MSG NETWORKS INC MSGN
March 11, 2016 - 1:31am EST by
Azalea
2016 2017
Price: 17.39 EPS 1.89 2.06
Shares Out. (in M): 75 P/E 9.2 8.4
Market Cap (in $M): 1,311 P/FCF 8.5 7.7
Net Debt (in $M): 1,300 EBIT 279 300
TEV ($): 2,838 TEV/EBIT 10.7 10.0

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  • Deleveraging
  • Recurring Revenues
  • Family Controlled
  • Potential Acquisition Target
  • Dolan Discount

Description

Investment Thesis:

 

MSG Networks (“MSGN” or “the Company”) offers investors the opportunity to own two highly profitable Regional Sports Networks (RSNs) including MSG and MSG+ that are trading at a meaningful discount to their private market values. If the public markets do not recognize the disconnect, MSGN will likely find itself as a target of a strategic acquirer. I believe that a potential transaction would likely take place at a nearly 100% premium to current levels and I would not be surprised if a takeout occurs within next 2 years.

 

Spin Off Summary:

 

In September 2015, MSG Networks became a stand-alone media company after it spun off its sports and entertainment properties. As part of the separation, investors received one share of The New Madison Square Garden Company (New MSG) for every three shares of the old MSG (now MSG Networks). In conjunction with the separation, MSGN incurred $1.55 billion of debt in order to pay a $1.45 billion dividend to New MSG and entered into a 20-year media rights agreement with New MSG for the local broadcast rights for the New York Knicks and New York Rangers. In my view, the spin off transaction paves the way for an acquisition of MSG Networks and I believe the Dolan Family, which controls MSG Networks via super-voting shares, would be amenable to selling the business. Contrary to popular belief, the Dolans are shareholder friendly and have unlocked a significant amount of shareholder value in recent years. Accordingly, I believe that shareholders of MSG Networks will ultimately be rewarded by their stewardship. In my view, the recent MSGN share price decline (down ~20% from recent post separation highs) has presented an attractive opportunity for investors.

 

Business Overview:

 

MSG Networks operates two RSNs (MSG and MSG+) that each reach approximately 7.5 million viewing subscribers (~15 million in the aggregate), primarily in New York, New Jersey, and Connecticut. The RSNs serve as the regional broadcast home to eight professional sports teams (Knicks, Rangers, Islanders, Devils, Sabres, Liberty, Red Bulls and Westchester Knicks). Each year, MSG and MSG+ collectively telecast approximately 700 live professional sporting events, as well as college football and basketball from top conferences. MSG Networks also features exclusive non game coverage of the New York Giants pursuant to a multi-year agreement, the latest of which was signed in 2013.

 

In addition to its live game programming, MSGN’s RSNs broadcast a full schedule of critically acclaimed original programming. Notably, MSGN has won 112 New York Emmy Awards over the past eight years, more than any single network or station in the region. MSG, MSG+ and MSG.com have a combined 129 wins during that time frame and a total of 232 over their history.

 

The Company’s MSG Go streaming product enables its RSN subscribers the ability to access a selection of its live programming (Knicks, Red Bulls, and Liberty) and video on demand offerings as well as current and past episodes of MSG Networks original programming over multiple platforms (smartphones, tablets, computers, etc.).

 

Why Does this Opportunity Exist?:

 

I believe there are several factor that are weighing on the valuation of MSGN including concerns over cable network industry subscriber trends in general and MSGN’s sub trends in particular, Altice’s proposed acquisition of Cablevision (MSGN’s largest customer), MSGN’s elevated leverage levels and a continued unwarranted “Dolan Discount.” Below I address each of these items.

 

  • Cable Network Valuations Under Pressure - The valuations of cable networks came under significant pressure last past summer after Disney cut the outlook for operating income at its cable unit to mid-single digit % growth from its earlier prediction of high single digit growth. Disney attributed its lowered outlook to modest subscriber declines at its flagship ESPN sports cable network.  The ESPN revelation added fuel to the cord cutting debate and set off fears about the potential for acceleration in industry video subscriber losses. While I’m not naïve enough to dismiss the impact that new distribution platforms are having on the pay-TV ecosystem, industry subscriber attrition is not gaining meaningful momentum, and in fact, the rate of decline has moderated noticeably. According to recent data (November 2015) from Leichtman Research Group, the top nine U.S. cable companies lost ~145k video subscribers in 3Q 2015 compared with a loss of ~440k subscribers in 3Q 2014, and a loss of nearly 600k subscribers in 3Q 2013. Notably, the sub losses by the top cable companies were the fewest in any third quarter since 2006.

     

    MSGN has not been immune to subscriber losses and has experienced a low single digit percent decrease in subs in each of the past two years. Management has primarily attributed the sub losses to migration of some consumers to skinnier packages and to a lesser extent cord cutting. While the sub losses are worth monitoring, it should be noted that MSGN has protections in its contracts that should help mitigate the risks of cord shaving. During the Company’s 1Q FY 2016 earnings call held in November 2015, MSGN CEO Andrea Greenberg described these protections in detail:

 

“While we are not going to get into the specifics of our percentage floors in individual affiliation agreements we can generally describe what they are and they are quite comprehensive. There is one or more of these protections included in every single one of our affiliate agreements and they all are designed to mitigate the impact of cord shaving. We have carriage minimums that require that our networks are made available to a significant percentage of our affiliate’s basic subs and those are actual penetration minimums. So we have to be in front of basic subscribers representing that percentage. We also have what we call tag along rights so to the extent that similarly situated networks are in incremental or additional packages that penetrate at higher levels than we do, we get that same tag along protection. And we have payment minimums. So, in addition to the penetration minimums the actual performance minimums, many of our contracts require that we get paid on a particular payment basis. I do think that it is important to point out that while and I think we expressed that we had experienced a low single digit decrease in subscribers, that quarter over quarter our revenue grew by 4%” (bold my emphasis).

 

While skinnier video packages are likely here to stay, the recent decision (February 2016) by FiOS to modify its Custom TV packages in order to be in compliance with existing programming contracts should help moderate MSGN’s recent subscriber weakness. FiOS is believed to be the third largest distributor of MSGN’s RSNs (~20%-25% of total subscribers) and Custom TV accounted for ~33% of FiOS’ video sales in the fourth quarter of 2015. The new FiOS Custom TV packages include one with sports networks and one without them whereas its prior Custom TV packages only included sports channels as optional add-on tiers.

 

  • Top Customer (Cablevision) is Being Acquired by Aggressive Cost Cutter – The proposed acquisition of Cablevision by Altice has also created some uncertainty, but I believe that concerns are overblown. Altice has gained a reputation as an aggressive cost cutter and there is the potential that it could end up scrutinizing its programming expenses to achieve their lofty cost reduction targets for Cablevision. With Cablevision representing ~40% of MSG’s RSN subs, the prospect that Altice drops the networks or demands a meaningful rate reduction could have a material negative impact on MSGN’s results. However, I believe that it is unlikely Altice would drop the networks and MSGN should have good leverage in 2019 when Cablevision’s current affiliate fee agreement comes up for renewal. The risk of not carrying MSGN’s RSNs would likely have a significant impact on Cablevision’s results due to the potential loss of a large number of highly profitable broadband subscribers. Cablevision CEO Jim Dolan stated at a recent investor conference that CVC’s broadband product is 7x more profitable than their video offering. With Altice levering up CVC to ~7.5x-8.0x at as part of its transaction, the loss of even a small amount of highly profitable broadband subscribers could be catastrophic. With little room for error coupled with the fact that Cablevision’s footprint has a significant overlap with FiOS (approaching 70%) providing consumers with a viable broadband alternative, I believe that MSGN will likely have the upper hand in its future negotiations with Altice. In addition, I estimate that Cablevision’s RSN affiliate fee agreement with the Company is now below the rate MSGN’s other distributors are paying (~$2.82 per month per sub for each network vs. ~$2.93 for non-Cablevision distributors), which should give MSGN additional negotiating leverage.

 

 

  • Elevated Leverage – Upon completion of the spin off, MSGN’s balance was heavily levered with net debt/EBITDA of nearly 5.0x. MSGN's elevated leverage, coupled with its recent adverse subscriber trends may give some investors pause. However, I estimate that MSGN will generate an average of ~$170 million in annual free cash flow (~12% FCF yield) over the next three years enabling it to delever meaningfully and therefore should end 2018 with leverage at just under 3.0x. It is also worth noting that MSGN received very attractive financing (effectively Libor + 200bps) for the $1.55 billion of debt it incurred in conjunction with the spin and this financing would likely not have been attained without meaningful visibility on its future prospects. MSGN is likely to follow the successful deleveraging playbook of AMC Networks, another Dolan controlled entity. During old MSG’s 3Q FY 2015 earnings call held in May 2015, MSGN’s Vice Chairman Gregg Seibert stated, “I think a fair way to look at things here is that sports and entertainment is likely to be the primary return of capital vehicle and the RSN equity return should be driven by both growth in the RSN and the ability of the RSN to deleverage rather rapidly after the spin-off.”

  • Continued Dolan Discount Unwarranted – MSG Networks is controlled by the Dolan Family Group, which has an ~20% economic interest, but holds ~70% of the Company’s voting power. While some in the investment community believe that a “Dolan discount” should be ascribed to Dolan controlled entities, I believe the Dolan Family is shareholder friendly as evidenced by a number of items including the spinoffs of MSG (2010) and AMC Networks (2011), the recent spinoff of the New MSG (September 2015), and the pending sale of Cablevision to Altice (2Q 2016 expected close). It should be noted that since just prior to the initial spin off of old MSG in 2010, one share of Cablevision has increased by 161% vs. a 61% increase in the S&P 500 (includes the value of both MSG and AMC spinoffs) through early March 2016. Investors should also take comfort in that fact that Gregg Seibert is continuing as Vice Chairman of MSG Networks. Mr. Seibert has been a member of Cablevision’s executive team since 2009 and has been instrumental in all of the aforementioned strategic initiatives including being heavily involved in Cablevision’s pending sale to Altice.

 

Despite Higher Sports Rights Fees MSGN’s RSNs Remain Highly Attractive Assets:

 

Despite now incurring additional sports rights fees, I believe that MSGN RSNs are a highly attractive asset reflecting their outsized profitability (mid-40s % EBITDA margins), strong revenue and cash flow visibility (over 85% of revenue secured pursuant to multi-year contracts), and extremely low capital intensity (capex/revenue 3 –year average: 1%). Following the separation of New MSG, the results of MSG Networks now reflect significantly higher rights fees associated with the Knicks and Rangers ($130 million in FY 2016 vs. $81 million in rights fees in FY 2015 for the old MSG Media segment). Nevertheless, MSG Networks still generates extremely high levels of profitability.  The following provides a summary of the Company’s pro-forma results for FY 2015, assuming that the new rights fees were included. Despite incremental rights fees expense of $49 million (prior results reflected an intercompany charge of $81 million in rights fees payable to the old MSG sports segment), MSG Networks would have still generated a pro forma AOCF margin of 44% (note that AOCF, which is similar to EBITDA, also excludes $186 million gain on Fuse sale) in FY 2015.

 

It should be noted that the pro-forma AOCF listed above actually understates MSGN’s true profitability as there are a meaningful amount of expenses included in the above AOCF calculation that MSGN will not incur going forward. In November 2015, MSGN stated that its 1Q FY 2016 operating expenses would have been lower by an estimated $27 million if it had been a stand-alone public company for the quarter. In addition, as detailed in a later section, there are a number of items that could drive profitability higher including affiliate fee and advertising revenue growth.

 

Attractive Business Model:

 

MSG Networks operates an attractive asset light business model with minimal capital expenditure requirements. The vast majority of MSG Network’s revenue is secured pursuant to multi-year agreements with annual escalators. In addition to its revenue visibility, the Company has its largest cost component (media rights fees) secured under very long term agreements. This attractive business model coupled with low cost financing will enable MSG Networks to generate an enormous amount of free cash flow, the vast majority of which will likely be earmarked for debt reduction in the near term. However, as a portion of its debt is paid down over the next year and the company’s strong cash generation continues, I would not be surprised if MSGN implemented a share repurchase program to capitalize on its undervalued shares.

  • Multi-Year Agreements Provide Revenue/Cash Flow Visibility – A key component of MSG’s business model is the revenue and cash flow visibility provided by the multi‑year affiliate fee agreements that MSG Networks receives from its pay-TV distributors. I estimate that ~85% of the Company’s revenues are derived from affiliate fee agreements and believe that there are currently mid-to-high single-digit escalators embedded in these contracts. The Company’s largest distributor agreement is with Cablevision and covers ~40% of the subs to the MSG and MSG+ networks. MSG Networks signed a 10‑year agreement for carriage of these networks with Cablevision in 2010, just prior to MSG’s separation from that company so there are four more years remaining on that agreement which runs through the 2019. In 2012, MSG signed an affiliate fee renewal with Time Warner Cable, the second largest MSGN distributor, covering approximately 30% of subs and I believe that there are ~2-3 years left under that agreement as affiliate fee agreements are typically reached for 5 to 7 year terms. In addition to the multi-year affiliate agreements, it is interesting to note that approximately one-third of MSGN’s advertising revenues are secured pursuant to multi-year contracts.

 

  • Differentiated Content – MSG’s RSNs serve large, loyal and passionate fan bases of several professional sports teams. Heading into the 2015/2016 season, the Knicks have sold out season tickets for five straight years while the Rangers’ streak is at 8 years. In addition, the Knicks and Rangers have sold out every game for the past five and 8 years, respectively. This is an impressive feat, especially for the Knicks whose performance on the court has been mixed in recent years. The high season tickets renewal rates for both the Knicks (past 4 year average: 95%) and the Rangers (91%) also help reinforce my view of the passionate fan base. With an estimated 20 million people residing within the New York Metropolitan area, the local fan base of the teams in the region is arguably the largest of any metro areas in the country even with multiple teams in both leagues. Outside of attending the team’s games in person, the RSNs are the only way for a fan residing in the region to watch the team’s games live. During MSG’s 4Q FY 2015 earnings call held in August 2015 MSG Networks’ Chairman Dolan stated, “At MSG, the product that we have, the professional piece in particular, is really core, core product for customers, particularly obviously in the New York marketplace. It is what I call a must-have product. If you are going to be a multichannel video provider, you have to have it. And so I actually think that bodes pretty well for the regional sports network and its long-term health.”

 

  • Significant Long-Term Cost Visibility – In addition to MSG’s revenue visibility, MSG has even greater visibility in terms of its cost structure. Sports rights are the largest expense flowing through the Company’s P&L (within direct operating expenses) and the vast majority of these rights are locked up pursuant to long term agreements with annual escalators believed to be in the low to mid single-digit range. In 2004, MSG signed a 20‑year agreement with the Devils, providing the network with local media rights through 2024. I would note the somewhat favorable timing of the New Jersey Devils agreement as it was negotiated several years before the recent surge in sports rights. This is somewhat offset by the fact that the Devils were a hot franchise at the time having appeared in three of the four Stanley Cup finals (two victories) preceding the 2004 agreement. According to recent data from Forbes, MSG is currently paying the Devils ~$25 million a year for rights, which appears reasonable in light of the recent Rangers agreement ($30 million per year) in a similar market. In addition, it is worth noting that the Devils agreement is well below the ~$40 million that the Toronto Maple Leafs team receives for its media rights. While the Devils’ TV ratings have been well below those of the Rangers with the Devils garnering an average rating of 0.25 for the 2014/2015 season compared with the Rangers’ 1.63 rating, I note that the Rangers have made the playoffs in nine of the past 10 years including a trip to the Stanley cup finals in 2013/2014. Meanwhile the Devils have not qualified for the playoffs in four of the past five years though they did make it to the Stanley Cup finals in 2011/2012. Similarly, the New York Islanders are believed to have signed a 30 year deal in the late 1990s (before sports rights escalation) with that deal expected to expire in 2031.

 

MSG Networks - Media Rights Agreement Summary

Team

FY2016 Estimated/Actual

Media Rights Fee ($MM)

Year

Agreement Reached

Expiration

NY Knicks1

$100

2015

2035

NY Rangers1

$30

2015

2035

NJ Devils2,3

$25

2004

2025

NY Islanders2

$27

late 1990s

2031

Buffalo Sabres2,4

$10

2006

2017

 

                                                                              Sources: 1) Company Filings

                                                                                2) Sports Business Daily March 17, 2014, p.22

                                                                                              http://www.sportsbusinessdaily.com/Journal/Issues/2014/03/17/In-Depth/RSN-chart.aspx

                                                                                3) http://www.prnewswire.com/news-releases/msg-networks-and-the-new-jersey-devils-announce-carriage-extension-75274257.html

                                                                                4) http://sabres.nhl.com/club/news.htm?id=437214

 

  • Minimal Capital Expenditures – MSG Network’s capital expenditure requirements are extremely low and have averaged just 1% of revenues in each of the past three years. I don’t believe that there are any major capital expenditures on the horizon and would note that MSGN opened up a new state of the art TV studio in 2014.

 

Growth Opportunities:

 

While MSGNs RSNs are mature cable properties, I believe that MSGN’s results will likely benefit from a couple of notable growth opportunities including increased adoption of the RSNs streaming capabilities by distributors and higher advertising revenues.

 

  • Increased MSG Go Penetration – At present, just two of MSGN’s distributors (Cablevision and Comcast) accounting for ~50-55% of MSGN subs have access to the MSG Go streaming product. MSG is currently in discussions with its other distributors about the product and I believe that there is a good chance they will eventually reach an agreement to offer MSG GO. With consumers increasingly seeking the ability to access content on multiple platforms I believe that MSG GO will be important from a distributor’s perspective in terms of subscriber retention. Increased distributor adoption of MSG GO should enable MSG Networks to extract higher affiliate fees and I would note that ESPN is believed to command an additional $0.20 per month per sub from its distributors for the ability to utilize their streaming product (Watch ESPN, etc.). One potential catalyst for the increased distributor adoption of MSG GO would be the addition of NHL content to the product. At present, regional sports networks do not have the rights to stream NHL games. While the league and teams/RSNs have been in negotiations/discussions about the local rights for multiple years, there is reason to be hopeful that an agreement could be on the horizon. In August 2015, the NHL and MLB Advanced Media (MLBAM) reached a six year deal for the distribution of the league's digital content. Notably, as part of the deal, MLBAM has the exclusive digital rights to live out of market games leaving open the possibility that a separate agreement could be reached with the teams/RSNs over the local streaming rights. During MSGN’s 1Q 2016 earnings call held in November 2015, MSGN CEO Greenberg stated, “The NHL has not yet granted any RSN over the top or online streaming rights. But we continue to talk to them and we certainly hope to make our NHL product available as part of our MSG GO offering in the very near future.”

 

  • Increased Advertising Revenues – Advertising revenues still account for just ~15% (MSGN does not disclose precise amount) of the RSNs’ revenues base, but I believe there are several factors that could increase the contribution from this high margin revenue source going forward. In today’s fragmented media landscape, advertisers are increasingly gravitating to live sports where DVR viewing is limited. According to MSGN management, over 99% of its viewers watch its game programming live. Furthermore, the vast majority of MSGN’s viewers are in the highly coveted 25 to 54 demographic and boast high household incomes. In addition to being viewed live, regional sports networks command large audiences, which is also attractive for advertisers. According to a recent article in Broadcasting & Cable, during the 2014/2015 NBA season, the top 10 NBA RSNs were ranked in the top 5 channels in their respective markets outpacing many popular broadcast and cable networks. Although ratings have been mixed for the Knicks during the 2015/2016 season, any sustained improvement in team’s performance could also help boost advertising revenues. The prospect for increased adoption of MSG GO also bodes well for future advertising revenue. The MSG GO distribution platform also offers increased advertising inventory with different ads often appearing on the linear and digital platforms. There is also the potential for MSGN's RSNs to benefit from targeted advertising as these capabilities are refined on both linear and streaming broadcasts.

 

MSG Networks Likely to be Acquired – Recent Commentary/Action Portend a Sale:

 

While I would never want the potential for a takeout to be the crux of an investment thesis, I believe that there is a high likelihood that MSG Networks will be sold in the near term. In my view, Comcast (CMCSA) and Twenty-First Century Fox (FOX) are logical acquirers since both operate large portfolios of regions sports networks. Another potential acquirer could include AT&T, which owns a small portfolio of RSNs (Root Sports) via its recent acquisition of DirecTV and it is also worth noting that DirecTV has ~750k MSG/MSG+ subs in the NY Metro area. I would also not rule out the potential that Altice emerges as a potential suitor for MSG Networks. Altice has expressed a strong desire to own local content in the NYC metro area and I believe that MSG Network’s RSNs would be particularly appealing. During Altice’s negotiations with the Dolan Family for control of Cablevision, Altice’s CEO Patrick Drahi made it clear that he wanted Cablevision’s local news cable networks (seven News 12 hyper local cable networks serving the NYC metro area) included in any potential transaction. Early in the Cablevision negotiations with Altice, the Dolans wanted to maintain control of these unprofitable local news assets by spinning them off prior to the completion of transaction involving the cable systems. The following are two items that I believe suggest that MSGN’s days as an independent public company could be numbered.

 

  • Management Commentary – Leading up to the separation, MSG’s management went out of their way to state that the spin off was not part of a plan to facilitate an acquisition of one of the entities. If such a plan was contemplated, it would likely jeopardize the tax free nature of the separation if an acquisition of MSGN were to occur in the near term. The following statements were made by MSG’s Vice Chairman Gregg Seibert during recent earnings calls (my emphasis added in bold):

 

“The purpose of the spin is to have two high quality management teams, have the opportunity to be able to grow their businesses. I think that you certainly have seen some degree of consolidation in the RSN space, but there’s no intention or interest at this point in time in selling either of these businesses. I think we believe that both businesses have a very attractive growth profile ahead of them on a long-term basis and we are doing the spins in order to set them up to be able to achieve that growth.”

                                                                                                                                                     – 4Q FY 2015 Earnings Call in August 2015

 

“Michael, let me comment on the strategy of the two companies because there is absolutely no present intention for either of these two entities to be sold and there is no present intention that either of them will make a very significant acquisition going forward. As Jim pointed out, the spin-offs are intended to give both companies more strategic flexibility, and as we look forward I think the strategic direction for both companies will be determined by Management and the Board of Directors of the independent separate companies.”

                                                                                                                                                                                                                                                      – 3Q FY 2015 Earnings Call in May 2015

 

  • Short-Term Financing – While the Company has attained extremely attractive financing (interest rate on ~$1.5 billion of term loans is effectively Libor + 200bps), I believe that if it was intended for MSG Networks to be an independent Company for several years, it would have issued debt with a term longer than five years, especially with the favorable interest rate/credit markets environment prevailing at the time of the separation.

 

YES Network Concerns Overblown:

 

Comcast’s recent decision to pull YES Network from its subs in the New York Metro area has also created some concern over regional sports networks. However, Comcast’s decision to stop carrying the network appears to be less about price and more about carriage of Fox’s other networks with both Comcast and new distribution platforms. It should be noted that Comcast’s agreement with the YES Network expired in January 2015 and Comcast agreed to pay a higher rate during contract extensions until it pulled the network after the MLB season ended. A further discussion of the affiliate fee dispute between YES Network and Comcast is detailed in the article below that recently appeared in The Wall Street Journal.

 

Here Are the Real Reasons Comcast Customers Won’t Get to Watch Nets, Yankees Games:

http://www.wsj.com/articles/heres-are-the-real-reasons-comcast-customers-wont-get-to-watch-nets-yankees-games-1448486543

 

It is also worth highlighting that in December 2015, Comcast became the second distributor to be granted rights to the MSG GO Product. The Comcast development likely implies that Comcast also recently renewed its affiliate fee agreement with MSGN.

 

MSG Networks Will Likely Command Premium Valuation In an Acquisition – Bidding War Could Erupt:

 

At current levels, MSGN trades at just $212 per my 2018E subscriber amount (~6% below current sub count) and a relatively modest 9.0x 2018E EBITDA (EV reflects one-time $152 million tax payment expected to be paid in FY 2016), representing a significant discount to the implied valuation of YES Network ($422 per sub and ~17.5x EBITDA) based on Fox’s 2014 investment for a controlling stake in that network. In my view, the discount (~50% based on both subs and EBITDA) is unwarranted given the similar financial profile of the networks. Even with the adverse impact on MSGN’s profitability from the increased rights fees, MSGN’s current EBITDA margins of ~45% are on par with the 45-50% EBITDA margins generated by YES Network. It is also worth highlighting that YES Network is believed to have signed a 20 year rights agreement with the Yankees in 2012. Utilizing a blended valuation approach and applying discounted multiples (relative to the aforementioned YES Network transaction) including $238 per subscriber and 12x EV/EBITDA to my estimated 2018 sub count  and EBITDA, respectively I derive a value of ~$35 a share, representing nearly 100% upside from current levels. It should be noted that the 12x multiple utilized is not only a discount to the YES Network comp, but also precedent transactions of cable network properties. If MSG Networks became the target of a strategic acquirer, I would not be surprised if it commanded a premium valuation as there are likely significant cost savings that would be able to be achieved by cutting the Company’s pricey executive staff and corporate overhead.

As noted above, I believe that Fox and Comcast would be logical acquirers and I would not be surprised if a bidding war ultimately erupts for the Company’s RSNs.  If Fox were to control the MSG RSNs, that company would have a near monopoly on professional sports programming in the NY Metro sports market, with rights to every major local professional sporting events that are broadcast on a regional sports network with the exception of the NY Mets, which have their own RSN. By controlling both YES and the MSG Networks in the NYC Metro area, Fox would garner significant leverage over pay-TV distributors and would likely be able to generate meaningful cost synergies. Looking out 5-10 years when streaming video is likely to become more mainstream and sports programming will likely be increasingly attractive for advertisers, the ability to put together a comprehensive streaming package of NY Sports content would also be particularly appealing. Comcast would also appear to have a strong interest in acquiring the MSG RSNs as a way of controlling their programming costs since it has nearly 1 million video subs in the NYC metropolitan area. In my view, Comcast would also likely be able to realize similar cost synergies due to its existing RSN portfolio including an interest in the Mets’ regional sports network (SportsNet New York). MSG Networks could also be an attractive property for Root Sports and now that the business is owned by AT&T (via DirecTV acquisition), Root Sports would have additional financial capacity to complete a transaction. DirecTV has long invested in sports content (NFL Sunday Ticket and niche rights for the PGA Tour, Professional Tennis, etc.) while AT&T has minority investments in the MLB and NHL networks.

Additional Risks and Mitigants:

 

  • Customer Concentration – MSGN’s top three distributors including Cablevision, Time Warner Cable and FiOS account for ~70% of overall revenue so the loss of one of these distributors would have a meaningful impact on MSGN’s results. However, I don’t believe that any one of these larger distributors will consider dropping the network given must have nature of MSGN’s contents and the high FiOS overlap in the NYC metro region. These factors should also give MSGN good negotiating leverage during future affiliate fee renewals.

 

  • Over-The-Top (OTT) Uncertainty – With consumers increasingly accessing content over multiple platforms, it is important for cable networks to offer its customers streaming capabilities. As part of a new 9-year media agreement (begins with 2016/2017 season) reached by the NBA with its broadcast partners (ESPN, TNT, etc.), MSG’s regional sports networks will maintain the same local market rights with the same number of exclusive local market games including streaming rights. For example, during the 2015/2016 season, MSG Networks will be telecasting 78 of the Knicks’ 82 regular season games. However, the new NBA media agreement does enable ESPN to offer a streaming package to non-pay TV subscribers, though the offering would only enable a subscriber to access out of market games. The NHL has yet to make a decision on its local media rights. According to press reports, the league has been in discussions with teams/RSNs over local rights for multiple years. As I noted above, the NHL recently announced an agreement with MLB Advanced Media for digital rights, but these agreements relate to out of market games providing reason to be hopeful that the league is looking to provide the teams/RSNs with these rights at some point in the future. Nevertheless, it’s possible that the league could also retain the local rights especially if it believes it could create a new revenue stream from the content.

 

  • Buffalo Sabres Renewal – The ownership of the Sabres (also owns the Buffalo Bills) hired Allen & Co. in 2015 to explore the creation of a regional sports network. While a final decision has yet to be made, the Sabres’ current agreement with MSG (2017 expiration) is very attractive and is expected to generate $10 million in rights fees plus the Sabres keep all the advertising revenue, which could add an additional $3 million to $5 million. Furthermore, the Sabres will likely be able to command higher fees from MSG in a future rights deal. The Sabres generate strong ratings and their loss would likely adversely impact MSGN’s profitability, but I believe the team is a relatively small contributor compared with MSGN’s other franchises, which operate in a much larger metropolitan area (metro population of 1.1 million in Buffalo vs. 20.1 million in the New York City metro region). Using annual rights fees as a guide, the ~$10 million that MSG Networks pays for Sabres rights accounts for approximately 6% of the MSG Network’s overall media rights fees.

 

  • Rising Interest Rates – MSG is currently heavily levered with floating rate debt so a rising interest rate environment would likely negatively impact future free cash flow generation. However, given the favorable financing secured as part of the separation, interest rates would have to rise meaningfully before it would be cause for concern. During 2Q FY 2016, MSGN’s interest expense was just $9.7 million ($39 million annual run rate) well below the ~$150 million of free cash flow I expect the Company to generate in FY 2016.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Improved subscriber loss trends

  • Further affiliate fee growth as MSG GO penetration increases

  • Increased advertising revenues

  • A sustained improvement in NY Knicks performance

  • Deployment of excess free cash flow towards share repurchases

  • An acquisition by a strategic acquirer

 

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    Description

    Investment Thesis:

     

    MSG Networks (“MSGN” or “the Company”) offers investors the opportunity to own two highly profitable Regional Sports Networks (RSNs) including MSG and MSG+ that are trading at a meaningful discount to their private market values. If the public markets do not recognize the disconnect, MSGN will likely find itself as a target of a strategic acquirer. I believe that a potential transaction would likely take place at a nearly 100% premium to current levels and I would not be surprised if a takeout occurs within next 2 years.

     

    Spin Off Summary:

     

    In September 2015, MSG Networks became a stand-alone media company after it spun off its sports and entertainment properties. As part of the separation, investors received one share of The New Madison Square Garden Company (New MSG) for every three shares of the old MSG (now MSG Networks). In conjunction with the separation, MSGN incurred $1.55 billion of debt in order to pay a $1.45 billion dividend to New MSG and entered into a 20-year media rights agreement with New MSG for the local broadcast rights for the New York Knicks and New York Rangers. In my view, the spin off transaction paves the way for an acquisition of MSG Networks and I believe the Dolan Family, which controls MSG Networks via super-voting shares, would be amenable to selling the business. Contrary to popular belief, the Dolans are shareholder friendly and have unlocked a significant amount of shareholder value in recent years. Accordingly, I believe that shareholders of MSG Networks will ultimately be rewarded by their stewardship. In my view, the recent MSGN share price decline (down ~20% from recent post separation highs) has presented an attractive opportunity for investors.

     

    Business Overview:

     

    MSG Networks operates two RSNs (MSG and MSG+) that each reach approximately 7.5 million viewing subscribers (~15 million in the aggregate), primarily in New York, New Jersey, and Connecticut. The RSNs serve as the regional broadcast home to eight professional sports teams (Knicks, Rangers, Islanders, Devils, Sabres, Liberty, Red Bulls and Westchester Knicks). Each year, MSG and MSG+ collectively telecast approximately 700 live professional sporting events, as well as college football and basketball from top conferences. MSG Networks also features exclusive non game coverage of the New York Giants pursuant to a multi-year agreement, the latest of which was signed in 2013.

     

    In addition to its live game programming, MSGN’s RSNs broadcast a full schedule of critically acclaimed original programming. Notably, MSGN has won 112 New York Emmy Awards over the past eight years, more than any single network or station in the region. MSG, MSG+ and MSG.com have a combined 129 wins during that time frame and a total of 232 over their history.

     

    The Company’s MSG Go streaming product enables its RSN subscribers the ability to access a selection of its live programming (Knicks, Red Bulls, and Liberty) and video on demand offerings as well as current and past episodes of MSG Networks original programming over multiple platforms (smartphones, tablets, computers, etc.).

     

    Why Does this Opportunity Exist?:

     

    I believe there are several factor that are weighing on the valuation of MSGN including concerns over cable network industry subscriber trends in general and MSGN’s sub trends in particular, Altice’s proposed acquisition of Cablevision (MSGN’s largest customer), MSGN’s elevated leverage levels and a continued unwarranted “Dolan Discount.” Below I address each of these items.

     

     

    “While we are not going to get into the specifics of our percentage floors in individual affiliation agreements we can generally describe what they are and they are quite comprehensive. There is one or more of these protections included in every single one of our affiliate agreements and they all are designed to mitigate the impact of cord shaving. We have carriage minimums that require that our networks are made available to a significant percentage of our affiliate’s basic subs and those are actual penetration minimums. So we have to be in front of basic subscribers representing that percentage. We also have what we call tag along rights so to the extent that similarly situated networks are in incremental or additional packages that penetrate at higher levels than we do, we get that same tag along protection. And we have payment minimums. So, in addition to the penetration minimums the actual performance minimums, many of our contracts require that we get paid on a particular payment basis. I do think that it is important to point out that while and I think we expressed that we had experienced a low single digit decrease in subscribers, that quarter over quarter our revenue grew by 4%” (bold my emphasis).

     

    While skinnier video packages are likely here to stay, the recent decision (February 2016) by FiOS to modify its Custom TV packages in order to be in compliance with existing programming contracts should help moderate MSGN’s recent subscriber weakness. FiOS is believed to be the third largest distributor of MSGN’s RSNs (~20%-25% of total subscribers) and Custom TV accounted for ~33% of FiOS’ video sales in the fourth quarter of 2015. The new FiOS Custom TV packages include one with sports networks and one without them whereas its prior Custom TV packages only included sports channels as optional add-on tiers.

     

     

     

     

    Despite Higher Sports Rights Fees MSGN’s RSNs Remain Highly Attractive Assets:

     

    Despite now incurring additional sports rights fees, I believe that MSGN RSNs are a highly attractive asset reflecting their outsized profitability (mid-40s % EBITDA margins), strong revenue and cash flow visibility (over 85% of revenue secured pursuant to multi-year contracts), and extremely low capital intensity (capex/revenue 3 –year average: 1%). Following the separation of New MSG, the results of MSG Networks now reflect significantly higher rights fees associated with the Knicks and Rangers ($130 million in FY 2016 vs. $81 million in rights fees in FY 2015 for the old MSG Media segment). Nevertheless, MSG Networks still generates extremely high levels of profitability.  The following provides a summary of the Company’s pro-forma results for FY 2015, assuming that the new rights fees were included. Despite incremental rights fees expense of $49 million (prior results reflected an intercompany charge of $81 million in rights fees payable to the old MSG sports segment), MSG Networks would have still generated a pro forma AOCF margin of 44% (note that AOCF, which is similar to EBITDA, also excludes $186 million gain on Fuse sale) in FY 2015.

     

    It should be noted that the pro-forma AOCF listed above actually understates MSGN’s true profitability as there are a meaningful amount of expenses included in the above AOCF calculation that MSGN will not incur going forward. In November 2015, MSGN stated that its 1Q FY 2016 operating expenses would have been lower by an estimated $27 million if it had been a stand-alone public company for the quarter. In addition, as detailed in a later section, there are a number of items that could drive profitability higher including affiliate fee and advertising revenue growth.

     

    Attractive Business Model:

     

    MSG Networks operates an attractive asset light business model with minimal capital expenditure requirements. The vast majority of MSG Network’s revenue is secured pursuant to multi-year agreements with annual escalators. In addition to its revenue visibility, the Company has its largest cost component (media rights fees) secured under very long term agreements. This attractive business model coupled with low cost financing will enable MSG Networks to generate an enormous amount of free cash flow, the vast majority of which will likely be earmarked for debt reduction in the near term. However, as a portion of its debt is paid down over the next year and the company’s strong cash generation continues, I would not be surprised if MSGN implemented a share repurchase program to capitalize on its undervalued shares.

     

     

     

    MSG Networks - Media Rights Agreement Summary

    Team

    FY2016 Estimated/Actual

    Media Rights Fee ($MM)

    Year

    Agreement Reached

    Expiration

    NY Knicks1

    $100

    2015

    2035

    NY Rangers1

    $30

    2015

    2035

    NJ Devils2,3

    $25

    2004

    2025

    NY Islanders2

    $27

    late 1990s

    2031

    Buffalo Sabres2,4

    $10

    2006

    2017

     

                                                                                  Sources: 1) Company Filings

                                                                                    2) Sports Business Daily March 17, 2014, p.22

                                                                                                  http://www.sportsbusinessdaily.com/Journal/Issues/2014/03/17/In-Depth/RSN-chart.aspx

                                                                                    3) http://www.prnewswire.com/news-releases/msg-networks-and-the-new-jersey-devils-announce-carriage-extension-75274257.html

                                                                                    4) http://sabres.nhl.com/club/news.htm?id=437214

     

     

    Growth Opportunities:

     

    While MSGNs RSNs are mature cable properties, I believe that MSGN’s results will likely benefit from a couple of notable growth opportunities including increased adoption of the RSNs streaming capabilities by distributors and higher advertising revenues.

     

     

     

    MSG Networks Likely to be Acquired – Recent Commentary/Action Portend a Sale:

     

    While I would never want the potential for a takeout to be the crux of an investment thesis, I believe that there is a high likelihood that MSG Networks will be sold in the near term. In my view, Comcast (CMCSA) and Twenty-First Century Fox (FOX) are logical acquirers since both operate large portfolios of regions sports networks. Another potential acquirer could include AT&T, which owns a small portfolio of RSNs (Root Sports) via its recent acquisition of DirecTV and it is also worth noting that DirecTV has ~750k MSG/MSG+ subs in the NY Metro area. I would also not rule out the potential that Altice emerges as a potential suitor for MSG Networks. Altice has expressed a strong desire to own local content in the NYC metro area and I believe that MSG Network’s RSNs would be particularly appealing. During Altice’s negotiations with the Dolan Family for control of Cablevision, Altice’s CEO Patrick Drahi made it clear that he wanted Cablevision’s local news cable networks (seven News 12 hyper local cable networks serving the NYC metro area) included in any potential transaction. Early in the Cablevision negotiations with Altice, the Dolans wanted to maintain control of these unprofitable local news assets by spinning them off prior to the completion of transaction involving the cable systems. The following are two items that I believe suggest that MSGN’s days as an independent public company could be numbered.

     

     

    “The purpose of the spin is to have two high quality management teams, have the opportunity to be able to grow their businesses. I think that you certainly have seen some degree of consolidation in the RSN space, but there’s no intention or interest at this point in time in selling either of these businesses. I think we believe that both businesses have a very attractive growth profile ahead of them on a long-term basis and we are doing the spins in order to set them up to be able to achieve that growth.”

                                                                                                                                                         – 4Q FY 2015 Earnings Call in August 2015

     

    “Michael, let me comment on the strategy of the two companies because there is absolutely no present intention for either of these two entities to be sold and there is no present intention that either of them will make a very significant acquisition going forward. As Jim pointed out, the spin-offs are intended to give both companies more strategic flexibility, and as we look forward I think the strategic direction for both companies will be determined by Management and the Board of Directors of the independent separate companies.”

                                                                                                                                                                                                                                                          – 3Q FY 2015 Earnings Call in May 2015

     

     

    YES Network Concerns Overblown:

     

    Comcast’s recent decision to pull YES Network from its subs in the New York Metro area has also created some concern over regional sports networks. However, Comcast’s decision to stop carrying the network appears to be less about price and more about carriage of Fox’s other networks with both Comcast and new distribution platforms. It should be noted that Comcast’s agreement with the YES Network expired in January 2015 and Comcast agreed to pay a higher rate during contract extensions until it pulled the network after the MLB season ended. A further discussion of the affiliate fee dispute between YES Network and Comcast is detailed in the article below that recently appeared in The Wall Street Journal.

     

    Here Are the Real Reasons Comcast Customers Won’t Get to Watch Nets, Yankees Games:

    http://www.wsj.com/articles/heres-are-the-real-reasons-comcast-customers-wont-get-to-watch-nets-yankees-games-1448486543

     

    It is also worth highlighting that in December 2015, Comcast became the second distributor to be granted rights to the MSG GO Product. The Comcast development likely implies that Comcast also recently renewed its affiliate fee agreement with MSGN.

     

    MSG Networks Will Likely Command Premium Valuation In an Acquisition – Bidding War Could Erupt:

     

    At current levels, MSGN trades at just $212 per my 2018E subscriber amount (~6% below current sub count) and a relatively modest 9.0x 2018E EBITDA (EV reflects one-time $152 million tax payment expected to be paid in FY 2016), representing a significant discount to the implied valuation of YES Network ($422 per sub and ~17.5x EBITDA) based on Fox’s 2014 investment for a controlling stake in that network. In my view, the discount (~50% based on both subs and EBITDA) is unwarranted given the similar financial profile of the networks. Even with the adverse impact on MSGN’s profitability from the increased rights fees, MSGN’s current EBITDA margins of ~45% are on par with the 45-50% EBITDA margins generated by YES Network. It is also worth highlighting that YES Network is believed to have signed a 20 year rights agreement with the Yankees in 2012. Utilizing a blended valuation approach and applying discounted multiples (relative to the aforementioned YES Network transaction) including $238 per subscriber and 12x EV/EBITDA to my estimated 2018 sub count  and EBITDA, respectively I derive a value of ~$35 a share, representing nearly 100% upside from current levels. It should be noted that the 12x multiple utilized is not only a discount to the YES Network comp, but also precedent transactions of cable network properties. If MSG Networks became the target of a strategic acquirer, I would not be surprised if it commanded a premium valuation as there are likely significant cost savings that would be able to be achieved by cutting the Company’s pricey executive staff and corporate overhead.

    As noted above, I believe that Fox and Comcast would be logical acquirers and I would not be surprised if a bidding war ultimately erupts for the Company’s RSNs.  If Fox were to control the MSG RSNs, that company would have a near monopoly on professional sports programming in the NY Metro sports market, with rights to every major local professional sporting events that are broadcast on a regional sports network with the exception of the NY Mets, which have their own RSN. By controlling both YES and the MSG Networks in the NYC Metro area, Fox would garner significant leverage over pay-TV distributors and would likely be able to generate meaningful cost synergies. Looking out 5-10 years when streaming video is likely to become more mainstream and sports programming will likely be increasingly attractive for advertisers, the ability to put together a comprehensive streaming package of NY Sports content would also be particularly appealing. Comcast would also appear to have a strong interest in acquiring the MSG RSNs as a way of controlling their programming costs since it has nearly 1 million video subs in the NYC metropolitan area. In my view, Comcast would also likely be able to realize similar cost synergies due to its existing RSN portfolio including an interest in the Mets’ regional sports network (SportsNet New York). MSG Networks could also be an attractive property for Root Sports and now that the business is owned by AT&T (via DirecTV acquisition), Root Sports would have additional financial capacity to complete a transaction. DirecTV has long invested in sports content (NFL Sunday Ticket and niche rights for the PGA Tour, Professional Tennis, etc.) while AT&T has minority investments in the MLB and NHL networks.

    Additional Risks and Mitigants:

     

     

     

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     

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