Salem Communications (SALM) is the largest Christian-focused radio broadcaster (and 3rd largest radio broadcaster in the Top 25 markets, where approximately half of the US population lives, and where stations typically have higher revenues, margins and asset values), with 95 stations across the country.

Although illiquid, this is a defensive investment with a very attractive upside potential.

Attractive Industry:

Let’s talk about perceptions. If I were to ask how the percentage of adults reading newspapers daily changed from 1970 to 2010, I think one would correctly say it declined. In fact, it went from 78% to 45%. Now let me ask the same question for percentage of adults who listen to the radio during any given week, over the same time period. Turns out that number was constant at 93%. Yes, Internet encroached and took away part of the advertising spend from other mediums, radio included – its share of advertising spend went from 8% in 1980 to 7% in 2010, but the pie however, expanded from $46.5B to $210.5B over the same time period.

Radio is a unique medium as it is free of charge to the consumer, can be used to target a mass audience (242M unique listeners per year in the US, a number which has consistently grown over the past years), reaches all age group demographics, and is also cheaper to advertisers ($5.35 average cost per thousand impressions in 2010 compared to $12.50 for network TV).

In addition, radio has a low capex, typically at 1% of revenues resulting in very high FCF generation.

Incremental revenues (that are expected to occur in 2012 as an election year) also have very high incremental margins.

Radio stations are in general dependent on local advertising, which can be as high as 80% of revenues, and those are yet to experience a material recovery. Broadcast advertising revenue for Salem was as high as $108M in 2006 and troughed at $74M in 2009, and is currently (LTM as of 6/11) $77M. So any recovery would provide significant operating leverage.

Attractive Niche:

In addition to the benefits derived from exposure to the radio business, Salem Communications benefits from its niche: Christian radio is one of the fastest growing formats in radio, with national audience share growing 39% since 2002 (turns out 46% of Americans read the Bible at least weekly and 43% of Americans reported weekly/almost weekly church attendance). Perhaps due to this niche (where over 35% of its revenues are sold as block programming, which are blocks of time being sold predominantly to Christian ministries, which have renewal rates exceeding 90%, with pricing expected to rise 3-6%), Salem proved more resilient in 2009, when its EBITDA declined 2% y/y compared to peer EBITDA declines of approximately 30%. Salem has also been growing its non-broadcast business (publishing and Internet), which already account for over 15% of revenues.

In addition, most traditional radio stations live and die by auto advertising.  However, SALM is not as dependent on one single category, and is more diversified in terms of industry exposure, with categories such as medical and dental, education, non-profits, etc; some of which I believe are even bigger than auto.

Despite the interesting backdrop, Salem trades at a free cash flow yield of over 35% on conservative 2012 numbers! (under 3x FCF multiple)

I believe the company is neglected due to its small size (~$60M cap) and limited float (as the CEO and the Chairman combined own 56% of the company). Its debt doesn’t mature until 12/2016, and given the high insider ownership, I believe they have an incentive to implement a regular or special dividend. Meanwhile, the company continues to delever aggressively (it has redeemed $47.5M since 4Q09).

Financials:

(1)  Assuming no market growth

(2)  $3.7M in political in 2010; Inside Radio expecting 35% spending from 2010 levels; $1.7M in 2011; assume 90% incremental margin

(3)  Last quarter annualized

(4)  9.625% on senior secured; giving no benefit from paydown

(5)  Substantial NOLs

(6)  24.75M shares

(7)  Based on current price of $2.50

Valuation:

If it were to trade in line with its radio peers, none of which pay dividends and are typically more levered and less defensive, SALM would be worth almost $9.

Alternatively, if it is able to pay a dividend of say $2.5M (approx ~$0.10/share), or slightly higher than 10% of free cash flow, it would be trading at dividend yield of ~4%, again compared to 0% for all its radio peers.  The closest company paying a dividend is CBS, which trades at a 1.4% yield (would imply a price of ~$7 for SALM).