Description

This is a buy recommendation on Paxson Communication’s 14.25% Preferred Stock. Paxson has been a company that has been wallowing in a valuation quagmire for some time now. On the one hand, it has a valuable collection of nation-wide broadcasting assets, and on the other, totally abysmal programming content, coupled with a majority shareholder who was reluctant to pursue any major strategic change of direction or restructuring. This has all changed in the past month with the announcement of a new deal with NBC Universal. Not only does this deal put the company “in play,” but also introduces a potential owner that can actually bring in meaningful content to Paxson’s far-reaching broadcasting assets and thereby realize their value more fully and quickly. I believe this transaction opens the door for a change of control event occurring within the next 12 months, resulting in the redemption of this preferred stock at 101%. This, along with the accrued 14.25%, makes for a nice, relatively low-risk return, given the current trading range of 87-88.

BUSINESS DESCRIPTION
Paxson is a network television broadcasting company that owns and operates 60 broadcast television stations in 40 of the top 50 U.S. markets. The PAX TV network reaches approximately 95 million homes, or 87% of prime time television households in the U.S. Paxson’s current programming consists mainly of shows that have appeared previously on other broadcast networks that Paxson has purchased the right to air, infomercials and public interest programming. Paxson derives its revenues through three segments: (1) infomercials (approximately 40%), (2) network spot advertising for nationwide coverage (approximately 20% of revenues), and (3) station advertising for local coverage (approximately 40% of revenues). Paxson has joint sales agreements (“JSAs”) with owners of broadcast stations in markets served by PAX, whereby the JSA partner has exclusive rights to sell Paxson’s station advertising in local and nationwide markets. Paxson distributes its programming through three major channels: (i) its network of 60 owned and operated TV stations, (ii) carriage rights with cable MSOs and satellite TV providers and (iii) PAX-affiliated stations. Bud Paxson, Chairman of the Board, controls the company through his ownership of the Class B voting shares.

NBC TRANSACTION
For some time, there had been speculation over the value imbedded in Paxson’s assets, but it was always unclear on what would trigger its realization. I believe that the NBC transaction clearly presents a logical sequence of events and a timetable for realizing this value.

Highlights of the Transaction:

- NBC Universal acquires a transferable 18-month call right on all of Bud Paxson’s common shares, including the Class B voting shares for $25 million. The exercise prices on this call option for the Class A and Class B shares are $0.25 and $0.29, respectively.

- To exercise the call, the owner of the call must make a tender offer to purchase all Class A common shares held by the public at $1.25/share. This price will appreciate annually at 10% until the tender is commenced.

- If the call is not exercised or transferred within 18 months, Class A shareholders will receive $105 million face value of Series B preferred stock, increasing by 10% until delivered.

- NBC will reduce the accrued and unpaid dividends on its 11% preferred (approx. $280 million) by $100 million, with the remainder converted into additional Series B preferred stock. The conversion price of this preferred is lowered from $22.06 to $2.00 per share.

- This transaction will cancel Bud Paxson’s warrants to purchase 32 million shares of Paxson Class A common stock.

- NBC executive Brandon Burgess assumes position as CEO and Chairman. Bud Paxson will remain as Chairman Emeritus.


WHAT DOES THIS TRANSACTION ACCOMPLISH?
In a nutshell, this transaction paves the way for NBC to assume financial and operating control over Paxson, unlocking value for investors. It takes Bud Paxson out of the equation; he had always been unwilling to sell the company unless it was at a significant premium to the annual appraised value. The NBC transaction effectively values Paxson in line with the recent appraised value of $2.3 billion. NBC also assumes the helm in the restructuring and sale process. Given NBC’s preferred stock holding in Paxson, I would think NBC would steer this toward a transaction that would retain and increase the value of that preferred (which is junior to the 14.25% preferred stock).

The transferability feature of the call right is important, since it allows a friendly third-party to effect the change of control, in the event that NBC’s ownership may violate ongoing FCC ownership restrictions. In all likelihood, NBC will (or already has) identified a partner with whom they could leverage the existing broadcasting presence of Paxson by infusing some meaningful content.

Given all these favorable events, however, this investment still comes down to two key issues: (1) the value of the assets, and (2) the probability that a change of control occurs (through the transfer of the call option). I’ll address these points below:

VALUE OF ASSETS
The first point of reference in terms of asset valuation is the annual appraisal that BIA Financial performs for Paxson’s broadcasting assets. Earlier this month, BIA placed this value at $2.3 billion. In the past, Paxson trading values have not reflected the appraised value, due to the fact that the heavy debt load and shareholder control issues (i.e. Bud Paxson) would preclude a sale of the entire company. However, the recent move up in trading levels of its securities puts the enterprise value near the appraised value of $2.3 billion. If we value the enterprise based on the current offer price of 88 on the 14.25% preferred stock ($523M face), we come up with approximately $1.5 billion, or a 35% discount to the appraised value. Note: along these lines, I’ve also done a station-by-station valuation, which lays out the per household captured by each metropolitan area. I would need to input very conservative per household metrics in order to get an enterprise value of $1.5B.

The second point of reference is the recent sales of “stick” stations sold by Granite at approximately $40 per household. In contrast, the $1.5B enterprise value discussed above places a per household value of under $22 for Paxson. Given that Paxson has valuable broadcasting presence in all the major metropolitan areas (including NYC, LA, Chicago, Philadelphia, etc.) and reaches 69% of prime time households, this 45% discount seems unwarranted and, in my view, is more representative of a liquidation scenario, rather than an ongoing concern with the strength of NBC backing it. To further validate this liquidation-type value of $1.5B, we can look at the appraisal put right that is included in the terms of the recent tender offer Paxson has made for its debt. According to these terms, if the appraised value of Paxson’s broadcasting assets is less than 1.5 times the total new debt of $1.13B (or $1.7B), the company is required to redeem the new notes at par. If this happens, then the company will need to sell off assets or file for bankruptcy.


PROBABILITY OF AN ACQUISITION
As I’ve mentioned above, I believe the terms of the NBC transaction spell out in many ways a high likelihood of a change of control event in the next 12 months. NBC now has the unfettered ability to restructure the company financially and operationally in order to optimize a sale, without the hindrance of prior Paxson management. The removal of Bud Paxson’s voting ability, the installation of an NBC executive as CEO, the settlement of litigation between NBC and Paxson, the tender offer for Paxson’s existing debt are all preparatory moves to facilitate this event. I believe the timing will be within the next 12-18 months, based on the fact that the redemptions on the two classes of preferred come up in November and December of 2006, and the requirement for the call right to be transferred by May 2007 if NBC wishes to avoid transferring over $100M of preferred stock to common shareholders.

Just to flip it around, what is the alternate scenario? For the 14.25% preferreds to be remotely at risk, the call right would have to be non-transferred/not exercised. Maybe this happens because the FCC does not allow NBC to hold onto the right nor allow a transfer of the right to a third party. But even then, in the worst-case scenario that the company were to file for Chapter 11 or liquidate assets, as I’ve stated before, I believe this senior preferred class is fully covered. So you end up with a low probability event in which you lose no money as the alternative – not bad.

Catalyst

- NBC orchestrating a change of control event within the next 12 months