Description

Shop At Home, Inc. (SATH) combines a margin of safety, lots of option value, and a catalyst. SATH stock price is $2.75; its hard assets net of debt are worth $4.00-$4.50 per share; incremental value from its operating business is between zero and $7 per share; thus total value is $4.00 to $11.50 or so. We also believe the board is planning to sell the company within the next 18 months. So we feel that worst case, you make 30% to 60% within 18 months, and best case you make up to 300%. When your worst case is a modest profit, and your best case is a big profit, and you have a catalyst, that makes for a great combination.

The $4.00 to $4.50 per share represents the value of the hard assets only (television stations), giving zero value to the operating business. A turnaround is being attempted in the operating business, which could allow the operating business to be worth up to another $7 per share. (The $7 is a very rough number – could be a lot higher or lower actually). The board and significant shareholders (including the Chairman of the board who has about 11% of the stock) are very interested in selling the company – after recently firing the former CEO; a search is now in progress for a new CEO who we believe will have the agenda of positioning the company for a sale.

SATH operates a television shopping network, similar to QVC and Home Shopping Network (HSN). SATH is actually the fourth largest player in this market, behind QVC and HSN which control over 90% of the market, and ValueVision (VVTV) with about 4 to 5% market share. SATH has a very small share, maybe 2 to 3%. Its operating business actually has not performed very well lately, due to various problems that started in mid-2000, although several years ago it was profitable. SATH creates its own programming, and then distributes its programming over cable television through carriage agreements with cable operators, and through broadcast stations that it owns. Customers then call SATH, and SATH has product shipped to the customers. They also operate a retail website which is a small part of the business.

The key margin of safety in this story is the TV stations. SATH owns 5 broadcast television stations, most of which are in key big markets (San Francisco, Boston, Cleveland, Bridgeport Connecticut which covers part of the New York City market, and Raleigh). The value of owning a broadcast station comes from the fact that, under the FCC’s “must carry” rules, the local cable systems must carry the local broadcast channels. So just as your local cable system carries the local NBC, ABC, and CBS broadcast stations, they must also carry the SATH stations in their markets. Typically, an operating TV station is valued on a multiple of cash flow like any other business – your local NBC affiliate generates cash by generating advertising revenues, less all the operating costs to run the station including programming costs. SATH’s stations, on the other hand, are really just distribution outlets for its programming, which is intended to sell products. So you cannot value SATH’s stations on multiples of cash flow. In the industry jargon, SATH’s stations would sell for “stick value” which is the asset value of the station and FCC license. “Stick value” transactions are not uncommon in the industry, and represent the value of a station that an operator is willing to pay for a station that they want to put their own programming on. A rule of thumb for “stick value” for TV stations is around $25 to $30 per TV household in the market – obviously there is variability due to the size of the market, the cable penetration in the market, the demographics of the market, etc. Univision recently acquired 13 stations plus minority interests in 4 other stations in major markets from USA Networks for $1.1 billion in a stick value transaction – Univision is going to use these stations for its Spanish language network, so was not buying operating businesses from USA Networks, they were buying the stations for stick value. These 13 stations plus 4 minority interest stations cover 34% of the 99 million TV households in the US, or about 33.9 mm households – so $1.1 billion over 33.9 million works out to $32 per household. SATH itself recently sold its Houston station for stick value – SATH received $57 mm for a station covering 1.71 million households, or $33 per household (SATH used the proceeds to pay down debt and redeem some preferred stock, and has the remaining cash on its balance sheet). (These are just two examples, there have been other stick value transactions but these seem to be the most recent.) There was nothing particularly special about this SATH Houston station versus the others owned by SATH. SATH believes that the Houston sale was a little bit above market because the buyer was very strategically motivated to get into Houston. Also the Univision deal averaged at $32 per household, but the bigger markets get premiums versus the smaller markets, and these stations were mostly in big markets. In addition to these comps of actual stick value transactions, we have talked to quite a few media brokers, who are specialized brokers who represent sellers of TV and radio stations, and they have confirmed that typically stick value transactions are at about $25 to $30 per household in today’s market. Other industry analysts and consultants specializing in valuing media assets (such as Paul Kagan Associates) have also confirmed this range. So while we don’t hold ourselves out to be TV station valuation experts, we have a reasonably strong belief that our numbers are fair.

If you look at SATH’s remaining five stations and value them at $25 to $30 per household, you come up with a value of $215 to $250 million for the stations (see 10K for households in each market). If you net out $77 mm in debt, but add back in $22 mm in cash (they actually had $32 mm in cash at end of last quarter, but we’re assuming they burn $10mm of that in fixing the operating business over the next few quarters), plus $14 mm proceeds from exercise of options and warrants – that gives you a value from the TV stations alone, net of debt, of $173 to $209 mm.. There are 39.5 mm common shares, but also 4.2 mm warrants (2.2 mm exercised in the last month) and 1.2 mm options with strike prices less than $6 – so that makes fully diluted shares about 44.9 mm. That leads to the range of roughly $4.00 to $4.50 per share of net asset value, giving absolutely no value to the operating business.

There are a couple of offsetting issues affecting station valuations today. One negative is that the advertising market has softened with the economy – given that advertising revenues drive TV station revenues and profits, this has temporarily softened the market for stations a little bit. TV stations seem to be holding their values, but not as many transactions are happening. One positive is that the new Bush administration FCC under new commissioner Michael Powell is taking a deregulatory stance on broadcast ownership rules, which will likely increase the value of TV stations. Today there are rules that prohibit one company from owning stations that cover more than 35% of the households in the US (the ownership cap), and rules the limit the number of stations in a market that can be owned (the duopoly rule allows a company to own 2 stations in a market only in specific circumstances), and rules that prohibit cross ownership of cable and TV station assets. If these rules are eased or lifted, particularly the ownership cap limit, that will open the door for big station groups such as NBC, Viacom, Fox, etc. to acquire more stations. More demand for TV stations from big strategic buyers means higher values. (In fact, the duopoly rule which allowed operators to own two stations in the same market for the first time has led to increases in station values in the last few years since this rule was enacted.) Michael Powell has publicly said that dealing with the media ownership rules is a high priority, but what that means in bureaucracy-time is unclear. These ownership caps are also working their way through the court system (Viacom is over the limit but doesn’t want to sell stations so is suing FCC over the 35% cap).

There is another potential positive for station values which is the transfer of certain TV station frequencies to wireless companies for use in 3G wireless applications. When these frequencies are eventually auctioned off by the FCC (auction has been postponed several times), the new owners of the frequencies will be allowed to use them starting in 2006 or when the penetration of digital television reaches 85% in the US (the TV stations currently on these frequencies get moved to new digital frequencies, so they don’t lose the right to operate). The kicker is that if the wireless companies want to get on these frequencies earlier, they can negotiate a “buy out” with the TV station owners to get on early. This issue provides some upside potential to SATH, but its speculative at this point given telecom industry problems and the fact that this does not look likely to happen fast, and its not clear if there will be much benefit to SATH from this – so we’re not including anything for this in our valuation.

SATH’s operating problems seem to have started in June quarter of 2000. Around this time they did a systems conversion which opened the door to increased levels of credit card fraud and product returns. At the same time they had a newer COO, who was experimenting with the product mix, moving SATH towards more expensive products. These issues resulted in SATH’s revenues coming down and the company going from EBITDA positive to EBITDA negative in the June 2000 quarter. They got rid of this COO, made some headcount reductions, consolidated operations, etc. and improved EBITDA from a loss of $8 mm in June 2000 quarter to a loss of $2.5 mm in December 2000 quarter. As a result of liquidity issues due to losses in the June 2000 quarter, they did a truly horrible convertible preferred stock deal – placing $20 mm of convertible preferred stock with a floating conversion price based on the current common price. As a result of poor performance and this exploding preferred deal which was extremely dilutive to the common, throughout the second half of 2000 SATH’s stock got pummeled, going from around $5 mid-year when they did this deal to about $1 by the end of the year. They have since redeemed or converted 100% of this preferred so it is no longer an issue. The former CEO (Kent Lillie) promised the board that the company would be EBITDA positive in the March 2001 quarter, but the company ended up losing about $2.5 mm EBITDA in the quarter (adjusted for additional one time charges). During early 2001, a group called Legacy Asset Management acquired a 5% position and began pressuring the board to fire Kent Lillie and to put the company up for sale. In order to pay down a secured loan and redeem the convertible preferred, SATH sold its Houston station for $57 mm which closed in the first quarter of 2001. Due to his poor performance the board fired Lillie in May 2001. At that time, the Chairman of the Board, J.D. Clinton who owns about 11% of current shares, created an “Office of the Chairman” to initiate a search for a new CEO. The plan at this point is to sell the company, but instead of trying to sell it today, they feel like they have a free option to turn the home shopping business around and get value for it, rather than just liquidating it today for nothing. Legacy has been pressuring the board to sell the company to unlock the value of the stations, and J.D. Clinton is ready to sell the company. SATH has realized that they need to be part of a bigger media company in order to effectively compete with QVC, HSN, and VVTV. They want to get a CEO experienced in the home shopping industry, preferably somebody from QVC or HSN, who can do a quick turnaround of SATH’s operations and position the company for a sale to a bigger media company. In the meantime, its expected that more deregulation will take place, leading to higher values for SATH’s TV assets. So while waiting for the softness in the advertising market to improve, and for more deregulation in TV station ownership restrictions, SATH has a window of opportunity to get its operating business turned around, to make the business attractive to strategic buyers. In calendar year 1999 before its operating problems, SATH averaged about a 4.6% EBITDA margin. If they could do that again in the near future on revenues of about $200 mm, that would be about $9 mm EBITDA, which at a conservative 6X creates additional value of $55 mm or $1.20 per share in the stock.

However, a strategic buyer could value SATH’s operating business at much more than 6X EBITDA. The best comp for SATH is ValueVision (VVTV), given that QVC and HSN are orders of magnitude bigger. A few years ago, VVTV was essentially the same size as SATH, but today VVTV is about double SATH’s size in terms of revenues. In the last few years, VVTV has essentially doubled its distribution. VVTV did this by entering a series of agreements with NBC and GE. NBC and GE now own about 40% of VVTV equity. In addition to helping VVTV get additional cable carriage to grow its distribution to households, in June of 2001 ValueVision was rebranded “ShopNBC”. Essentially VVTV is becoming an NBC branded property, similar to the way that NBC created CNBC from Financial News Network. VVTV represents NBC’s way to get a toehold into the convergence of TV and retailing. In addition to the current operation of the ShopNBC network, there are potential synergies between TV and retailing that could arise once TV becomes more interactive. An example (from a ValueVision executive) is that someday you may be watching golf on TV on NBC, and if you are interested in the club that Tiger Woods is using, you could click on an NBC icon at the bottom of the TV screen, and a small window might pop up which would allow you to buy a set of these clubs through NBC. We wouldn’t bet on that at this point, but you can see how a strategic buyer might get excited about prospects like this. A strategic buyer with a vision of some type of interactive TV retailing would value SATH’s capabilities to produce video programming that is product focused, SATH’s programming distribution (cable agreements and stations), and SATH’s customer service capabilities. With VVTV stock at $21, VVTV has about a $1.1 billion market cap, less cash of $242 mm, giving VVTV an enterprise value of about $850 million. VVTV has 2001 projected sales of around $500 million and EBITDA of $35-$40 million. So VVTV is selling at about 1.7 times sales and 21-24 times EBITDA. VVTV doesn’t own any TV stations like SATH does, so that is just the value of the operating business. If SATH’s operating business sold for 1.5X sales, that would be about $300 mm or $7 per share, to add to the value from the TV stations.

Understand that if SATH didn’t own the TV stations and was trading at $3, we wouldn’t be buying the stock based on a bet that a strategic buyer will pay 1.5X revenue or some big multiple of EBITDA. But with the TV stations providing a margin of safety versus the current stock price, and with management and big shareholders intent on selling the company, you get for free the option value associated with a strategic buyer paying some high price for the home shopping business. With QVC part of Comcast, HSN part of USA Networks, and VVTV tied up with NBC, SATH is the only independent home shopping network. There are high barriers to entry, because you need to reach a critical mass of homes reached in order to get this type of network going. So arguably there could be any number of strategic buyers interested in SATH – including NBC (although they are tied up with VVTV, VVTV doesn’t have any 24 hour stations, since they buy coverage from cable carriers, plus NBC has a relationship with Paxson Communications which is interested in getting back into home shopping), Fox, Univision (growing Hispanic network, would be interested more in stick value of SATH’s stations), etc. Supposedly in January of 2000, USA Networks was interested in buying ½ of SATH for $15 per share. While its hard to predict what a strategic buyer might pay, you can see how a big media company might be interested in paying a good price for this type of business – one that allows them to take advantage of the convergence of TV, commerce, internet, etc.

In summary, SATH has multiple positives going for it: 1) stock price at discount to hard asset liquidation value, providing a margin of safety, 2) in place catalyst due to significant shareholders and management ready to sell the company, 3) potential for increase in asset values of TV stations due to deregulatory environment, and 4) potential for a strategic buyer to pay a fancy price for the home shopping business if it can be turned around. The biggest negative seems to be the fact that the company is currently losing money from the home shopping business (which means the company as a whole is losing money since the TV stations do not generate cash flow), but in our liquidation analysis we’ve assumed that they burn about $10mm cash before they either turn it around or shut it down.

Catalyst

1) Management and significant shareholders ready to sell the company.
2) Potential increase in TV station asset values due to deregulation.
3) Potential for strategic buyer to pay a big price for operating business.