Berkshire Hathaway in June 2012 that began to transform the company. The transactions included Berkshire receiving penny warrants for nearly 20% of MEG’s outstanding shares. MEG arrived a bit late to the M&A party but ultimately made an aggressive move by merging with Young Broadcasting, which was controlled by the distressed debt/event-driven investment firm Standard General. The merger with Young brought increased scale, geographic and network affiliate diversification, and a means to deleverage as Young had a healthy balance sheet. MEG was actually able to re-finance its senior debt at effectively 4.25%, allowing the combined MEG/Young entity to cut its annual interest expense by nearly 50%.

Fast forward to 2014 and MEG made another bold move by agreeing to merge with LIN Media LLC (LIN). (1) With this merger, MEG will become the third largest station group by number of stations and fourth largest by percentage of U.S. households reached. Increased scale in this industry has brought economic benefits along several dimensions, the most prominent of which has been in negotiating retransmission consent payments. After the LIN deal closes, we expect MEG to continue to deploy capital in value-creating M&A transactions.

The most compelling aspect of this investment lies in the free cash flow generation potential pro forma for the LIN merger. Given the political ad spend that is a boon to the industry every two years (and especially every four years with the presidential election), we look at two-year average annual cash flow. As we look over the 2015-2016 period, we estimate the company has the potential to generate $575 million in average annual EBITDA. The company's debt carries very favorable terms, costing the company approximately $105 million in annual cash interest expense. The company has $680 million in NOLs, thereby providing considerable tax shield. Our bottom line is that we conservatively expect the company to generate average annual free cash flow for the next cycle of at least $2.50 per share. At a $14 stock price, we find a nearly 20% free cash flow yield extremely compelling and believe a 10% free cash flow yield – and at least a $25 stock price – to be more appropriate. It's also worth pointing out that there is underlying asset value in the spectrum MEG owns. The market will begin to place a value on that spectrum if the FCC successfully conducts its incentive auction for broadcasting spectrum planned for next year.

Finally, it’s worth noting the combined MEG/LIN shareholder base will include Berkshire Hathaway, Gabelli Funds, Standard General, Hicks Muse, and Michael Dell’s family office. We don’t often see this type of sponsorship in our small-cap stocks.