Newsletter Media Sector Review July 2018

A Sense of Urgency

Not surprisingly, Television stocks came back to life after a first quarter lull. The improved performance was on the heels of a pick-up in M&A, which is discussed later in this report.

Gray Television announced a planned merger with Raycom Media on June 25th and there is speculation that financial investors are beginning to consider entering the TV space as well. We believe that broadcasters have a sense of urgency to take advantage of the relaxed ownership rules and more favorable regulatory environment. While there is a current majority of Republican FCC commissioners, the push for relaxation of ownership rules may run into resistance and/or the leadership may not have the wherewithal to fight should the Democrats perform well in the upcoming mid-term elections.

Meanwhile investors await the FCC Quadrennial Media Review. The Review of media ownership rules is largely expected to be delivered by the end of this year, but may slip into next year, in our view. With the prospect that companies may be grandfathered under the current relaxed rules should the regulatory climate change, broadcasters seem to be hustling to take advantage of the current improved in-market ownership rules and relaxed ownership caps, particularly the UHF discount rule. As such, we anticipate that there will be a heightened M&A environment, including the prospect of television station swaps, leading into the Presidential election in 2020.

Enter the financial buyers? Interestingly, the television stocks seem to be piquing the interest of financial buyers. Such groups may be attracted to TV’s increasingly predictable cash flow streams afforded by retransmission revenue, which has become a significant and growing portion of total revenue. Given the factors of the mid-term elections, growing need to increase scale, and capable balance sheets of certain broadcasters and financial buyers, we anticipate that the M&A activity may accelerate throughout the balance of the year. This is a little unusual since M&A activity is higher in off election year cycles as acquiring companies position to utilize high margin political advertising to pare down debt from the acquisition. But, the unusual circumstances of the regulatory environment may be a reason to be more aggressive. Such heightened M&A activity should support higher cash flow valuations in the industry and is one of the reasons we remain constructive on broadcast TV stocks.


Television Broadcasting
Investor fatigue?
The recent bounce in broadcast television stocks did not overcome the deficit of the first quarter. Broadcast TV stocks were up 6.8% in the second quarter, outperforming the general market, but largely driven by heightened M&A activity in the sector. Despite the advance, the average Television stock is down 13.6% for the year to date, under-performing the general market’s 1.7% gain.

The strongest performer was Gray Television, up 24.4% in the latest quarter. Investors cheered the company’s announced plans on June 25th to merge with closely held Raycom Media. The deal is expected to close by year end.

Investors strongly favor companies that have scale to negotiate retransmission fees and network compensation. But, there seems to be investor fatigue in the group, possibly due to the late stage of the economic cycle, current lackluster core advertising, and uneasiness over relatively high debt levels in a rising interest rate environment. In addition, there is the situation of the Sinclair and Tribune Media merger, which is still in limbo. As we stated before, we remain concerned that the DOJ may continue to be a thorn in the merger as it is currently planned. The recently announced appeal of the AT&T and Time Warner merger may be a sign.

Nonetheless, we believe that the industry is learning lessons from the Sinclair and Tribune Media merger. The roughly 5 revisions for in-market ownerships provided to the DOJ has allowed the industry to determine acceptable limits of advertising market share. Consequently, we believe that future television station swaps and mergers may be tailored to avoid the DOJ mine field, much like the Gray and Raycom deal.

In our view, heightened M&A activity will likely be the single largest catalyst toward higher stock valuations. This is a function of the late stage economic cycle and the prospect of lackluster core advertising, which is expected to weigh on investors. For the year, the strength of political advertising likely will provide some fuel for positive upside surprises, which we expect from certain broadcasters in the upcoming second quarter results and potentially into the second half. Most broadcasters have set low expectations following the disappointing presidential election in 2016, providing upside surprise potential.

With the recent speculation that Nexstar may be a focus of attention from a financial buyer, the shares of Tegna have drifted. Tegna had been viewed as one of the potential targets for Nexstar. Near current levels, we remain constructive on the Television stocks, with Tegna and E.W. Scripps being our current favorites based on valuation and the prospect of deal activity among these companies, given that both are the least debt levered in the industry.

Radio Broadcasting
Radio stocks are still struggling to find traction and leadership. After a poor first quarter stock performance, the average radio stock was down 2.4% in the second quarter versus a 2.9% gain for the general market as measured by the S&P 500 Index in the comparable period. Individual stocks in the Index were very volatile, much more than the average stock performance suggests. For instance, the shares of Entercom were down 21% for the quarter and down 30% for year to date; Townsquare was down 18% for the quarter and 15% for the year to date; while, Salem Media was up 43% in the quarter and up 14% year to date.

We believe that Entercom had a lot to do with the poor performance of many of the stocks in the industry, as investors poured out of the sector. In our view, the weak first quarter results at Entercom were largely due to weak performance at the CBS Radio stations. First quarter total company revenues declined 7% and the revenue outlook for the second quarter was lackluster as well. We believe that Entercom management has a lot on its plate to right that ship. But, the management team is very capable of fixing it and has made some progress. Ratings at its stations have shown some improvement, albeit relatively modest thus far. In addition, we believe that the management and format changes will begin to show results later in the year. Given the weak fundamental outlook at the company, we believe that investors will focus on the planned station sales, with proceeds to be used to pare down debt.

To that end, the M&A environment is expected to be fairly active, including radio stations that E.W. Scripps plans to sell. As a side note, we are perplexed by the strength in the Salem Media shares, although the bounce is off ofoff depressed levels. We wonder if investors were looking for plays on political advertising, given the recent strength in that category. While we are constructive on the SALM shares, we believe that the stock may have gone a little too high, too fast in the very near term. In looking at the current stock valuations, we believe that Townsquare offers the most attractive entry point for the sector.

Publishing Broadcasting
Once again, the Publishing group not only outperformed the Media sector, but the general market, as well. Publishing stocks were up an average 8.9% in the second quarter versus a 2.9% gain for the general market. For the year, Publishing stocks are up 8.4%, much better than the general market’s 1.7% advance. The latest quarter largely reflected the industry’s debt reduction efforts.

While most of the Publishing stocks were up in the latest quarter, the strongest performance was driven by Lee Enterprises, up 46.2% in the latest quarter and up a hefty 21.3% year to date. The company benefited from an agreement with Berkshire Hathaway to manage that company’s newspapers and digital operations in 30 markets. Lee Enterprises will receive a fixed annual fee of $5 million for five years, plus a major share of profits over certain benchmarks. The move is a significant benefit to Lee, which allows the company to more aggressively pare down its debt.
Another company that significantly reduced debt in the quarter was Tronc. The sale of its California Newspaper Group was completed on June 19, providing the company with $500 million in proceeds and eliminating a large portion of its unfunded pension liability. Net proceeds from the sale are expected to virtually eliminate the company’s long-term debt and allow it to maintain a solid cash position. As such, the company is in a strong position to accelerate its digital transformation through possible acquisitions.

Furthermore, companies like McClatchy and Gannett have strengthened balance sheets by either extending debt maturities or repositioned it with attractive fixed/convertible debt. The investment community seems to recognize the improved balance sheets in the industry, but still does not appear ready to recognize the digital contributions. Notably, many of the publishers have digital businesses that may be worth more than the total enterprise value of the company. As such, investors would be getting the print business for free. In our view, the industry needs to do a better job in making the digital businesses more transparent so that investors can identify the significant digital value creation. We remain constructive on the Publishing stocks and expect that there will be more acquisition growth coming.


Internet and Digital Media
On June 12th, a federal judge approved AT&T’s proposed acquisition of Time Warner. The ruling was expected to unleash a new round of M&A, particularly in the media sector. Sure enough, the very next day Comcast announced it had made an unsolicited offer to acquire most of 21st Century Fox, which kicked off a bidding war with Disney. The digital advertising sector also perked up: on June 25th, AT&T announced it would acquire AppNexus. Two factors seem to be driving digital advertising/ad tech consolidation: 1) scale and 2) the need to be on a client’s vendor short list.

As far as the scale issue is concerned, advertisers (and investors) are concerned that the industry is dominated by Google and Facebook. Advertisers would welcome alternatives to the “Big Two”. Verizon’s Oath (a combination of Yahoo! and AOL!), AT&T/Appnexus, and Amazon appear to be well positioned to create the next tier of leaders in the digital advertising space.

Two months ago, the Internet Advertising Bureau (IAB) reported that 2017 internet advertising revenues increased by 23% to $88B from $71.6B in 2016. Google and Facebook account for the lion’s share of the industry’s growth. As shown in the chart below, Google’s advertising revenues increased by $7.4B and Facebook’s advertising revenues increased by $5.2B. As a consequence, Google and Facebook accounted for 77% of the industry’s $16.4B increase in advertising. Fortunately, this suggests that the remaining piece of the pie that all other digital advertising companies fought over was still substantial, at $25.5B. It also implies that there was substantial growth in ad revenues for “all others”, with revenue growth of 18%.

In an analysis of publicly traded digital advertising companies, 2017 internet revenues increased by 27.8%, with the group’s growth rate driven by Google’s 22.8% and Facebook’s 47.1% growth. Nevertheless, the sector’s growth rate remained compelling even when excluding Google and Facebook’s results. As shown below, excluding Google and Facebook, the internet advertising revenue growth for the rest of the publicly traded companies increased by a healthy 14.4%.

Through the first six months of the year, stocks in the ad tech, marketing tech, social media and digital media sectors significantly outperformed the S&P 500, posting returns of 39%, 35% 12%, and 8%, respectively, versus a 2% return for the S&P 500. As usual, the FAANG stocks all outperformed the market, led by Netflix (+104%), Amazon (+45%), Facebook (+10%), Apple (+9%) and Google (+7%). Other digital advertising standouts include The Trade Desk (+105%), Twitter (+82%), Pandora (+64%), Yext (+61%), and The Meet Group (+59%).