Description

Summary

Business overview: Sinclair is a local television broadcast company that earns revenue from advertising, retransmission consent fees paid by cable and satellite companies, and digital advertising

Current trading: despite a positive industry outlook and highly accretive recent acquisitions, the company trades at a 21% normalized free cash flow yield

Investment thesis: high free cash flow yield, low single-digit organic revenue growth, sticky local advertising base, new revenue streams (retrans and digital) not fully appreciated by the market

Additional catalysts: the market does not fully appreciate the free cash flow contribution of approximately $1.1bn of acquisitions completed in the last 12 months.  Despite guidance from the company, consensus EBITDA in 2014 is still significantly below where the company has guided for pro forma EBITDA in 2012

Price target: ~12% normalized free cash flow yield implies $23 share price

Company Overview

Sinclair Broadcast Group (“SBGI”) is the largest independent television broadcasting company in the U.S.  The company owns or operates 84 stations in 46 markets, reaching 27% of the American population.    SBGI’s television portfolio includes 22 FOX, 20 MTN, 15 CW, 11 ABC, 11 CBS, 3 NBC, 1 Azteca and 1 independent.  In addition to television broadcasting, SBGI also has an assortment of other businesses, including an alarm monitoring business, a commercial sign fabricator and various real estate ventures.    

As of Q3 2012, revenue by affiliates was the following (excl. the Newport acquisition):

Fox – 36%

ABC – 20%

CBS – 18%

MTN – 14%

CW – 10%

IND – 1%

NBC – 1%

The company generates revenue through three primary channels: advertising, retransmission fees and digital marketing.    Approximately 70% of advertising revenue is derived locally, and in the 46 markets where SBGI operates, the company takes approximately 20% of the local ad share.  Local markets are a primary focus of the company, as advertising buys are more relationship-driven and stable, unlike national advertising purchases, which are more commodity based.  Due to broadcasters’ regional monopoly status (via the affiliate arrangement with the network and an FCC license), broadcast companies have deep economic moats.  SBGI in particular has a strong operational track record, posting an average ROIC over the last five years of 33.4% and broadcast cash flow (“BCF”), defined as broadcast EBITDA before corporate allocation, margins of ~45% with minimum maintenance capex required (<$300k per station in a typical year).

Television Broadcast Industry Background

Commercial television broadcasting companies operate regional TV stations that are often affiliated with a major network (NBC, CBS, ABC or Fox).  The major networks own most of the television stations in the top 10 designated market areas (“DMAs”), but rely on affiliates to broadcast content in smaller markets.  Although only about 11 million television households (out of ~114 million) depend solely on over-the-air signal, all television households have access to local network channels through their cable and satellite services (multichannel video programming distributors or “MVPDs”).  Although the broadcast industry is mature, it is far from a state of terminal decline.  According to a recently published FCC document, nearly 78% of Americans say that on a typical day they get news from their local broadcast station (either directly over-the-air, or through MVPDs) – more than from newspapers, the internet or the radio.  In addition, the three major broadcast networks’ nationwide evening newscasts draw 22 million viewers, five times the number of primetime viewers for the three major cable news networks (CNN, Fox News Channel, and MSNBC).  Furthermore, 96 of the top 100 TV shows in the 2011-2012 season originated on broadcast television.  Despite the rise of internet advertising, local TV advertising’s share of the total advertising spend has remained relatively constant through time (~10%) and more importantly, studies continue to indicate that television is by far the most effective advertising medium for raising new product awareness.  Although with the rise of MVPDs and their non-network program offerings there is increased competition for local ad share, broadcast television networks remain the only ad medium viewable in 100% of television households (whereas the MVPDs can only air advertisements to their subscribers).  This creates a significant competitive advantage for the network affiliates, especially with regards to political advertising.  Industry analysts have long proclaimed the downfall of television advertising.  Most notably, McKinsey released a study in 2006 that claimed by 2010 TV advertising would be only one-third as effective as it was in 1990.  Although the financial crisis significantly reduced advertising budgets in 2009-2010, the television Armageddon scenario envisioned by various media analysts has yet to occur.  AT Kearny recently published a research piece on precisely this topic: “Contrary to the fears of many, the Internet – and social media, in particular - hasn’t yet cannibalized TV advertising.  In fact, it may even be improving the TV experience for viewers and advertisers alike.”  The report also estimated that television’s share of the overall ad market rose 3% between 2006-2010 while the gains in Internet advertising have come largely at the expense of print.

Since the great recession, there have been three major industry developments, described below, that have created a step-change in television broadcaster profitability: retransmission revenue, duopolies, and digital revenue.

Retransmission Revenue 

Retransmission (“retrans”) fees represent the compensation paid by MVPDs to local broadcast television stations for the right to carry their content as part of the MVPD’s program offering.  As recently as five years ago, MVPDs did not compensate networks or affiliates for retransmitting their content.  It was generally assumed that carrying local broadcast content for free and allowing the networks and affiliates to show advertising was fair compensation.  The historical dynamic changed as increased competition between MVPDs allowed local broadcast stations to begin demanding a subscriber fee, similar to cable channels.  In 2009, the last year that SBGI broke retrans revenue out separately, the company earned approximately $97mm in retrans fees and expected that to grow to ~$106mm in 2010.  Retrans revenue, similar to royalty revenue, is highly attractive as there are no costs associated with it.  In addition, total industry retrans revenue is still growing rapidly.  Somewhat mitigating this windfall, however, is the fact that most broadcast companies are being forced to share some of this revenue with the networks, as Fox, NBC, etc. are beginning to demand a share of this increasingly large pie.  Nevertheless, most broadcast company management teams are optimistic that retrans revenue will continue to be a major profit driver for the industry.   While MVPDs pay approximately $33 billion per year for content that they air on their platform, network broadcasts, which bring in 35-40% of the audience share, receive less than 10% of the total (~$2.4bn in 2012).  SNL Kagan recently updated their long-term industry retransmission forecast and project that by 2018, total retran fees will surpass $6bn, representing ~13% of total affiliate fees paid by MVPDs.  SNL Kagan’s estimate assumes an average fee per subscriber of slightly less than $1.00 per month, while each MVPD would be responsible for aggregate retrans fees of $4.86 per subscriber.  This does not seem unreasonable when considering the audience share that networks draw.   To put this estimate in perspective, SNL projects that the current average retrans fee per subscriber is ~$0.47 per month (similar to what SBGI likely earns).  In comparison, ESPN currently earns ~$4.75, TNT earns ~$1.20, and Disney earns ~$1.00 per sub per month.   As mentioned above, the most significant factor mitigating this windfall to TV broadcasters is that the networks are increasingly demanding a share of the retrans fees (called “reverse compensation” or “reverse retrans”).   SBGI started to pay Fox a reverse retrans fee in 2011 and management has stated that reverse retrans may eventually approach 50% of total retrans revenue.  Although in the short term, management expects some mismatches (i.e., network affiliation agreements being renewed before MVPD contracts are renewed) that cause temporary declines in retrans profit (retran revenue – reverse retrans), they are confident that over the next few years retrans profits will grow significantly.  In addition, there have been recent proposals by the networks to negotiate on behalf of the affiliates for higher retrans fees.  In exchange, the networks would expect a higher percentage of the proceeds.  Local television broadcasters do, however, have leverage in the retrans negotiations via their production of local news, widely considered ‘must-have’ content.  SBGI produces the local news in 75% of its markets.  Although there may be some near-term pressure on retrans profit over the next 12 months, it will likely not be material.  Additionally, with the help of networks’ negotiating leverage, the retrans revenue stream is poised to grow significantly over the next decade.

Duopolies

The television broadcast industry is heavily regulated by the FCC.  Until the mid-1980s, a single company could only own five television stations.  Thus, the major networks owned stations in the nation’s largest markets and were forced to run their programming through affiliates in the other markets.  In the 1980s-1990s, regulations were gradually loosened to eventually allow a single owner to operate stations that reach up to 39% of the country’s population.  However, the same company cannot own two of the top four stations in a given market. 

In many of SBGI’s markets, the company operates multiple stations.  Although in some cases, this is permitted by the FCC, SBGI and other broadcast companies (most notably Nexstar) have been accused of sidestepping the legislation by establishing shared services agreements and local marketing agreements with stations owned by shell companies, thus effectively controlling them.  Despite the criticism, ‘duopolies,’ as these arrangements are called, have resulted in significant cost savings, as redundant production, sales and overhead expenses can be eliminated.  Nexstar, perhaps the industry’s most vocal proponent of the duopoly model, claims that broadcast cash flow margins in duopoly markets are approximately 500bps higher than non-duopoly markets.  Although the FCC has begun to scrutinize this relatively recent industry development, broadcasters insist that without duopolies many stations in small markets would be unable to compete effectively and would likely go off-air.   

Digital Revenue  

Online advertising has increasingly become a focus for television broadcasters as companies sell ads on local news channel websites as well as mobile apps (i.e., weather and traffic).  A recent study by Borrell Associates found that local advertising grew 38% in 2011 and that local TV captured a larger share (11.8% in 2011 compared to 10.5% in 2010).  Digital’s importance is also increasing for television broadcasters, making up 6.9% of industry revenue in 2010 compared to 3.7% in 2007. SBGI does not break out digital revenue, but it is reasonable to assume that the revenue contribution from digital is in-line with its peers. 

Free Cash Flow Accretive Recent Acquisitions

SBGI has completed five acquisitions over the last 12 months that have expanded the number of stations by ~44% and will significantly increase free cash flow.  All of the acquisitions are being funded internally through cash on hand and new debt issuance.  It is important to note that all of SBGI’s acquisitions are asset purchases and the resulting D&A (i.e., goodwill amortization) is fully-deductible for tax purposes. 

Illustrative Transaction Returns

The summary below gauges the value creation of the announced transactions with an illustrative ‘even-odd’ free cash flow calculation.  Due to the cyclicality of political advertising, broadcaster earnings are typically much stronger in even years (~15-20% higher).  As a result, it is common to analyze broadcast businesses on an even-odd average basis (i.e. ’11-‘12E).  

• Assuming leverage of 5.0x BCF at 7.0% cost of debt and a conservative 15-year full amortization of transaction TEV, the free cash flow yield on the ~$270mm of equity deployed would be 29.9% 
• Transactions TEV: $1052; debt @ 5.0x BCF: $782mm; implied equity: $270mm

• The above math suggests that the recent acquisitions will be highly accretive using a reasonable hypothetical capital structure.  Note that the actual equity deployed to fund the acquisitions was negligible.  The company issued $180mm of term loan to fund the Four Points acquisition which closed 1/1/12, $350mm of term loan to fund the Freedom acquisition which closed 4/1/12 and $500mm of senior notes to fund the Newport, Bay Television and Beaumont station acquisitions, which closed 12/1/12.  Pro forma for the new debt issuances, the company’s weighted average cost of debt is ~6.3%.

SBGI Valuation

SBGI’s current valuation implies a very high free cash flow yield.  Using management’s pro forma figures, as well as some reasonable estimates for D&A and pro forma interest expense, we can calculate a normalized ‘even-odd’ year free cash flow for the company.

Price per share assuming 15% normalized FCF yield - $18.30 (41% premium to current)

Private Market Valuation

In the past 18 months, over $2bn of TV assets have been sold at multiples ranging from 8.5x to 11x BCF.  Nevertheless, public valuations continue to trade 3 to 5 multiple points below this range.  See below a take-private valuation analysis assuming a BCF multiple at the bottom of the precedent transaction comp range.

BCF even-odd year average: $459mm (pro forma for acquisitions, assumes 2011 BCF is representative ‘odd’ year, 2012 representative ‘even’ year)

Assumed multiple - 8.5x

Implied TEV – $3,902mm

Less: estimated net debt at Dec. ‘12 – $2,113mm (per company presentation)

Implied equity valuation: $1,789mm / $22.00 per share (70% premium to current)

This analysis excludes the value of SBGI’s other investments (i.e., the alarm monitoring business, real estate ventures, etc.).   As of 9/30/12, the book value of the non-broadcast division was $279mm.  Applying a 30% discount to the book value adds $2.40 of additional equity value per share.  This valuation does not seem unreasonable given that the company has recently monetized several real estate assets for gains (average annualized return of ~22%) and was recently offered $50mm for the alarm monitoring business.

Implied equity valuation – $1,985mm / $24.40 per share (88% premium to current)

Normalized even-odd FCF yield – 11.2%

TEV / Normalized even-odd EBITDA – 9.2x

Normalized even-odd P/E – 15.6x

Over the past five years, valuation multiples have come down substantially for television broadcast companies, despite improving industry fundamentals in the form of higher digital and retrans revenue.  Before the financial crisis, SBGI traded in a range between 9.0-11.5x EBITDA, which was in the middle of the comparable company range.  Today, SBGI trades at 7.1x even-odd PF EBITDA, approximately in the middle of the range for its peers.  In addition, the company pays a quarterly dividend of $0.15, representing approximately a 4.6% annualized yield at SBGI’s current price.   

Investment Thesis

• Bolt-on acquisitions.  SBGI has aggressively purchased broadcast assets as they have come to market.  With the abundance of private equity deals completed pre-crisis, it is likely that additional stations will shake loose over the next 24 months. If this were to occur, SBGI would almost certainly be a major player, acquiring companies at valuations that are free cash flow accretive (as the acquisition analysis above demonstrated).
• Stable market share.  According to Magna Global, local TV’s share of advertising spend has stayed relatively constant over the last several years (9.0% in 2006 vs. 10.3% estimated for 2012).  In addition, Morgan Stanley’s 2012 advertising forecast projects that advertising share will shift away from print (-308bps) toward internet (+260bps), cable TV (+30bps) and broadcast TV (+18bps).  In an increasingly fragmented world, there has been an increased willingness of advertisers to pay for the aggregation of viewers that broadcast TV provides.  The TV broadcast industry is not terminal, yet the company’s normalized FCF yield of 21% seems to suggest that the current profitability is not sustainable.
• Retransmission revenue.  This relatively new revenue stream does not seem to be fully appreciated by the market.  SNL Kagan projects total industry retrans revenue to nearly triple by 2018 from 2012.  Although networks are now demanding a portion of the fees, the increased bargaining power vis-à-vis MVPDs resulting from networks negotiating on behalf of affiliates will buttress the growth in industry-wide retrans revenues and ultimately the affiliates’ portion.
• Increasing political advertising spend.  SBGI is forecasting approximately $100mm of political revenue for FY2012 (~11% of total) compared to $54.9mm, pro forma for acquisitions, in 2008.  This represents an 82% increase.  According the Magna Global, U.S. political ad spending on local TV increased by 43% overall from ’08 to ‘12.  SBGI’s position in critical swing states has helped the company grow political revenue by nearly 2x the market growth rate.  Magna projects that political ad spending on local TV will increase by ~9% in 2014 and ~8% in 2018.  The increase has been driven by increased PAC spending and the Citizens United supreme court decision, providing the green light for super PACs to collect unlimited sums from individuals, labor unions, and corporations for independent spending.
• Automotive recovery.  For each auto that is sold in the U.S., dealers and manufacturers spend on average ~$900 on advertising.  Auto ad sales represent ~20% of SBGI’s ad time sales.  This year the auto industry is projected to sell ~14.5mm new vehicles, a sales number the industry has not achieved since 2007.  This resurgence has sparked a fight for market share, which has led to increased advertising.  According to Nielsen, spot TV ad spend in the auto industry increased 26% from Q2 2011 to Q2 2012.
• Mobile DTV.  Streaming to cellphones and tablets represent a meaningful upside if widespread adoption were to occur. Although the technology exists, the rollout has been slow and it is uncertain whether Americans will ever adopt the technology.

Investment risks

• FCC regulation.  The FCC recently issued a Notice of Proposed Rulemaking to scrutinize the negotiation of retransmission fees between affiliates and MVPDs.  The broadcast industry opposes potential government regulation and insists that without fair market negotiations, local content will suffer.  The FCC is also set to examine shared services agreements to determine whether to adopt more specific criteria regarding ownership rules for DMAs.
• Local broadcast stations lose advertising share.  As advertising spend continues to shift toward internet, broadcast television could be affected.  Although to-date the rise of internet advertising has largely unaffected broadcasters’ share, there is no assurance that the trend will continue.  In addition, the major networks’ ratings have been in secular decline for decades (television affiliate average primetime rating was 44.8 in ’84 vs. vs. 25.6 in ’08) due to fragmentation in cable and satellite program offerings.  However, somewhat mitigating the decline is an increased willingness to pay for the aggregation of viewers that network television provides.
• Economic sensitivity.  Network broadcast revenue is highly susceptible to a general economic slowdown, as the vast majority of industry revenue is still advertising-based.
• Reverse retransmission fees.  Networks are becoming more aggressive in negotiating reverse retrans from affiliates.  Fox has been the most aggressive network in this regard, which is a threat to SBGI as Fox represents the company’s largest network partner. 
• DVR penetration. DVR penetration has risen from under 20% in 2007 to nearly 45% today.  If usage of DVR devices rises significantly, the advertising-based model utilized by broadcasters may be threatened.   Nevertheless, despite the increase in DVR penetration, usage is still a small fraction of live TV viewing (the average American views 22 minutes of pre-recorded DVR programming daily vs. 4 hours and 35 minutes of live TV).  In addition, the 2012 figure was only a 2 minute increase from the 20 minutes on average in 2011.  Further mitigating the threat of DVR penetration is that according to Nielsen, time-shifted viewers are still watching nearly 50% of the commercials.  Some network executives even claim that DVR usage increases total commercial impressions, as many of the time-shifted viewers would otherwise have not watched the program.
• Smith family control. The company is controlled by the Smith family through the ownership of super-voting Class B shares (82% of votes; 36% of total shares).  As a result, the company engages in frequent side ventures including investments in a sign manufacturer, an alarm monitoring company, real estate ventures, and most recently, a wrestling franchise.   Fortunately, these investments are small as a percentage of annual free cash flow and the company’s track record is surprisingly robust.  Further mitigating this risk, the company has stated several times that the dividend is important to the family and returning capital to shareholders will continue to be a primary managerial goal.

Catalyst