“While we are passing HBO in domestic members in 2013, it will be several years before we are peers with them in terms of Original programming, Emmy awards, and international members. It wouldn’t be surprising to us if HBO does their best work and achieves their highest growth over the next decade, spurred on by the Netflix competition and the Internet TV opportunity.” – Reed Hastings, April 2013 letter to shareholders
February 28, 2014 Volume XL, Issue II SEARCHING FOR VALUE SINCE 1975
Page 1 UPDATE: Bed Bath & Beyond Inc. ($67.82) Bed Bath & Beyond Inc. is a major operator within the retail sector. BBBY operates roughly 1,500 stores and the firm generates annual revenue of over $10 billion. The stores are primarily located in the U.S., and consist of the following brands: Bed Bath & Beyond, Christmas Tree Shops, Harmon, buybuy BABY, and Cost Plus World Market. BBBY has achieved an impressive record of growth during its operating history, but the rate of expansion has moderated during recent years as the business has matured. A key driver of BBBY’s past success has been its coherent and well-executed strategy. Management utilizes an “everyday low price” philosophy to help maintain competitiveness. However, pricing is not the only means of differentiation at BBBY. The assortment and presentation of BBBY’s merchandise are unique factors not typically found at its competitors among both conventional and online players. Moreover, the firm’s emphasis on customer service is a key source of differentiation. The firm’s competitive position is further supported by a strong balance sheet (over $3 per share in net cash), and steady cash flow generation. Management has consistently exhibited a shareholder mindset via BBBY’s significant stock repurchase activity (shares outstanding down by 17% since 2011). Following a modest shortfall in earnings reported in early January, shares have declined about 15%. The negative sentiment toward the stock was exacerbated by a general aversion to retail stocks during early 2014. In our view, this recent pullback in BBBY shares has been unwarranted, and it offers an attractive buying opportunity for long-term investors. Assuming BBBY can eventually trade at 8.5x EV/EBITDA, and our FY 2015 projections are attainable, the stock’s intrinsic value should be at least $100 per share within the next 2-3 years. This estimate implies appreciation potential of 47% relative to the stock’s current price. Page 13 UPDATE: The Madison Square Garden Company ($57.01) While MSG’s shares have been a strong performer since its 2010 spinoff from Cablevision, we continue to believe the current valuation does not reflect its free cash flow generating abilities, further earnings improvement potential at its highly profitable RSNs (MSG & MSG+), long-term earnings visibility thanks to multi-year agreements (affiliate fees, sponsorships and corporate suites) and unique assets that would be nearly impossible to replicate. With MSG’s multi-year, $1 billion+ renovation of its eponymous arena now complete, MSG is on the cusp of experiencing a significant acceleration in free cash flow. Results at the MSG Media segment, which generates the vast majority of overall profitability, have been impressive with revenues and EBITDA increasing at an 11% and 23% CAGR, respectively, over the past 3.5 years with margins expanding by over 1,600 basis points. Despite these strong results, we see further improvement as affiliate fee agreements for the Company’s RSNs (MSG and MSG+) with distributors accounting for ~40% of its subscribers should come up for renewal over the next 2-3 years. Notably, based on our projections, the current market rate for affiliate fees is 10%-15% higher than what these distributors are currently paying. MSG’s Sports and Entertainment segments had been particularly impacted by the Garden’s renovation. However, we see improved prospects for both segments now that the transformation of the iconic arena is complete. Our estimate of the Company’s intrinsic value is $80, representing 41% upside from current levels. There are a number of items that could drive further upside including the deployment of its overcapitalized balance sheet ($155 million of cash and no debt) and growing stream of FCF towards shareholder friendly initiatives, monetization of its valuable air rights, or a going private offer by the Dolan Family Group. Page 33 UPDATE: Time Warner Inc. ($67.13) Time Warner’s stable of businesses include the leading film and TV production studio (Warner Bros.), the dominant premium pay TV network (HBO), a collection of top-10 cable networks (Turner Networks), and the largest domestic print magazine portfolio (Time Inc.). TWX shares have rallied 140% since AAF last profiled the Company in January 2011, reflecting double-digit annual EPS growth as well as improved investor sentiment. However, in our estimation TWX still trades at an unwarranted discount to peers considering its dominant franchises. The upcoming spinoff of Time Inc. could provide a catalyst for closing this discount by separating the un-loved, declining publishing business from TWX’s more attractive assets. Pro forma for the separation, TWX will generate approximately 80% of revenue from subscription and content sources. The Company will also generate close to 30% of revenue internationally. Management expects TWX to grow EPS by double-digits again in 2014, and the Company has a tremendous platform to continue that growth going forward. In our sum-of-the-parts analysis, we apply higher multiples to the premium HBO (12.5x 2016E OIBDA) and Turner Networks (11x) business units than to the low-growth Warner Bros. filmed entertainment division (10x) to derive an estimated intrinsic value of approximately $92 per share. Notably, these multiples still represent discounts to the divisions’ respective peers. Adding in Time Inc. at a discounted 6.5x 2013 OIBDA, TWX shares have 46% upside to our estimate of intrinsic value looking out over the next 2-3 years. In February 2014, TWX also began separately reporting results at HBO and Turner Networks. At the least, this could be a catalyst for investors to begin to properly ascribe a premium multiple to HBO. More optimistically, we would not dismiss the possibility that TWX eventually considers a separation of Turner and/or HBO. Absent further deconsolidation, TWX should continue to create shareholder value via aggressive return of capital.
Published by: BOYAR'S INTRINSIC VALUE RESEARCH LLC 6 East 32nd St. 7th Floor New York, NY 10016 Tel: 212-995-8300 Fax: 212-995-5636 www.BoyarValueGroup.com Asset Analysis Focus is not an investment advisory bulletin, recommending the purchase or sale of any security. Rather it should be used as a guide in aiding the investment community to better understand the intrinsic worth of a corporation. The service is not intended to replace fundamental research, but should be used in conjunction with it. Additional information is available on request. The statistical and other information contained in this document has been obtained from official reports, current manuals and other sources which we believe reliable. While we cannot guarantee its entire accuracy or completeness, we believe it may be accepted as substantially correct. Boyar's Intrinsic Value Research LLC its officers, directors and employees may at times have a position in any security mentioned herein. Boyar's Intrinsic Value Research LLC Copyright 2014.
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February 28, 2014 Volume XL, Issue II Bed Bath & Beyond Inc. Nasdaq: BBBY
Dow Jones Indus: 16,321.71 Initially Probed: Volume XXXVIII, Issue VII & VIII @ $69.77 S&P 500: 1,859.45 Last Probed: Volume XXXIX, Issue XI & XII @ $76.52 Russell 2000: 1,183.03 Trigger: No Index Component: S&P 500 Type of Situation: Business Value
Price: $ 67.82 Shares Outstanding (MM): 209.7 Fully Diluted (MM): 212.3 (1.2%) Average Daily Volume (MM): 2.6 Market Cap (MM): $ 14.2 Enterprise Value (MM): $ 13.4 Percentage Closely Held: Insiders ~4%
52-Week High/Low: $ 80.82/56.37 5-Year High/Low: $ 80.82/19.52
Trailing Twelve Months Price/Earnings: 13.8x Overview Price/Stated Book Value: 3.4x Bed Bath & Beyond Inc. (“BBBY” or “the Net Cash & Investments (MM): $ 781 Company”) is a major operator within the retail sector. Upside to Estimate of BBBY operates roughly 1,500 stores and employs Intrinsic Value: 47% approximately 57,000 people throughout North America, and the firm generates annual revenue of over Dividend: $ NA $10 billion. The stores are primarily located in the U.S., Yield: NA and consist of the following brands: Bed Bath &
Beyond, Christmas Tree Shops, Harmon, buybuy Net Revenue Per Share: BABY, and Cost Plus World Market. BBBY’s product LTM: $ 55.12 line includes a wide range of domestic merchandise 2012: $ 44.75 and home furnishings. Examples of BBBY’s product 2011: $ 38.95 assortment include bed linens, bath items, kitchen 2010: $ 33.93 textiles, tabletop items, basic housewares, and general
home furnishings and consumables. Earnings Per Share: 2012: $ 4.56 A key driver of BBBY’s past success has been 2011: $ 4.06 its coherent and well-executed strategy. BBBY has 2010: $ 3.07 achieved an impressive record of growth during its operating history, but the rate of expansion has Fiscal Year Ends: February 28 moderated during recent years as the business has Company Address: 650 Liberty Avenue gained greater scale. Growth at BBBY has largely been Union, NJ 07083 driven by internal investment opportunities that have Telephone: 908-688-0888 been periodically supplemented by relatively small M&A CEO: Steven H. Temares transactions. Clients of Boyar Asset Management, Inc. own 33,250 shares of Bed The intense competition found within the retail Bath & Beyond Inc. common stock at a cost of $64.40 per share. industry, and the changes associated with new sales Analysts employed by Boyar’s Intrinsic Value Research LLC own channels (e-commerce, etc.) make a coherent strategy shares of Bed Bath & Beyond Inc. common stock.
- 1 - Bed Bath & Beyond Inc. as important as ever. Management utilizes an “everyday low price” philosophy, designed to maintain competitiveness within the marketplace. BBBY considers price competitiveness to be a key means of establishing and maintaining customer relationships. Despite the increased prominence of e-commerce and the perceived savings consumers associate with online shopping, BBBY is actually quite price competitive with what can be found elsewhere. A 2013 study conducted by BB&T Capital Markets found that on a basket consisting of 30 different BBBY products, prices for those products were actually 6.5% lower compared to what was available on Amazon (not including the impact of BBBY coupons). However, pricing is not the only means of differentiation at BBBY. The assortment and presentation of BBBY’s merchandise are unique factors not typically found at its competition among both conventional and online players. Moreover, BBBY’s emphasis on customer service is a key source of differentiation in the in-store experience relative to both e-commerce competitors and other conventional retailers.
Following a modest shortfall in earnings reported in early January, shares have declined about 15%. The negative sentiment for the stock was exacerbated by a general aversion to retail stocks during early 2014, reflecting broader concerns such as challenging weather conditions and security of customer data. In our view, this recent pullback in BBBY has been unwarranted, and it offers an attractive buying opportunity for long-term investors. Based on our projection for FY 2015, the stock is currently trading at an EV/EBITDA multiple of less than 6.0x, a modest multiple relative to BBBY’s historical trading range. Over the past decade, the stock has typically traded within a range of 6.0x-10.0x from an EV/EBITDA perspective. Assuming BBBY shares can eventually trade at 8.5x EV/EBITDA, and our FY 2015 projections are attainable, the stock’s intrinsic value should be at least $100 per share within the next 2-3 years. This estimate implies appreciation potential of 47% relative to the stock’s current price.
Although near-term performance could remain choppy, we believe the stock’s attractive valuation, combined with BBBY’s solid balance sheet (over $3 per share in net cash) and ongoing share repurchase program (expected to repurchase $1.7 billion of stock by the end of FY 2015) should provide support for the shares. The near-term concerns related to recent earnings results and the overall industry environment have become overstated from our perspective, causing investors to not fully appreciate BBBY’s strong fundamentals and outlook. The firm’s strong financial footing and competitive position could attract the interest of private equity investors at some stage. We would also highlight the relatively advanced ages of BBBY’s founders and co-chairmen (ages 83 and 77 respectively) as another consideration which could make such a scenario possible during the coming years. According to a 2013 report by Harris Williams & Company, the median EV/EBITDA multiple (LTM) paid for retail and consumer companies since 2006 has been 10.0x. Applying such a multiple to our projections for BBBY would suggest a transaction value of approximately $115.
Background & Business Description Bed Bath & Beyond began as a 2 store operation selling bed linens and bath accessories in the New York City area in 1971. Since that time co-founders Leonard Feinstein and Warren Eisenberg have pursued a disciplined and measured growth strategy, in terms of concepts, store count, and product offerings. The result is a diversified retail operation that generated almost $11 billion in sales in FY 2012. Importantly the Company’s growth trajectory has remained robust despite its increasing size, with revenue CAGR of 11.6% between FY 2010 and FY 2012.
The Bed Bath & Beyond Timeline
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Successful growth has been facilitated by a management philosophy that is largely “hands off” at the local level, with on-site inventory management, and a high level of autonomy for store managers to adjust product offerings to meet localized needs. An added benefit of this autonomy is a labor turnover rate among employees that is lower than average for the industry. Despite this autonomy, two constants have been a focus on customer service and a broad product offering. Bed Bath & Beyond has an “everyday low price” philosophy, and was a retail pioneer in terms of the “superstore” concept. The demographic profile of BBBY customers tend to be female, 35-50 years old, with a middle to upper-middle class income level.
This business model has allowed Bed Bath & Beyond to grow from its original concept and 2 stores into 5 concepts and ~1,500 leased stores employing ~57,000 people. The 5 concepts are Bed Bath & Beyond, Christmas Tree Shops, Harmon, buybuy Baby, and Cost Plus World Market. None of the four additional concepts is home grown. Rather, they have been wisely acquired early in their development, and then allowed to organically grow under the Bed Bath & Beyond umbrella. The Company actively seeks to integrate merchandise assortments among its concepts, allowing the smaller concepts to benefit from the economies of scale at the parent level. Additionally, the Company relies on simple modular fixtures for the design of its stores and presentation of its offerings. This allows store layouts to be effortlessly reconfigured as demand for assorted products fluctuates both seasonally and cyclically. The Company purchases merchandise from approximately 7,800 suppliers with no long term contracts in place, and the largest supplier accounts for only 5% of purchases. In addition to its core retail operations, BBBY acquired Linen Holdings, LLC for $105M in June of 2012. Linen Holdings is a distributor of a variety of textile products to institutional customers in the hospitality, cruise, food service and healthcare industries.
Bed Bath & Beyond stores encompass approximately 42.5 million square feet, with the typical store ranging from 20,000-70,000 square feet. Additionally the Company is a partner in a Mexican JV that operates four retail stores under the Bed Bath & Beyond name. The Company’s 5 concepts allow Bed Bath & Beyond to offer a variety of products including bed linens, bath items, kitchen textiles, basic house wares, general home furnishings, and consumables. Bed Bath & Beyond (1,011 stores): The flagship brand is a dominant presence in houseware goods across such verticals as bed linens, bath accessories, kitchen related products, and small appliances. The Company has also expanded their offerings of food and drinks in recent years. While Bed Bath & Beyond has a national presence, they are predominately an East Coast brand. Cost Plus World Market (269 stores): Acquired in June of 2012, Cost Plus focuses on home decorating, furniture, and specialty food and beverage. The segment operates stores under the names World Market, Cost Plus World Market, Cost Plus Imports, and World Market Stores. Cost Plus is headquartered in Oakland, California and is primarily a West Coast brand, although they operate in 30 states. Christmas Tree Shops (76 stores): In the 11 years since acquiring Christmas Tree Shops for $200 million BBBY has more than tripled store count from 23 to 76 as the concept has expanded from its New England roots across the East Coast. In addition to seasonal decorations these stores offer traditional home furnishings. buybuy BABY (86 stores): BBBY has grown buybuy BABY from 8 stores in 4 East Coast states to 86 stores in 28 states in the 7 years since they acquired the brand. These stores are one stop shops for new parents, offering everything from nursery toys to car seats. Harmon (49 stores): Harmon is a New Jersey based discount provider of health and beauty products with the majority of their stores located in the NJ, NY, CT Tri-State area. This concept represents BBBY’s first foray with acquisitions. In the twelve years since the purchase store count has grown from 27 to 49, but the geographic footprint has largely remained localized.
Management Management at BBBY is a model of consistency, with the least tenured executive officer being CFO Susan Lattman, a relative newcomer with only 18 years of service to the Company. Of note, Lattman replaced Eugene Castagna as CFO, who was promoted to COO, on February 26, 2014. Co-founders Warren Eisenberg (83) and Leonard Feinstein (77) remain actively involved with their Company despite their advancing ages, providing a continuity and quality to capital allocation and overall culture that is common among “owner/operator”
- 3 - Bed Bath & Beyond Inc. companies. The two remain under contract until February 25, 2017. There are no other members of the founding families involved with senior management or the Board, and it is Company policy that the Chairman and CEO positions be held by separate individuals. In addition, as a matter of Company policy, relatives from the founding families typically do not advance beyond the Vice President level. Insider ownership at BBBY currently stands at about 4%.
Executive Officers Age Background Warren Eisenberg, Co-Chairman 83 Co-Founder, Co-CEO of BBBY 1971-2003 Leonard Feinstein, Co-Chairman 77 Co-Founder, Co-CEO of BBBY 1971-2003 Steven Temares, Chief Executive Officer 55 Appointed CEO in 2003, joined firm in 1992 Eugene Castagna, Chief Operating Officer 48 Appointed COO in ’14, CFO in ‘06, joined firm in ‘94 Arthur Stark, President & Chief Merchandising Officer 59 Appointed CMO in 1999, joined firm in 1977 Matthew Fiorilli, Senior Vice President-Stores 57 Appointed SVP-Stores in 1999, joined firm in 1973 Susan Lattmann Chief Financial Officer 46 Appointed CFO in 2014, joined firm in 1996
Recent Developments BBBY 3Q Earnings Report Disappoints One of the main catalysts for the stock’s recent correction relates to a weaker than expected fiscal 3Q earnings report released in January 2014. BBBY reported fiscal 3Q-2013 EPS of $1.12, a 9% year over year increase but $0.03 below investor expectations. Revenue was also modestly disappointing relative to projections, up 6% from 3Q-2012. Same store sales advanced 1.3%, representing a deceleration relative to levels achieved during recent quarters. BBBY modestly increased store count (10 new store locations), illustrated by a 1.4% year over year increase in overall Company square footage. Management cited several issues that contributed to a challenging fundamental backdrop, providing headwinds for margins (both gross and operating margins contracted modestly from a year over year perspective). Among the primary challenges were higher inventory acquisitions costs, increased coupon utilization, and a less favorable sales mix. Importantly, the firm continues to generate a steady stream of cash flow, helping BBBY to maintain a strong balance sheet and return capital to shareholders. BBBY repurchased $171 million of its shares during 3Q-2013 (average price $74 per share), and the Company’s overall shares outstanding were down 6% relative to the same period in fiscal 2012. BBBY ended the quarter with net cash and investments of $781 million (over $3 per share). Following the earnings report, BBBY shares dropped by about 12%.
The negative investor reaction also reflected a reduction in future guidance provided by management in conjunction with the earnings report. Looking ahead, BBBY expects fiscal 4Q EPS to be in the range of $1.60 to $1.67 (about a 6% downward revision), implying full-year EPS guidance of $4.79 to $4.86. 4Q comparable same store sales are now expected to increase 2%-4% (down from a previous expectation of 3.5%-5.5%). Going forward, there may also be a temporary uptick in some expenses such as SG&A as the firm continues to spend on initiatives pertaining to its e-commerce capabilities and overall IT infrastructure. Shares of BBBY continued to slide following the earnings and guidance update (down about 15% since the release). However, we would attribute much of the further sell-off to industry related concerns, which caused the overall retail sector to be out of favor in early 2014. Potential implications pertaining to customer data security concerns (highlighted by the data breach at Target), and adverse winter weather conditions in several regions of the U.S. have likely contributed to the general sell-off among retail stocks during recent months. Although data security (additional investments in technology infrastructure) and weak sales comparisons due to weather may be recurring issues across the industry in the near-term, we do not believe these factors materially alter the fundamental outlook for retailers over the long-term.
Industry Analysis: Navigating the Effects of E-Commerce The emergence of the Internet has yielded far-reaching effects across the economy, significantly impacting consumer behavior and the overall industry landscape for retailers. The Internet has empowered consumers with an enhanced shopping experience, characterized by improved product research, greater price transparency, and enhanced convenience. Not surprisingly, these benefits have helped fuel the emergence of e-commerce during the past 1-2 decades across the U.S. economy. According to the U.S. Census Bureau, total e-commerce sales in 2013 were over $263 billion, and accounted for 7% of total sales during the most recent quarter. In fact, annual growth in e-commerce has largely remained in a low-mid teens range (excluding the - 4 - Bed Bath & Beyond Inc. recent recessionary period), and e-commerce has gained an increasingly important role within the overall economy (see chart). The implications are potentially profound within the retail industry, and these considerations will likely gain even greater prominence during the coming years. Findings from a recent report by Forrester Research suggest that by 2017, 60% of all U.S. retail sales will involve the Internet to some degree (research, transactions, etc.). The same report projects that online purchases will represent over 10% of total retail sales within the next five years (almost double 2012 levels). E-commerce utilization also exhibits some seasonality as it tends to represent a higher percentage of overall transactions during the crucial 4Q holiday season.
Estimated Quarterly U.S. Retail E-commerce Sales as a Percent of Total Quarterly Retail Sales (1st Quarter 2004 – 4th Quarter 2013)
Not Adjusted
Adjusted
Source: U.S. Census Bureau News, February 2013
The emergence of e-commerce has also impacted the overall competitive landscape within retail. Many e-commerce providers have gained significant prominence within the retailing marketplace, and conventional “bricks and mortar” players have been forced to make adjustments to this new reality, investing substantial sums into information technology to support their own e-commerce capabilities. The most obvious success story that has emerged in this new marketplace has been Amazon (AMZN). The firm has established a dominant presence within e-commerce across many segments within the retail space. AMZN has built a track record of substantial growth that has exceeded many of its peers, supported by internal investment and M&A. Amazon’s sales now exceed $70 billion and its current market capitalization stands at over $160 billion. As the following chart depicts, AMZN has achieved a superior growth trajectory within the e-commerce space. AMZN now has more online sales than its top 12 competitors combined. AMZN’s emergence reflects the new industry reality that conventional retailers now face. In our view, this evolving marketplace presents both a challenge and opportunity for retailers. Moreover, we believe it would be erroneous to assume that all conventional retailers are incapable of successfully adapting to this new environment.
Amazon Growth Far Exceeds the Competition
Amazon.com
Source: Internet Retailer, The Wall Street Journal, wsj.com
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However, investors should not disregard the strategic importance of e-commerce and its impact on the competitive landscape within retail. This growing sales channel empowers consumers to make more informed purchase decisions, evaluating retailer product lines based on considerations such as product quality, customer service, and price. One of the most obvious effects of this new environment is the customer behavior known as “showrooming.” According to the Oxford dictionary, showrooming is “the practice of visiting a store or stores in order to examine a product before buying it online at a lower price.” This type of shopping strategy has become more prevalent during recent years as e-commerce players have become more prominent within the industry, and it has been further fueled by the increased utilization of mobile devices such as web-enabled smartphones. A Pew Internet Study conducted in 2013 found that 56% of U.S adults now possess a smartphone (an increasingly important consumer tool, used for in-store research, comparison shopping, etc.). Product categories such as apparel, home improvement and consumer electronics are considered to be among the most influenced by internet-driven research. Based on a study by eMarketer, the number of mobile shoppers in the U.S is projected to increase from 95 million in 2012 to 175 million in 2016. Not surprisingly, this type of behavior is more common among younger consumers. A 2013 survey conducted by Vibes (a firm that specializes in mobile marketing) indicated that 50% of consumers under the age of 35 showroom at least half of the time, while consumers over 35 have a showrooming rate of 31%. Importantly, showrooming is equally prevalent across the full spectrum of income levels. Yet, it warrants mention that an increasing movement toward taxation of Internet-based transactions may cause such price discrepancies between e-commerce providers and conventional retailers to be less pronounced going forward.
The showrooming trend has served to reinforce the importance of price competitiveness for retailers across the industry. However, price alone is not the sole driver of a purchase decision. Rather, retailers can differentiate themselves in the marketplace through other considerations such as product offerings, customer service, and increasingly personalized marketing strategies. Conventional retailers can distinguish product lines by its diversity, and by offering products or brands that are exclusively available within their respective stores. Customer service (depending on the product category) is often a key aspect of the in-store experience, and is difficult to replicate via mobile or online channels in our view. Personalized marketing messages (often delivered by email or mobile message) can be used to segment and target customers based on consumer data and transaction history, creating a more relevant marketing message that is more likely to result in a sale. Yet, we believe the more important take-away is that conventional retailers must be positioned to compete across all possible sales channels (in-store, online, mobile). This “omni-channel” retailing approach will likely be increasingly crucial to long-term success within the industry, as retailers utilize all possible venues (using an integrated approach) to meet consumer needs and ultimately drive transactions. An omni-channel strategy requires significant capabilities that involve meaningful investment in areas such as technology, distribution, and order fulfillment. Retailers that can build and maintain such capabilities will be best positioned to gain market share over the long-term. Moreover, such capabilities could represent a barrier to entry to new competitors within the retail sector during the coming years. A 2013 report by Jones Lang LaSalle on the subject of e-commerce helped to summarize the requirements for executing the omni-channel strategy:
“The key to omni-channel is the integration of processes, information systems and infrastructure, including property, to enable the retailer to meet customer demand from whatever location is positioned to provide the best customer experience.” – Jones Lang LaSalle report, November 2013
Bed Bath & Beyond: Future Strategy A key driver of BBBY’s past success has been its coherent and well-executed strategy. The intense competition found within the retail industry, and the changes associated with new sales channels make this issue as important as ever. As mentioned earlier in this report, management utilizes an “everyday low price” philosophy, designed to maintain competitiveness within the marketplace. BBBY considers price competitiveness to be a key means of establishing and maintaining customer relationships. The firm also sometimes relies on promotions and coupons to help stimulate sales and traffic. Despite the increased prominence of e-commerce and the perceived savings consumers associate with online shopping, BBBY is actually quite price competitive. A 2013 study conducted by BB&T Capital Markets found that on a basket consisting of 30 different BBBY products, prices for those products were actually 6.5% lower compared to what was available on Amazon (not including the impact of BBBY coupons).
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However, pricing is not the only means of differentiation at BBBY. The assortment and presentation of BBBY’s merchandise are unique factors not typically found at its competitors among both conventional and online players. BBBY’s diverse product line is apparent when entering one of its store locations. Products consist of both well-recognized outside brands and the Company’s own proprietary brands. Although proprietary products likely represent a relatively modest portion of overall sales (not quantified by the Company), this could be an area of emphasis going forward as a means of further differentiating the product line. The wide breadth of products allows BBBY to gain a greater share of customer purchases, while serving to reinforce the Company’s strong brand identity. BBBY is continuously testing new products and merchandise categories in order to adapt to changing consumer tastes, and can adjust the assortment and mix of merchandise to reflect a store’s local market conditions. Store layouts are organized by product categories (kitchen section, bedroom section, etc.) in order to create the appearance of several individual specialty stores within one site. The generous dimensions of most stores (typically 20,000-70,000 feet) allow most inventory to be kept at the store site, helping to further demonstrate the breadth and diversity of BBBY’s product line. BBBY relies on a diverse network of largely domestic suppliers, and most supplier contracts are short term in nature.
In our view, BBBY’s emphasis on customer service is a key source of differentiation relative to both e-commerce competitors and other conventional retailers. The knowledge and service of the store personnel is a key aspect of the BBBY shopping experience, and is supported by employee training and a “promote from within” approach that incentivizes employee performance and translates to below average employee turnover. Importantly, each individual store manager is afforded relatively high flexibility to manage product mix to adapt to local customer preferences. To create maximum shopping convenience, store layouts are clearly organized so that customer can easily access the desired products and expertise. Most BBBY store locations are open 7 days a week. Products can also be purchased 24 hours a day via the e-commerce channels. Each store concept has its own individual web site which offers assistance with product purchases, product returns, and other information. BBBY has focused on significantly enhancing its ecommerce presence and capabilities during recent years via investment in information technology and related infrastructure. To support inventory management and order fulfillment, BBBY utilizes 15 distribution facilities (about 6 million square feet).
The Company’s reputation for merchandise and customer service allow it to largely rely on “word of mouth” advertising as existing customers help to communicate the firm’s value proposition within the marketplace. As a result, BBBY does not invest significant resources in advertising, although it does opportunistically utilize promotional methods such as circulars and direct mail to raise customer awareness and stimulate traffic in the stores. Ultimately, couponing and other promotional tools are designed to acquire new customer relationships that will extend beyond promotionally priced items. The Company also utilizes digital channels for advertising and product promotion (email, mobile, Internet search advertising, etc.) During the last 3 fiscal years, annual net advertising costs have averaged about $214 million, translating to about 2% of sales (this figure can be closer to 4% for firms such as Pier 1 Imports).
Bed Bath & Beyond: Growth Opportunities BBBY has achieved an impressive record of growth during its operating history, but the rate of expansion has moderated during recent years as the business has gained greater scale. Growth at BBBY has largely been driven by internal investment opportunities that have been periodically supplemented by relatively small M&A transactions. It is important to mention that growth opportunities have historically been pursued in a financially responsible manner which has allowed the firm to also maintain strong returns throughout its history, with little or no debt (see following table for a 10-year history). Looking ahead, we believe there are ample organic opportunities for growth at BBBY during the coming years. However, such growth will likely be pursued in a measured way, consistent with BBBY’s track record and management’s general philosophy concerning creating long-term shareholder value. Additionally, improvements in general fundamentals for the U.S. economy and U.S. residential real estate could provide additional tailwinds for growth in sales and profits during the coming years. Utilizing relatively conservative assumptions, we believe sales of $12.6 billion and EBITDA of $2.1 billion could be attainable by FY 2015.
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A Record of Profitable Growth 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 AVG Sales Growth 22.2% 15.0% 12.9% 13.9% 6.5% 2.3% 8.6% 11.9% 8.5% 14.9% 11.7% Operating Margin 14.3% 15.4% 15.1% 13.4% 11.9% 9.3% 12.5% 14.7% 16.5% 15.0% 13.8% ROE 23.2% 24.1% 25.7% 24.2% 21.6% 15.3% 18.0% 20.9% 25.2% 25.9% 22.4% Debt Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil
The Company’s largest store concept (Bed Bath & Beyond) continues to be the primary driver of sales and profits, with over 1,000 store locations (roughly two-thirds of the total Company store base). Management believes that markets in the United States and Canada could ultimately support 1,300 stores. Although management has already conducted significant due diligence to identify potential new store locations, no time frame has been provided for reaching the 1,300 store count objective. Given BBBY’s current geographic footprint, relatively under-penetrated regions such as the Mountain West and West Coast could represent the best opportunities for store expansion. Given the Company’s operating philosophy and recent record of expansion, we would expect year over growth in Bed Bath & Beyond stores to be relatively modest during the coming years (likely in the 1%-3% range).
In our view, the growth potential of BBBY’s smaller concepts (Cost Plus World Market, Christmas Tree Shops, buybuy BABY, Harmon) is often overlooked by investors. Collectively, these concepts now represent about one-third of BBBY’s total store base, and this figure will likely rise over time. The respective sales contributions of these stores are not currently disclosed by management, but the increases in store locations are difficult to ignore. Just since our last Asset Analysis Focus report on BBBY (published September 2012), store counts for these concepts are up 8%, compared to a 2% increase in store count for Bed Bath & Beyond stores during the same period. The biggest growth driver (buybuy Baby) has increased store count by 26% since September-2012. We expect mid-high single digit growth to remain attainable for BBBY’s smaller concepts for the foreseeable future given their relatively modest levels of penetration from a national perspective. Additionally, these smaller store concepts help to complement the Bed Bath & Beyond stores, via product line expansions and “store-in-store” layouts. It is conceivable that management may consider acquiring other store brands over time, provided such transactions fit with the existing strategy and culture. In our view, such M&A would likely take the form of smaller bolt-on type transactions, rather than a larger scale or more transformative deal.
Although the rates of growth achieved by BBBY in its earlier years is unlikely to be repeated given the firm’s increased scale and market presence, meaningful expansion opportunities still do exist. Importantly, investors are likely overlooking these opportunities as recent earnings disappointments and a general investor aversion to the retail industry have caused undue emphasis on short-term factors. Expansion opportunities for Bed Bath & Beyond stores remain significant, and the Company’s smaller concepts such as Harmon and buybuy BABY should provide an increasingly important source of sales growth going forward. Despite industry pressures such as the emergence of e-commerce, we believe BBBY continues to possess a strong competitive position that can support additional gains in sales and profits during the coming years. Looking to FY 2015, we believe sales and EBITDA of $12.6 billion and $2.1 billion should be attainable, representing growth of 8% and 10% relative to expectations for the current fiscal year (FY 2013).
Balance Sheet and Financial Position With no debt, ~$780 million in cash and investments ($3.67/share), and healthy free cash flow, BBBY’s financial position is secure. A brief history of the Company’s cash balance provides evidence that the Company is able to build cash quickly in a diverse range of environments, and is willing to deploy it aggressively when opportunities arise. On an equivalent quarter basis, at the end of Q3’07, the Company had total cash and securities of $377,358. By Q3’11 this number had jumped more than 330% as the Company turned defensive given the financial crisis. As signs of the recovery began to take hold, the Company turned aggressive and made their largest acquisition to date (Cost Plus World Market for ~$495M). In the last few years the Company has continued to deploy cash as a large acquirer of their own stock (more on this below).
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Currently cash and investments are made up of 60% Cash & Equivalent, 29% Short Term Investment Securities, and 11% Long Term Investment Securities. Investment securities are predominantly U.S. Treasury Bills, and they hold ~$51 million in auction rate securities. While the Company is debt free, they do lease substantially all of their existing stores under leases that generally range from 10 to 15 years. Most leases provide for renewal options, some have rent increases built in, and some include contingent rent kickers. As of the most recent 10-K the Company disclosed ~$3.3 billion in operating lease obligations. BBBY would consider taking on debt in order to pursue the right opportunity in the marketplace, but management does not view a financially leveraged balance sheet as a positive driver of long-term value.
Free cash flow has averaged ~$890 million over the last three years, equating to a current yield of more than 6% on a FCF basis. While the Company has not historically paid a dividend, management has proven that they are capable capital allocators, having used their cash to opportunistically and successfully acquire new brands, and having been consistent repurchasers of their own stock. Since their 2004 10-K, buybacks have totaled more than $5.8 billion and shares outstanding have declined more than 29%. The Company has been particularly aggressive in recent years, with shares outstanding down by 17% since 2011, and having returned ~86% of cash flow from operations to shareholders over the last 2 years. The current authorization has approximately $1.7B left, which at current prices equates to about 12% of shares outstanding. Management has indicated that they expect this authorization will be completed by the end of fiscal 2015. BBBY’s board of directors is not averse to considering issuing dividends to shareholders in the future, but has historically preferred share repurchase as a flexible means of opportunistically returning capital to investors.
We view BBBY’s strong financial position and robust cash flow generation as competitive advantages in a segment with relatively low barriers to entry. The Company’s strong financial position provides management with optionality to help stave off the impact of cyclical as well as secular threats. We believe this to be particularly important in a world where online competition remains stiff and attempts to compete on price with bricks & mortar retailers. Opportunistic M&A remains a possibility as well, particularly in the current challenging retail environment which likely has many smaller brands struggling to maintain their nascent position, let alone finance growth. We suspect that BBBY’s culture of decentralized management and history of successfully developing acquired brands would make them a preferred buyer for independent retail operators that would tuck in nicely.
Management has guided CapEx for fiscal 2013 to be $340M, which we believe is likely above “normal.” This elevated level is tied to several major initiatives which have been undertaken in 2013, including overhauling www.buybuybaby.com and www.bedbathandbeyond.com, upgrading mobile sites and apps, building a new IT Data Center, and investing in in-store POS improvements. This increased spend should contribute to the Company’s success over time and will likely drop off as these improvements are completed. That being said, current plans call for opening 30 new stores across all concepts in fiscal 2014 versus 10 new stores in fiscal 2013. This increased pace will of course result in higher CapEx, but we note that this is clearly growth CapEx and could be easily adjusted downward if necessary. We believe a more “normal” CapEx level to be closer to $300M.
Valuation & Conclusion From a historical point of view, BBBY shares have been a very sound investment. The stock has roughly doubled over the past decade, and appreciation has been even more pronounced from a longer-term perspective. Clearly, the firm’s well established record of profitable growth has been a key driver of shareholder value, further supported by consistent returns of capital to shareholders via stock buybacks. Although BBBY’s growth trajectory has entered into a more moderate phase, we believe the Company continues to have an attractive set of opportunities to grow profits over the coming years and further enhance long-term shareholder value. BBBY shares were also solid performers during 2013 (up over 40%), but more recent performance has been less robust. Following a modest shortfall in earnings reported in early January, shares have declined about 15%. The negative sentiment for the stock was exacerbated by a general aversion to retail stocks during early 2014, reflecting broader concerns such as challenging weather conditions and security of customer data. In our view, this recent pullback in BBBY has been unwarranted, and it offers an attractive buying opportunity for long- term investors.
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TTM TTM Company Name Ticker TTM P/E EV/EBITDA Operating Margin TTM ROE Home Depot HD 21.8x 11.5x 11.6% 35.6% Lowe's Companies LOW 23.3x 10.9x 7.8% 17.8% Pier 1 Imports PIR 15.7x 7.5x 11.4% 25.8% Williams Sonoma WSM 22.0x 9.9x 10.6% 23.3% Average 20.7x 9.9x 10.4% 25.6% Bed Bath & Beyond BBBY 13.8x 7.0 x 14.4% 26.2%
Based on our projections for FY 2015, the stock is current trading at an EV/EBITDA multiple of less than 6.0x, a modest multiple relative to BBBY’s historical trading range. BBBY’s current valuation is also modest relative to similar publicly traded companies (BBBY trading at about a 30% discount to peers), despite possessing a superior level of profitability (see table above). Over the past decade, the stock has typically traded within a range of 6.0x-10.0x from an EV/EBITDA perspective. Assuming BBBY shares can eventually trade at 8.5x EV/EBITDA, and our FY 2015 projections are attainable, the stock’s intrinsic value could be at least $100 per share within the next 2-3 years. This estimate of intrinsic value implies appreciation potential of 47% relative to the stock’s current price (see following table). Although near-term performance could remain choppy, we believe the stock’s attractive valuation, combined with BBBY’s solid balance sheet (over $3 per share in net cash) and ongoing share repurchase program (expected to repurchase $1.7 billion of stock by the end of FY 2015) should provide support for the shares.
BBBY Estimate of Intrinsic Value FY 2015 Value ($MM) BBBY @ 8.5x EV/EBITDA $18,002 Net Cash & Investments (3Q FY13) 781 Equity Value $18,783
Shares Outstanding (FY 2015) 188
Intrinsic Value Estimate Per Share $99.91
Upside from Current Price 47%
In our view, our estimate of BBBY’s intrinsic value could prove to be conservative from a long-term perspective. Assuming a favorable economic backdrop, sales and EBITDA could potentially exceed our projections. Moreover, the firm’s strong financial footing and competitive position could attract the interest of private equity investors at some stage. We would also highlight the relatively advanced ages of BBBY’s founders and co-chairmen (ages 83 and 77) as another consideration which could make such a scenario possible during the coming years (Warren Eisenberg and Leonard Feinstein currently own about 3% of BBBY shares). According to a 2013 report by Harris Williams & Company, the median EV/EBITDA multiple (LTM) paid for retail and consumer companies since 2006 has been 10.0x. Applying such a multiple to our FY 2015 projections for BBBY would suggest a transaction value of approximately $115.
Overall, we view BBBY as a well managed retailer that is poised to create long-term value for its shareholders. The Company’s strong financial footing and competitive position, combined with consistent return of capital to shareholders should translate to both growth and multiple expansion during the coming years. Our estimate of intrinsic value suggests potential upside of 47% from the current price, and this could prove to be conservative from a long-term perspective. The near-term concerns related to recent earnings results and the overall industry environment have become overstated in our view, causing investors to overlook BBBY’s strong fundamentals and outlook.
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Risks The Company’s primary risks include: BBBY’s strong balance sheet and cash flow generation could allow management to pursue M&A opportunities that are financially or strategically unattractive. A general downturn in fundamentals for consumer activity or general economic conditions could cause BBBY’s future trends in sales and profitability to come under pressure. The further emergence of e-commerce competitors, and failure to address e-commerce issues could jeopardize BBBY’s long-term profitability and competitive position within the industry. A reduced role of BBBY’s co-founders could cause unfavorable changes in management style and Company culture over the long-term. The Company’s strong growth record and increased industry prominence could make future growth rates more modest relative to past years.
Analyst Certification Asset Analysis Focus certifies that the views expressed in this report accurately reflect the personal views of our analysts about the subject securities and issuers mentioned. We also certify that no part of our analysts’ compensation was, is, or will be, directly or indirectly, related to the specific views expressed in this report.
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BED BATH & BEYOND INC. CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)
ASSETS Nov. 30, 2013 March 2, 2013 Current assets: Cash and cash equivalents $ 471,064 $ 564,971 Short term investment securities 223,114 449,933 Merchandise inventories 2,881,561 2,466,214 Other current assets 478,865 386,367 Total current assets 4,054,604 3,867,485
Long term investment securities 87,021 77,325 Property and equipment, net 1,523,253 1,466,667 Goodwill 486,279 483,518 Other assets 393,332 384,957 TOTAL ASSETS $ 6,544,489 $ 6,279,952
LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,145,281 $ 913,365 Accrued expenses and other current liabilities 417,073 393,094 Merchandise credit and gift card liabilities 267,332 251,481 Current income taxes payable 3,674 77,270 Total current liabilities 1,833,360 1,635,210
Deferred rent and other liabilities 493,845 484,868 Income taxes payable 87,456 80,144 TOTAL LIABILITIES 2,414,661 2,200,222 Shareholders' equity: Preferred stock - $0.01 par value – – Common stock - $0.01 par value 3,349 3,327 Additional paid-in capital 1,658,082 1,540,451 Retained earnings 8,262,603 7,573,612 Treasury stock, at cost (5,785,579) (5,033,340) Accumulated other comprehensive loss (8,627) (4,320) TOTAL SHAREHOLDERS' EQUITY 4,129,828 4,079,730 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 6,544,489 $ 6,279,952
- 12 - February 28, 2014 Volume XL, Issue II The Madison Square Garden Company NASDAQ: MSG
Dow Jones Indus: 16,321.71 Initially Probed: Volume XXXVI, Issue III @ $21.91 S&P 500: 1,859.45 Last Probed: Volume XXXIX, Issue XI &XII @ $54.30 Russell 2000: 1,183.03 Trigger: No Index Component: N/A Type of Situation: Consumer Franchise, Business Value
Price: $ 57.01 Shares Outstanding (MM): 77.0 Fully Diluted (MM) (% Increase): 78.1 (1.4%) Average Daily Volume (MM): 0.5 Market Cap (MM): $ 4,453 Enterprise Value (MM): $ 4,299 Percentage Closely Held: The Dolan Family Group: 19% Economic; 69% Voting 52-Week High/Low: $ 62.66/54.30 5-Year High/Low: $ 652.66/17.50
Trailing Twelve Months Price/Earnings: 27.9x Introduction Price/Stated Book Value: 2.8x Shares of the Madison Square Garden Long Term Debt (MM): $ Nil Company (“MSG” or “the Company”) have performed Implied Upside to Estimate of well (+58% vs. the S&P 500 +33%) since we re-visited Intrinsic Value: 41% them (profiled in March 2010 and May 2011) within our topic addressing the attractiveness of sports media Dividend: $ Nil rights in our April 2012 AAF issue. Despite the share Yield: N/A price advance, we do not believe MSG’s current valuation adequately reflects its free cash flow Net Revenue Per Share: generating abilities, further earnings improvement TTM $ 18.87 potential at its highly profitable Regional Sports FY 2013: $ 17.20 Networks (MSG & MSG+), long-term earnings visibility FY 2012: $ 16.58 thanks to multi-year agreements (affiliate fees, sponsorships and corporate suites) and unique assets Earnings Per Share: that would be nearly impossible to replicate. TTM $ 2.04 On October 25, 2013, “The World’s Most FY 2013: $ 1.83 Famous Arena” also became known as “The World’s FY 2012: $ 1.38 Most State of the Art Arena” following a $1 billion+ renovation. With the arena transformation complete,
MSG is on the cusp of experiencing a significant Fiscal Year Ends: June 30 acceleration in free cash flow. MSG’s capital Company Address: Two Pennsylvania Plaza expenditures, which have averaged $316 million over New York, NY the past two years, should decline to more normalized Telephone: 212-465-6000 levels (<$50 million) beginning in FY 2015 (begins Chairman/CEO: James L. Dolan July 1, 2014). While management seems inclined to Clients of Boyar Asset Management, Inc. own 58,012 shares of The pursue growth opportunities to drive long-term Madison Square Garden Companyat a cost of $20.55 per share. shareholder value, we believe that capital returns to Analysts employed by Boyar’s Intrinsic Value Research LLC own shareholders will also be utilized to unlock shareholder shares of MSG common stock. value given MSG’s FCF acceleration and the
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Company’s fortress like balance sheet ($155 million of cash and no debt). We are clearly not enamored with MSG’s two recent investments including a 50% stake in Irving Azoff’s latest artist management venture ($150 million) and a $25 million investment to establish a venue in Las Vegas with the creators of Brooklyn Bowl. While MSG’s/CVC’s last investment with Mr. Azoff turned out to be a profitable endeavor, we believe the Company’s future capital deployment is worth monitoring.
Results at the MSG Media segment have been impressive with revenues and AOCF (AOCF is MSG’s preferred method of EBITDA, which excludes stock based comp) increasing at a 11% and 23% CAGR, respectively over the past 3.5 years with margins expanding by over 1,600 basis points. Despite this growth, we see further improvement as affiliate fee agreements for the Company’s RSNs (MSG and MSG+) with distributors accounting for ~40% of its subscribers should come up for renewal over the next 2-3 years. Notably, based on our projections, the current market rate for affiliate fees is 10%-15% higher than what these distributors are currently paying. In addition to affiliate fee growth, there are multiple items that should bolster segment results including increased advertising revenues (underpenetrated at the RSNs), monetization of Knicks and Rangers streaming rights, and the potential divestiture of fledgling and currently loss making Fuse (in November 2013 the Company announced it was exploring strategic alternatives for the network), which is masking overall segment profitability.
MSG’s Sports and Entertainment segments had been particularly impacted by the Garden’s renovation. However, we see improved prospects for both segments now that the transformation of the iconic arena is complete. Both segments are poised to reap the full benefits (higher sponsorship, corporate suites and ancillary revenues) of the transformation beginning in FY 2015 (begins July 1, 2014) and we note that calendar year 2014 will be the first time in four years that the Garden will be open/available for the entire year. The Sports segment should also be a beneficiary of the robust market for sports media rights. The NHL recently garnered a 12-year agreement for its Canadian media rights (begins with the 2014/2015 season) that was nearly 6x the amount of the previous contract and will significantly increase the amount of revenue sharing the Rangers receive from the league. Meanwhile, the NBA’s national media contract currently runs through the 2015/2016 season and we would expect the league to command a significant increase when the contract is renegotiated. Our view reflects the increasingly valuable nature of live sports (DVR proof, which is attractive for advertisers) and the fact that the current contract was signed amidst record low league TV ratings, which have rebounded substantially. While the Entertainment segment has been under pressure in recent years, the strategic acquisition of the LA Forum, an iconic arena in an attractive, and underserved entertainment market, should bolster future results. The Forum, which opened in January 2014 following a facelift of its own, has already secured multi-year sponsorships with a number of companies including JPMorgan Chase, Toyota, Corona, Caesers Entertainment and The NY Times.
In determining our valuation for MSG, we have employed a sum of the part valuation methodology. While some investors may question the use of the approach given the integration of the Sports and Media segments, we are highly confident that the Company could sell the Knicks and Rangers franchises for a significant sum, even if they were offered for sale without the media rights. Our estimate of the Company’s intrinsic value is $80, representing 41% upside from current levels. There are a number of items that could drive further upside including the deployment of its overcapitalized balance sheet and growing stream of FCF towards shareholder friendly initiatives, monetization of its valuable air rights, or a going private offer by the Dolan Family Group. As we have previously detailed, we believe the Dolans’ long term interests reside with the sports and entertainment businesses. With distributor consolidation heating up in the cable industry, the sale of Cablevision would provide the Dolans with ample capacity to pursue a transaction, in our view.
Business Overview MSG is a vertically integrated sports, entertainment and media Company. The Company’s business is built on its iconic assets including the storied Madison Square Garden Arena, Radio City Music Hall and the trophy sports franchises of the NY Knicks and NY Rangers. MSG reports the results of its operations within three business segments including MSG Media, MSG Entertainment and MSG Sports. The following provides a breakdown of the Company’s total revenue in FY 2013 by segment.
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FY 2013 MSG Total Revenues ($MM)
MSG Sports $470.3 34% MSG Media $677.7 48% MSG Entertainment $252.2 18%
Total Revenues: $1,400.2 MM
Note: FY 2013 Revenues do not exclude $59.9 million of Inter-Segment Eliminations
MSG Media (48% of FY 2013 Revenues) – MSG Media is comprised of two regional sports networks (RSNs) including MSG and MSG+, and Fuse, which is a national television network dedicated to music. The Company’s RSNs are home to seven professional sports teams. In addition to the broadcast rights that it holds for its owned professional sports teams (Knicks, Rangers and Liberty), the Company has multi-year agreements with the Islanders, Devils, Sabres and New York Red Bulls. MSG is also the official regional home of the NY Giants and provides exclusive non- game coverage of the NFL team. The Company’s RSNs also telecast college football and college basketball from top conferences (e.g. SEC, ACC, Big East and PAC 12). In addition to broadcasting live sporting events, MSG’s RSNs also produce original programming that increases exposure of the Company’s brands and builds a valuable content library.
MSG Sports (34%) – The MSG Sports segment owns and operates four sports franchises (Knicks, Rangers, Liberty (WNBA) and Wolfpack, a minor league hockey team), which provide valuable content to the MSG media segment. In addition, MSG also promotes, produces and/or presents a wide range of other live sporting events such as professional boxing, college basketball, gymnastics, track and field, professional bull riding, tennis and wrestling as well as the NFL draft.
MSG Entertainment (18%) – The MSG Entertainment segment presents or hosts live entertainment events, including concerts, family shows, performing arts and special events in its seven venues including the Garden, the Forum, Radio City Music Hall, The Theater at Madison Square, The Beacon Theater, Wang Theater and The Chicago Theater.
Although the Company primarily licenses its venues to third-party promoters for a fee, MSG also promotes or co-promotes shows and assumes an economic risk related to the event. Promoted events include the Radio City Christmas Spectacular, featuring the Rockettes, which is the top grossing live holiday show in North America. The Radio City Christmas Spectacular franchise accounted for approximately 40% of the MSG Entertainment segment revenue during FY 2013.
Regional Sports Networks – Crown Jewel with Further Opportunity to Expand Profitability In our view, the crown jewel of MSG’s business is its two RSNs (MSG and MSG+), which serve ~8 million subscribers in the New York Metropolitan region. The Company’s RSNs telecast approximately 700 live sporting events and over 3,100 hours of live original programming each year. During 2013, MSG won 18 local Emmy awards giving the network a total of 97 Emmys over the past six years including 85 for MSG. The momentum has continued into 2014 with the Company nominated for 73 local Emmys (64 for MSG). The Company’s RSNs boast superior profitability to their peers due in part to MSG’s ownership of two of the sports
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teams (NY Knicks and NY Rangers) for which it telecasts programming. As illustrated in the chart below, MSG’s RSNs command margins that are nearly double that of the RSNs controlled by Comcast, Fox and DIRECTV.
Comparative RSN EBITDA Margins, FY13E
Source: Company data, Credit Suisse estimates, SNL Kagan, via Credit Suisse Equity Research April 2013
MSG’s RSNs serve a large, loyal and passionate fan base and provide MSG Media with good revenue and cash flow visibility thanks to a recurring and growing stream of affiliate fee revenues. As we noted in our prior reports on MSG, the Company signed a 10-year affiliation agreement with Cablevision accounting for ~40% of the RSN sub base that took effect on January 1, 2010, just prior to its spinoff from that entity. Notably, the renewal represented a significant increase over Cablevision’s prior agreement. It should be noted that the annual escalator embedded in the Cablevision agreement is ~7% and is calculated based on information that MSG discloses in its public filings. The Cablevision agreement coupled with a contentious 2012 affiliate fee renewal with Time Warner Cable (discussed in our 2012 Sports Media Rights piece) have enhanced MSG Media’s revenues, profitability and margins. Between calendar year-end 2009 and FY 2014 (a period representing 3.5 years) MSG’s Media segment revenues and AOCF have increased at an 11% and 23% CAGR, respectively while AOCF margins have expanded by over 1,600 basis points to 51.6% from 31.3%.
MSG Media - Selected Financial Results ($ MM) 6 Months 6 Months 2009 2010 FY 2011 FY 2012 FY 2013 12/31/2102 12/31/2013 Revenues $474.1 $551.5 $564.7 $614.2 $677.7 $316.3 $347.3 % Change – 16.3% – 8.8% 10.3% – 9.8% Operating Income $141.8 $209.4 $204.7 $228.3 $328.6 $161.2 $157.4 Operating Income Margin (%) 29.9% 38.0% 36.2% 37.2% 48.5% 51.0% 45.3% AOCF $167.4 $231.3 $228.2 $258.6 $349.5 $172.3 $167.2 AOCF Margin (%) 35.3% 41.9% 40.4% 42.1% 51.6% 54.5% 48.2% Note: 2009 and 2010 results are Calendar year; Fiscal year results are provided from FY 2011-FY 2013
MSG’s results in FY 2014 will face difficult comparisons with FY 2013 due to a few one-time items including the benefit it received from the 2012/2013 hockey lockout (lower rights fees and production expenses associated with a shortened season) and a short-term licensing agreement that will not reoccur ($10-$15 million headwind associated with sublicensing some college sports programming that ended in April 2013). Management has also noted that incremental investments at Fuse as part of the network’s strategy to bolster its programming lineup will also have an adverse impact on FY 2014 results. Despite these headwinds, as illustrated above, MSG media segment margins for the first half of FY 2014 of 48% are still above (~800 bps) the full year profitability levels posted during the 2009 to 2012 time frame. Going forward, we believe there are multiple items that will favorably impact future MSG profitability including the realization of higher RSN affiliate rates as distributor agreements come up for renewal, increased advertising revenues, monetization of digital rights, and divestiture of Fuse, which we believe is currently generating a loss and masking segment profitability.
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Upcoming Affiliate Fee Renewals Should Command Significantly Higher Rates While MSG’s agreements with Cablevision and Time Warner Cable account for approximately 60% of the subscribers receiving MSG networks, we believe that agreements covering the remaining 40% will come up for renewal over the next 3 years. While the Company does not disclose the terms of its affiliated fee agreements, we believe that current agreements with MSG’s major distributors including DIRECTV (~700k subs) Comcast (~800k), and FiOS (~1.2 million) were all signed before the Company’s 2010 spinoff from Cablevision. Based on press reports we know that DIRECTV’s agreement was signed at year end 2009. Given the Company’s strategy to “strategically scatter” its affiliate agreements coupled with the 2010 and 2012 renewals with Cablevision and TWC (which renewed in 2012 after its former 7 year agreement lapsed), we believe that the other distributors will likely be renegotiating carriage agreements for MSG in the 2014-2016 time frame. Notably, based upon our analysis, we believe affiliate fee amounts currently being paid by Cablevision and TWC are 10-15% above the remaining distributors providing a significant opportunity as agreements are renegotiated. Based on data from MSG’s filings, and utilizing assumptions for Fuse affiliate fees and subscribers we currently estimate that Cabelvison’s monthly per subscriber payment for MSG’s networks is $5.16 vs. $4.69 for non CVC/TWC subs.
In determining the current monthly affiliate fee rate for the non CVC/TWC subscribers, we assume that TWC’s current rate approximates what we estimate Cablevision is paying. It’s possible that TWC’s affiliate fee payment is higher than Cablevision’s since the value of live sporting events has increased since Cablevision signed its 2010 agreement. In addition, notwithstanding this year’s poor performance, the on-court performance of the NY Knicks has also improved markedly with the Knicks making the playoffs in each of the past three years following a 6 year drought. Further, the Knicks’ resurgence has resulted in significantly higher viewership for NY Knicks games with ratings for the 2010/2011 and 2011/2012 seasons increasing by 100% and 80%, respectively. The strong ratings momentum continued for the 2012/2013 season. With the exception of the strike shortened 2011/2012 NBA season, the 2012/2013 season was the highest rated Knicks regular season in the 25 years that the network has been tracking household ratings. If TWC’s current MSG affiliate fee payment exceeds CVC’s, then this would imply that there is additional upside (beyond the 10-15% cited above) to future affiliate fee renewals as they are renewed over the next 2-3 years. Although current team performance could result in upcoming renewals becoming more challenging, we would note that affiliate fee agreements are typically multi-year, which give the Company the opportunity to sell their recent ratings improvement, in our view.
While Comcast’s proposed acquisition of TWC may create some unease given that both companies are key MSG distributors (combined subs would be 3.2 million or ~40% of MSG’s total), we do not believe MSG’s future affiliate fees will be pressured. Comcast is the second largest owner of RSNs (after Fox) and is intimately familiar with the value of live, regional sports programming. As illustrated in the table below, Comcast-owned RSNs command some of the highest affiliate fees in the industry including Comcast SportsNet Washington, which is the country’s most expensive RSN. Although the combined MSG and MSG+ generate a higher affiliate fee amount than Comcast SportsNet (CSN) Washington, we believe MSG’s networks deserve to command higher fees as they telecast games of five major professional teams compared with just two for CSN Washington (Wizards and Capitals).
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2012 Affiliate Fees for Select Regional Sports Networks 2012 Estimated Affiliate Revenue per Average Sub per Month ($) Comcast SportsNet Washington 4.02 FOX Sports Wisconsin 2.57 FOX Sports North 3.68 Prime Ticket 2.56 New England Sports Network 3.56 SportsNet New York 2.55 Root Sports Pittsburgh 3.26 FOX Sports Carolinas 2.45 Comcast SportsNet Philadelphia 3.18 FOX Sports Tennessee 2.45 Comcast SportsNet Bay Area 3.05 FOX SportsSouth 2.45 YES Network 2.99 Root Sports Rocky Mountain 2.33 FOX Sports Southwest 2.88 MSG Plus 2.28 FOX Sports Detroit 2.86 FOX Sports Florida 2.27 Attitude Sports & Entertainment 2.85 SportsTime Ohio 2.21 Root Sports Northwest 2.85 Comcast SportsNet Northwest 2.19 FOX Sports Arizona 2.75 Mid-Atlantic Sports Network 2.14 Comcast SportsNet Chicago 2.75 Comcast SportsNet New England 2.13 FOX Sports Ohio 2.71 Channel 4 San Diego 1.59 Sun Sports 2.69 Comcast SportsNet California 1.35 FOX Sports West 2.63 Cox Sports Television 0.74 Madison Square Garden Network 2.63 SportSouth 0.62 FOX Sports Midwest 2.61 Comcast/Charter Sports Southeast 0.57
RSN Industry Average 2.49
Source: SNL Kagan, April 2012
While we don’t see the proposed Comcast/Time Warner Cable merger having an impact on affiliate fee pricing, we note that there could be an adverse short-term headwind for MSG to the extent that Comcast’s affiliate agreement is meaningfully below Time Warner’s cable rate (which we believe is the case). According to MSG’s most recent 10-K filing:
“In some cases, if a Distributor is acquired, the affiliation agreement of the acquiring Distributor will govern following the acquisition. In those circumstances, the acquisition of a Distributor that is a party to one or more affiliation agreements with us on terms that are more favorable to us could have a material negative impact on our business and results of operations.”
With the proposed deal not expected to close until year end coupled with the fact that Comcast’s affiliate agreement will likely be negotiated (upward based on recent trends) within the next year or two, we don’t believe there will be a longer term negative impact. On a potential positive impact, should the Comcast/TWC merger be approved, we would not be surprised if it spurs a tie up between DTV and Dish. With Dish dropping MSG in 2010 as part of a strategy to exit regional sports programming in the NYC market, there could be an opportunity to add MSG to ~250k Dish Subscribers in the NYC area.
Advertising Remains Underpenetrated In contrast to large national cable networks that typically derive a fairly even split between affiliate fees and advertising revenues, RSNs typically generate the vast majority of revenues from affiliate fees. MSG is no exception and based on industry researcher Kagan’s projection of MSG’s 2013 advertising revenue (~$65 million), we estimate that advertising revenues at the Company’s RSNs currently account for 10-15% of the RSNs total revenues (MSG has historically stated that affiliate fees represent the vast majority of its RSNs revenues). As we have noted in prior AAF reports, the value of large, live audiences will likely become increasingly attractive to advertisers in today’s fragmented media landscape. As illustrated in the graphic below, sports viewership has held fairly consistent over time as broadcast networks have experienced significant declines.
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Viewership of Major Sports on Pay TV Has Been Consistent
Source: SNL Kagan, Nomura Securities, Nielsen data as calculated by a third party major media concern via The Wall Street Journal
Not only are the audiences of the Big 4 declining as illustrated above, but a large amount of the programming is consumed via DVRs that enable consumers to fast forward through advertisements. According to a Nielsen study, viewers watched 97% of sports programming live during 2012, down slightly from 98% in 2008. However, approximately 75% of nonsports programming was viewed live, down sharply from 93% in 2008. We would expect live viewership of nonsports programming to continue to decline as penetration of DVRs increase. At present, 47% of households have DVRs according to Leichtman Research leaving plenty of room for further penetration. While some observers project DVR penetration to slow going forward as consumers embrace video streaming, we would note that streaming viewing also presents reduced potential for advertising and contributes to fragmented media audiences. In addition to the improved ratings for the Knicks (discussed above), the Rangers and the other NHL teams that MSG has telecast rights for have also registered strong gains presenting additional opportunities to capture high margin advertising dollars. During the 2012/2013 season the Rangers experienced a 65% increase in average household ratings with the Islanders (+100%) and Devils (+40%) also registering strong gains. It’s also worth noting that the current 2013/2014 season is the first time in three years that MSG will be broadcasting full seasons of the Knicks and Rangers due to past work stoppages, so the Company’s true advertising potential will likely begin to emerge.
Monetization of Digital Rights To date, the Company has yet to monetize its digital/streaming rights associated with NY Knicks and NY Rangers telecasts. Given consumer trends that have resulted in an increased amount of content consumption over multiple distribution platforms, streaming viewing is likely to become an opportunity for the Company going forward. While MSG might not develop its own direct to consumer streaming product, it may choose to work with its distributors who can offer streaming products to their consumers on an authenticated basis. In our view, by providing the distributors the ability to offer its customers streaming capabilities (e.g. MSG to Go), we believe MSG should be able to command higher affiliate fees from its distributors.
MSG Exploring Strategic Alternatives for Fuse - Divestiture Would Benefit Segment Profitability In November 2013, MSG announced that it had engaged JPMorgan Chase to explore strategic initiatives for Fuse. In our view, and as we noted in the 2014 Forgotten Forty MSG report, we do not believe that Fuse will ever command an appropriate level of affiliate fees (and profitability) under MSG’s umbrella with little leverage over distributors as a single national network company. Fuse currently commands a monthly affiliate fee payment of ~$0.08 per sub, which is well below the $0.41 and $0.19 fee garnered by MTV and VH-1, respectively, based on projections from Kagan. Although we fully recognize that Fuse is not MTV, Fuse appears to be capitalizing on an attractive market opportunity created by MTV, which has shifted its focus to reality programming.
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Despite adding ~14 million Fuse subscribers from in October 2012 as part of that distributors settlement with Cablevision, we do not believe that Fuse is currently profitable due to ongoing programming investments (original, news, acquired and live events) to attract a larger audience and drive increased advertising revenues. Recent attempts to improve the Company’s audience through its programming investment have been encouraging. Two of the Company’s recent shows including Insane Clown Posse and Big Freedia: Queen of Bounce have garnered significant national media attention. According to a recent Multichannel news article, Season one of Big Freedia was Fuse’s top original series on total viewer delivery reaching more than 4 million viewers and set a Fuse record for P18-34 and P18-49 delivery. Fuse has recently announced that the show has been renewed for a second season. As part of Fuse’s strategy to increase the audience at its linear network (where MSG management acknowledges the economics are), Fuse utilizes its digital properties such as its website (fuse.tv) and YouTube channel as a proving ground and as a means of building a broad audience. During MSG’s 3Q FY 2013 earnings call, management noted that its Fuse YouTube channel is consistently averaging over 2 million viewers each week. In announcing that the Company is exploring its options for the network, management noted, “Fuse's value has not gone unnoticed with various parties expressing strategic interest in the network.”
We view favorably the Company’s decision to explore strategic alternatives for the network though we wouldn’t be surprised if MSG were to retain a stake in Fuse if it ultimately decides to sell the property. With its control of 7 premier entertainment venues, MSG would arguably have a valuable stream of content that it could provide to the network. By retaining a stake in the network, the Company could also capitalize on the potential future value of Fuse that could be unlocked as part of a larger entertainment company. In addition to closing the affiliate fee gap, there is also an opportunity to meaningfully expand Fuse’s distribution. According to Nielsen, Fuse currently has ~74 million subs, which is well below the 90+ million subs of fully distributed cable networks. Nevertheless, Fuse boasts what management terms “beach front” real estate as it currently has distribution with every major distributor. With Fuse currently residing on digital tiers, we suspect that a larger media company could also use its leverage to boost subscribers by negotiating broader distribution on expanded basic tiers.
MSG Sports Boasts Good L-T Revenue Visibility Following a three-year, $1.1 billion makeover, “The World’s Most Famous Arena” also became “The World’s Most State of the Art Arena” when it reopened on October 25, 2013. With the transformation completed in stages during the offseasons over the past three years, the Company has realized some of the benefits associated with the project (corporate sponsorships and suite revenues, etc.). However, it will not be until FY 2015 (which begins July 1, 2014) that MSG will fully capture all of the improved economics associated with the renovated arena. In addition, recent NBA and NHL work stoppages during the prior two seasons have also had a negative impact on MSG Sports segment results with both leagues conducting shortened schedules (the NBA in 2011/2012 and the NHL for the 2012/2013 season).
MSG Sports - Selected Financial Results ($ MM) 6 Months 6 Months 2009 2010 FY 2011 FY 2012 FY 2013 12/31/2102 12/31/2013 Revenues $368.6 $372.2 $398.8 $464.7 $470.3 $121.5 $221.6 % Change - 1.0% - 16.5% 1.2% - 82.4% Operating Income ($31.9) ($1.8) ($7.2) $13.1 $13.5 ($3.3) ($20.4) Operating Income Margin (%) -8.7% -0.5% -1.8% 2.8% 2.9% -2.7% -9.2% AOCF ($18.0) $11.7 $7.0 $28.7 $27.0 ($13.0) $4.0 AOCF Margin (%) -4.9% 3.1% 1.8% 6.2% 5.7% -10.7% 1.8% Note: 2009 and 2010 results are Calendar year; Fiscal year results are provided from FY 2011-FY 2013
In our view, the transformed arena significantly enhances the prospects of the MSG Sports segment with both sponsorship and suite agreements secured pursuant to multi-year agreements with annual escalators. As illustrated in the following graphic, the MSG Sports segment offers significant revenue visibility with the vast majority of its revenue sources secured under long-term contracts or are from sources (e.g. season ticket sales) which have proven to be historically stable.
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MSG Sports Revenue Breakdown, FY13E
Source: Company data, Credit Suisse estimates via Credit Suisse Equity Research April 2013
In addition to the enhanced ancillary revenue opportunities from the Garden, we believe there are several other items that bode well for the Sports segment’s future prospects. The NBA and NHL have adversely impacted MSG’s results in recent years, but each of these leagues now have long-term labor agreements in place. Notwithstanding the Knicks’ performance to date, the performance of the teams has been strong in recent years allowing the Company to secure strong season ticket renewals. The robust market for sports media rights has a favorable impact on sports segment revenues as the Company’s team ownership allows it to share in the revenue that the league generates from national/international broadcast rights. As we detail below, this revenue stream should be meaningfully enhanced in the coming years.
Suite and Sponsorship Revenues Secured Under Long-Term Agreements with Annual Escalators We previously estimated in our May 2011 report on MSG that the full-year incremental impact on the Garden’s new suites would be ~$40 million. However, we would not be surprised if this proved conservative as press reports have indicated that the amounts the Company received for its new suites were much greater than our estimates. MSG has also done a good job of securing premium sponsorship agreements. We’ve previously discussed the Company’s deal with JPMorgan Chase (reportedly signed a 10-year $30 million deal) whereby it became the Company’s Marquee partner as well as signature partner agreements with Coca-Cola, Anheuser- Busch, and Delta Airlines. The Company has made further inroads adding to its base of signature partners, which now also include Kia Motors, Lexus and SAP. All of these agreements are believed to be multi-year, multi-million dollar agreements. While MSG does not disclose financial terms, the Company has previously stated that each sponsorship agreement it has signed is much larger than the sponsorship category that MSG previously sold.
Sports Ticket Demand Remains Robust and Provides Revenue Stability The improved fan experience from the renovated arena (better sightlines and wider concourses, etc.) coupled with the improved team performance of the Knicks and Rangers has also led to robust demand for season ticket sales. According to MSG, the renewal rate for Knicks and Rangers season tickets, which covers the vast majority of tickets sold, for the 2013/2014 season were 97% and 92%, respectively. This marked the fourth consecutive year that Knicks season tickets were sold out and the seventh consecutive year for the Rangers. The New York Knicks’ 2012/2013 season was the team’s most successful in 16 years as the team won the NBA’s Atlantic Division title for the first time since 1994 and advanced to the second round of the NBA playoffs. Meanwhile the Rangers have advanced to the playoffs in 7 of the past 8 years. In addition to team performance, strong season ticket renewals are a testament to the Company’s passionate and affluent fan base. For the 2013/2014 season, the average season ticket renewal price increase for the Knicks and Rangers was
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6.4% and 4%, respectively. While season tickets have recently been increasing at a low single digit rate, we would note that season tickets for the Rangers and Knicks increased markedly at the outset of the transformation with Knicks average season ticket prices increasing by 49% and Rangers average season ticket increasing at 23% rate for the 2011/2012 season.
NBA/NHL Have Secured Long-Term Labor Agreements While the NBA and NHL have had recent work stoppages, we note that both of these leagues now has extensive long-term labor agreement in place, which should minimize disruptions for many years. The current NBA collective bargaining agreement expires after the 2020/2021 season (the NBA and its players association each have the right to terminate after the 2016/2017 season) while the NHL’s recently signed agreement expires on September 15, 2022 with the league and its players association having the right to end the CBA following the 2019/2020 season. Although the long-term agreements are encouraging, the NBA’s move to a progressive luxury tax could prove costly for segment profitability if player expenses are not managed prudently. As detailed in MSG’s FY 2013 10-K filing: “we expect our NBA luxury tax obligations for the 2013-14 season to grow substantially. Subsequent years beyond the 2013-14 season will be subject to contractual player payroll obligations and corresponding NBA luxury tax thresholds.” During FY 2013, playoff appearances (both the Knicks and Rangers) generated $47 million in revenue and ~$16 million in direct contribution to the sports segment. With an appearance in the playoffs having a meaningful impact on MSG’s overall profitability, management needs to successfully balance the player expense/benefit trade off. MSG CEO Hank Ratner acknowledged as such during the Company’s 1Q 2014 earnings call:
“As it relates to the NBA, there is a progressive tax that is a, you know, an absolute part of the calculation when you’re going and putting your roster together and signing players. That’s something you need to be – remain cognizant of when you’re building your team and you need to factor it in to your financial model when you’re making your decisions, and it’s something that we do, and we look at the effects of our team and our roster has on the overall business, and we make what we consider the best and smart business decisions taking everything into account, so, that’s what we’ve done to date. That’s what we’ll continue to do going forward.”
NBA and NHL League Media Contracts Could Provide Good Growth Opportunity MSG’s ownership of the Knicks and Rangers allows the Sports segment to benefit from the robust environment for sports media rights due to league revenue sharing of national broadcast contracts. In 2011, NBC signed a $2 billion, 10-year agreement with the NHL to broadcast games in the U.S. The new deal with the NHL was approximately double the prior amount the NHL was receiving for its rights. In late 2013, the NHL reached a 12 year $4.9 billion deal with Rogers Communications for the Canadian broadcast rights to the NHL. As part of the agreement, Rogers will make an upfront payment of $142 million and make annual payments beginning with the 2014/2015 season of $285 million that will increase to $474 million at the end of the term. Notably, the recent Rogers deal is nearly six times the value of the current agreement that the NHL has with its three broadcast partners and it is estimated that each NHL team will receive $5 million from the upfront payment and $10-$15 million per year over the life of the deal.
The current NBA league media contract was signed in 2007 and runs through the 2015/2016 season. The 8-year, $7.4 billion extension (+20% vs. the prior deal) was signed in the midst of challenging ratings for the league. Given the surge in sports media rights values since the last NBA deal, we suspect the next agreement will command a meaningful premium. In addition, the NBA’s ratings have increased or held steady over the past 6 years after a record low registered during the 2006/2007 season. If the NBA is able to sustain its recent popularity surge for another year or so, we suspect the league will be able to generate a substantial increase over the prior contract. To the extent that player salaries do not increase in lock step with the higher revenue sharing agreements (league salary caps are tied to league revenues), future segment profitability should be favorably impacted.
Transformation, Forum Acquisition and Growth Opportunities Should Boost Entertainment Prospects “With respect to MSG Entertainment, We remain confident that we have the right strategy and mix of assets in place to return this segment to AOCF profitability. We’re looking forward to the remainder of this fiscal year which we expect to include improved results for the Radio City Christmas Spectacular franchise, the reopening of the Forum in January, and the - 22 - The Madison Square Garden Company
spring debut of Heart and Lights, our new large scale theatrical production at radio city music hall.” – Hank Ratner MSG President and CEO during MSG’s 1Q 2014 Earnings Call
MSG’s Entertainment segment has been disproportionately impacted by the renovation of the Garden with the arena and attached theater (Theater at MSG) closed for approximately 5-6 months each year during the 3 year renovation. As illustrated in the table below, MSG’s Entertainment Segment has posted losses during much of the 2010 to 2013 transformation.
MSG Entertainment - Selected Financial Results ($ MM) 6 Months 6 Months 2009 2010 FY 2011 FY 2012 FY 2013 12/31/2102 12/31/2013 Revenues $286.5 $304.0 $294.5 $264.0 $252.2 $181.9 $191.7 % Change - 6.1% - -10.4% -4.5% - 5.4% Operating Income ($37.6) ($38.6) ($24.0) ($9.3) ($24.7) $19.8 $10.2 Operating Income Margin (%) -13.1% -12.7% -8.1% -3.5% -9.8% 10.9% 5.3% AOCF ($21.8) ($25.5) ($11.5) $5.3 ($10.2) $27.3 $17.5 AOCF Margin (%) -7.6% -8.4% -3.9% 2.0% -4.0% 15.0% 9.1% Note: 2009 and 2010 results are Calendar year; Fiscal year results are provided from FY 2011-FY 2013
With the transformation complete, we believe MSG’s Entertainment segment is poised to generate meaningfully higher levels of profitability. Similar to the Sports segment, Entertainment results will be favorably impacted by higher suite, sponsorship and ancillary revenues. In addition to the transformation benefits, the acquisition of the LA Forum should have a favorable impact on overall segment profitability.
Strategic Forum Acquisition Could be a Game Changer for MSG Entertainment Segment In June 2012, the Company acquired the LA Forum in Inglewood, California for $23.5 million from the Faithful Bible Church. The Forum was formerly the home of the Lakers and Kings until they moved to the downtown Staples Center following the 1998/1999 season. As part of the acquisition, the Company received an $18 million construction loan from the City of Inglewood conditioned upon MSG spending at least $50 million to renovate the arena and according to management restore it “back to its original glory.” In addition, the City of Inglewood has agreed to forgive the loan as long as certain conditions are met (e.g. providing the Forum parking lot rent free to the local community to hold farmers markets on Saturday mornings, etc.). MSG noted on its 2Q FY 2012 earnings call that its total cost for the Forum acquisition and related renovation would be $120 million, which is net of the loan forgiveness and certain tax credits.
While the project came in slightly over its initial budget, we believe the acquisition makes strategic sense for a number of reasons. First, the Forum diversifies the Company’s revenue outside of the NY Metropolitan region providing a presence in the number two entertainment market in the country. Second, the Los Angeles market is underserved from a concert/entertainment perspective. While management stated that the arena will host some sporting events (boxing, tennis, etc.), it will primarily be a venue that hosts concerts, family shows, award shows and special events. In a July 2013 LA Times article Chairman Dolan stated, “There are plenty of venues in the L.A. market, but none of this size that can accommodate artists like the Eagles, with multiple-day runs where the venue is completely tuned into the concerts that are going to be put on.” 1
The nearby Staples Center is home to four professional franchises (Lakers, Clippers, Kings, and Sparks), which utilize the facility for approximately half the year while the Honda Center, which is located in Anaheim, is home to both an NHL and Arena football team. Another similarly sized arena, the LA Sports Arena has been rumored to be razed to make room for a soccer stadium. With re-development scheduled for Hollywood Park (a race track adjacent to the Forum that has recently closed), the Forum should benefit from future revitalization of the area surrounding the arena. Finally, the arena provides Chairman Dolan with access
1 LA Times, July 2013 http://www.latimes.com/entertainment/music/posts/la-et-ms-forum-renovation-20130730-dto,0,7822933.htmlstory#ixzz2ujYhbk7h - 23 - The Madison Square Garden Company to another marquee outlet for his blues-based rock band (not surprisingly, JD & the Straight Shot served as the opening act for the Eagles, which reopened the Forum with six shows in January 2014).
MSG has already secured meaningful multi-year sponsorships for the Forum, which should bolster MSG Entertainment segment profitability. In August 2013, MSG announced that JPM Chase had signed on as presenting partner, which includes being part of the venue’s official name “The Forum presented by Chase.” In addition, the Company has also secured agreements with Caesars Entertainment, Toyota and The NY Times. While it may take some time for the renovated arena to gain traction among acts, comments by Glen Fry (lead singer) of the Eagles, who helped reopen the arena with six performances in January 2014, called the Forum the best sounding arena he’s ever heard, should go a long way towards making the Arena a must play venue.
Heart & Lights and Billy Joel Series Highlight Entertainment Growth Opportunities During the spring of 2014, MSG will debut a spring production at Radio City Music Hall featuring the Rockettes entitled Heart & Lights. MSG is aiming to capitalize on the success/popularity of the Rockettes, which is the number one holiday show in the country and a key franchise for the Company. Heart & Lights, which is being produced by MSG (and therefore the Company takes on the economic risk), features a story by Doug Wright (Pulitzer Prize and Tony Award winner) that follows two teenage girls through New York as they unearth clues about their grandmother’s past. While it is difficult for us to handicap the success of this venture, management believes that Heart & Lights has the ability to serve as an anchor tenant at Radio City Music Hall for a long time.
In December 2013, MSG announced that Billy Joel would become the Company’s first ever music franchise of the World’s Most Famous Arena. As part of the agreement, Billy Joel is expected to play a show a month at the Garden for as long as there is demand. During MSG’s 2Q FY 2014 earnings call held in early 2014, MSG noted that all shows through September were sold out (incuding two that occurred in January and February). While the Billy Joel initiative is unlikely to be significant enough to move the needle at the Entertainment segment, the move appears to be a good and profitable way to increase venue utilization. In addition, if the concept proves successful, we would not be surprised if additional opportunities presented themselves.
Barclays Center Competition Appears Overblown In our prior MSG reports, we had dismissed competitive threats from the Barclays Center, an arena that opened up in Brooklyn in 2012. Our skepticism was based, in part, on the Arena’s inferior location. While the Barclays Center has only been open for less than two years, early results suggest that the arena’s results are falling short of expectations. The following excerpt appeared in an October 2013 Wall Street Journal article entitled “Brooklyn Arena is Glitzy, but Profits so Far Aren’t Golden.”
“Developer Forest City Ratner Cos., which owns the Barclays Center with Russian billionaire Mikhail Prokhorov, had projected the arena would have more than $76 million of operating income in its first year of operation, according to bond documents. But Barclays said the number was $19 million in operating income in the nine months ended in July, According to Forest City Security filings. That puts Barclays Center on pace to produce $25 million for the year. Not only would that be two-thirds less than projections, it also would be less than the arena’s $29 million in annual debt service on the $511 million the development borrowed by selling tax-exempt bonds.”
Perhaps the arena’s fortunes will improve when they gain another full time tenant (the NY Islanders in 2015). However, it should be noted that with the Islanders occupying the arena for a full season (41 home games), potential competition with the Garden will be lessened since the Barclays center will have less availability to accommodate top acts. We continue to believe that the Garden is a place that artists aspire to play with an appearance at the iconic arena often a major milestone in a performer’s career. Management has often noted that it is not seeing a significant impact from the new arena in Brooklyn. In fact, Melissa Ormond, President of MSG Entertainment recently stated, “Our biggest challenge when booking events at the Garden continues to be not having enough date availability to accommodate every artist and event that wants to play the arena.” Our view of the Garden’s panache is further reinforced by the fact that Barclays, which is the named major sponsor of the Brooklyn arena, has a long term agreement for one of the Garden’s prestigious Madison
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Level suites, which sports an annual price tag of nearly $1 million. It is also worth highlighting that during 2013, Madison Square Garden was named arena of the year by Pollstar (despite being closed for several months to accommodate renovations) for the 11th consecutive year, an award the Garden has won 18 of the past 20 years.
We would be remiss if we did not mention that Forest City Ratner (Owner of the Barclay’s Center) recently prevailed in securing the right from Nassau County (Long Island, NY) to renovate the Nassau Colliseum and redevelop the property (discussed in additional detail in a later section). While this facility could present some heightened competition for the Garden when the project is finalized, we don’t believe that it will present any significant challenges for the Company. It should be noted that the Nassau Coliseum is a current competitor since it hosts concerts/family events when the Islanders are not using the arena.
Free Cash Flow Poised to Accelerate “…, but I think if you go back historically and look at some of our pre-transformation financials, you’ll get a sense of what that could be, and it’s probably tens of millions versus hundreds of millions. That’s sort of the scale of what we’re talking about.” – Robert Pollichino MSG’s CFO regarding MSG’s Post Transformation Capex on 4Q FY2013 earnings call
MSG is on the cusp of experiencing a significant acceleration in free cash flow. The vast majority of expenses associated with the Garden transformation and Forum renovation have already been paid for with less than $150 million remaining to be paid for both projects as of December 31, 2014. MSG’s capital expenditures should return to more normalized levels beginning with 4Q 2014 and FY 2015 (begins July 1, 2014) will be the first full Fiscal Year that capital intensity will revert to more normalized levels. The following illustrates MSG’s capital intensity over the past 8 years:
MSG's Historical Capex Summary ($MM)
$403.4 100% $400 $367.7 90% $350 80% $300 70%
$250 $229.5 60% Revenues)
$200 50% Total
($MM)
of
40% $150 $132.9 33.5% (%
31.4% Capex 30% $100
17.1% Capex $55.2 $59.4 20% $50 11.5% $23.8 $30.1 5.3% 5.6% 10% 2.6% 3.0% $0 0% 2006 2007 2008 2009 2010 2011 FY2012 FY2013 Capital Expenditures ($MM) Capex (% of Total Revenues)
Note: Effective June 30, 2011, MSG changed its fiscal year-end from December 31st to June 30th to better align the financial planning and reporting cycles with the seasonality of its business, particularly the MSG Sports and MSG Entertainment segments. As a result, the results for the 6 month period ending December 2011 are included in 2011 results (2nd half) and the first six months of FY 2012.
Given that the Garden was an aging arena prior to commencing the recent renovation, we would not be surprised if the historical level of capex overstates the Company’s future run-rate. While MSG has another major arena in its portfolio that will need maintenance, as we noted above the Forum has been modernized, which should minimize future maintenance capex going forward. Over the next three years, we believe the Company’s
- 25 - The Madison Square Garden Company free cash flow could approach $300 million (which would represent a ~7% FCF yield), up from ~$200-$225 million in FY 2013. The vast majority of the Company’s free cash flow is currently being generated by the Media segment, but future growth is likely reflecting significant opportunities at the RSNs and profitability improvement at the Sports and Entertainment segments.
Significant Capacity to Pursue Growth Opportunities and Return Value to Shareholders MSG’s strong free cash flow generation coupled with its overcapitalized balance sheet should provide the Company with plenty of excess capacity to both pursue acquisitions and return value to shareholders. At the end of 2Q FY 2014 (December 2014), MSG had $155 million of cash, no debt and $368 million of available capacity under its revolver (reflects $7 million in letters of credit outstanding).
With the Company in a strong financial position and good visibility on the completion of the Garden, management pursued the acquisition of the Forum in 2012. As we noted above, we believe that this acquisition was a good use of the Company’s excess capital. More recently, with the capital projects coming to an end and boasting a strong cash position (at FY 2013 the Company had $278 million of cash) MSG made two investments that we believe to questionable. In August 2013, the Company announced that it would be investing $25 million in a new partnership with the owners of Brooklyn Bowl to establish a new venue in Las Vegas. The venue will be modeled after Brooklyn Bowl, which combines music, bowling and a restaurant with food by the Blue Ribbon Restaurant Group. In September 2013, MSG announced that it was investing $150 million to acquire a 50% stake in Irving Azoff’s new artist management and entertainment/digital businesses entitled Azoff MSG Management (AME). In addition, as part of the investment MSG has agreed to provide up to $50 million of revolving credit loans to AME. While we view skeptically these two recent investments, we’re willing to give the Company a pass given the strategic deployment of capital toward the Garden renovation and Forum Acquisition. Although the strategic merit for the Azoff investment appears particularly questionable, we’ve have had a favorable view of Live Nation in recent years. Our belief in the attractiveness of that business was largely based on the opportunities at Ticketmaster, an attractive and overlooked business amid the artist management and promotion operations. It is worth noting that Cablevsision’s/MSG’s last investment with Azoff proved to be a profitable endeavor.
MSG has frustrated investors recently by not committing to some sort of shareholder friendly endeavor (share buybacks or dividends) even as they boast a pristine balance sheet with meaningful free cash flow generation potential on the horizon. While shareholders may be uneasy with the Company’s potential future capital allocation, we note the Dolans, contrary to popular belief, have a successful history of implementing shareholder friendly initiatives. Supporting this view are the MSG and AMC spinoffs and the family’s, robust buyback (though ill-timed) and dividend policy at Cablevision (among the highest yielding cable stocks). In addition, we believe that the Company will be a disciplined acquirer in the pursuit of potential future acquisitions. Supporting this view is the Company’s recent proposal for the Nassau Colliseum project. While MSG had agreed to invest more in the project than the winning bidder, the amount of total revenue the Company was willing to share with the County was significantly lower. While management’s current inclination according to CEO Hank Ratner, is in “pursuing additional investment opportunities to drive continued value creation over the long term,” we would not rule out a the potential for a return of capital to shareholders in the not too distant future. Management has previously stated that growing the Company and returning capital to shareholders are not mutually exclusive events.
Management Changes and Permit Issues are a Non-Event President and CEO Hank Ratner Steps Down and Remains with MSG as Vice Chairman On February 28 2014, Hank Ratner stepped down as President and CEO of MSG, though Mr. Ratner will remain with the Company taking on a new role as Vice Chairman and joining the board of directors. Mr. Ratner’s replacement is Tad Smith, who according to MSG is “a well-regarded executive with a proven track record of effectively operating and growing diverse organizations.” Prior to the appointment, Mr. Smith had been President of local media at Cablevision for the past 5 years. While the leadership change may cause some unease, the fact that Mr. Ratner is remaining with the Company and joining the board should ease investor concerns. While we are not privy to the details of the management change, we believe that Mr. Ratner’s decision to step away from his day to day responsibilities could reflect a choice to unwind a bit after successfully managing a complex multi-year renovation project. As we noted in our initial MSG report (March 2010), one industry observer compared the renovation of MSG to replacing an air-craft engine in mid-flight. While Mr. Smith - 26 - The Madison Square Garden Company is an unproven and relatively unknown executive, MSG noted in its press release announcing the leadership change that Mr. Ratner is expected to work closely with Mr. Smith on the Company’s future growth.
MSG Receives 10-Year Permit Extension Following the expiration of its city venue permit, MSG received a 10 year permit extension in July 2013. While MSG was seeking to extend its permit in perpetuity, The New York City Council only agreed to a 10 year extension, ostensibly to make way for a significant enhancement to the current and outdated Penn Station, which currently resides below the Garden. Prior to the permit extension, Joel Fisher, who serves as VP of Sports and Arena Transformation, stated the following in an opinion column published in the NY Post in May 2013:
“Not only can we not be forced to move, but we’d still have the right, even if there was no arena, to build an office tower, with no obligation to free up space for Penn Station…Even if there was a feasible plan to improve Penn Station, it would need massive funding – in excess of $1 billion, not including the billions more that would be needed to compensate MSG for its property and building of a new arena.”
Accordingly, we find it difficult to believe that MSG will be forced to relocate, without receiving appropriate compensation.
Valuation and Conclusion While MSG’s shares have performed will since its 2010 spinoff from Cablevision, we believe the Company’s trophy properties including its namesake arena, regional sports networks and sports franchises (Knicks and Rangers) trade at a substantial discount to our estimate of their intrinsic value. In determining our valuation for MSG, we have employed a sum of the parts approach. While some investors may question using such a methodology given the benefit MSG Media derives from ownership of the Knicks and Rangers, we believe that the Company would be able to sell its sports teams/franchises without the media rights for a significant premium to recent Forbes values.
Value ($MM) MSG Real Estate Valuation $1,478 MSG Media Valuation (Average of Per Subscriber, Precedent transactions (EBITDA), and DCF) $3,326 MSG Entertainment @ 1x TTM Revenues (Includes Radio City, Beacon Theater, the Chicago Theater and others) $262 NY Knicks & NY Rangers @ 75% of Forbes 2013 Value (Excludes Amount Forbes Attributes to Stadium Value) $1,189 Other Investments (Azoff and Las Vegas @ 50% of Initial Investment) $88 2013 Corporate Expenses @ 8x ($86) Remaining Renovation Expense to be Paid in Cash ($150) Net Cash/(Debt) $155 Equity Value $6,261
Diluted Shares Outstanding 78.1
Per Share $80.15
% Upside to Estimate of Intrinsic Value 41%
There are a number of items that could drive further upside for MSG shares including the deployment of its overcapitalized balance sheet and growing stream of FCF towards shareholder friendly initiatives, monetization of its valuable air rights, or a going private offer by the Dolan Family Group. As we have previously detailed, we believe the Dolans’ long term interests reside with the sports and entertainment businesses. With distributor consolidation heating up in the cable industry, the sale of Cablevision would provide the Dolans with
- 27 - The Madison Square Garden Company ample capacity to pursue a transaction, in our view. In addition, we would also note that funding could also come from the sale of AMC, another Dolan asset that is an attractive acquisition candidate.
Overview of Key Valuation Assumptions MSG Media – Our MSG Media valuation is derived by utilizing a blended approach taking into consideration precedent transactions (on a per subscriber and EBITDA basis) and a DCF analysis. Our per subscriber valuation is derived by applying $125 per subscriber for the MSG network and $75 per subscriber for the MSG+ network (fewer Knicks and Rangers games), which implies a valuation of $100 a subscriber for both networks. In our view this represents a conservative amount given that this value is at the low end of the range of historical precedent transactions (see Appendix p. 32) for RSN precedent transactions that have been included in prior reports). It is worth noting that sports rights have increased in value since the transactions highlighted occurred. We’ve only ascribed a $10 per sub value for Fuse, which is at the low end of historical cable network transactions. In our previous AAF reports featuring companies with cable network properties, we have illustrated precedent transactions based on EBITDA multiples (for a summary of recent transactions (see Appendix p. 32). Historically, cable networks have commanded low to mid/high teens multiple on an EBITDA basis. In deriving a valuation based on our projected AOCF for MSG, we’ve applied a 12x multiple, representing a significant discount to historical transactions. While we generally prefer not to hang our hat on a DCF approach given its limitations, we believe it is useful in valuing MSG’s Media segment given the long term visibility of affiliate fees. The assumptions for the DCF component are summarized in the Appendix p. 32.
MSG Media Blended Valuation MSG Media Per Subscriber Valuation Analysis ($MM) 8MM MSG Subscribers @ $125 Per Sub $1,000.0 8MM MSG+ Subscribers @ $75 Per Sub $600.0
73MM Fuse Subscribers @ $10 Per Sub $730.0 Total: $2,330.0
MSG Media Valuation Based On Precedent Transaction ($MM) MSG Media @ 12x 2013E EBITDA $4,432.2
MSG Media DCF Valuation ($MM) MSG Media DCF Valuation $3,216.88
Average: $3,326.35
MSG Sports – Our valuation for the MSG Sports segment utilizes recent values derived by Forbes for Sports Franchises. Given the erratic profitability of professional sports franchises, we believe this to be a better approach than assigning a multiple applied to future earnings. In determining our valuation for MSG’s Sports segment, we have valued the Knicks and Rangers at 75% of the Forbes 2013 value (excluding the value Forbes attributes to the stadium, which translates to a $1.2 billion valuation). We believe this to be a conservative approach that may understate the true value of these first rate franchises. It is not uncommon for sports franchises to
- 28 - The Madison Square Garden Company
command irrational private market valuations and we believe there would be multiple bidders if the Rangers and Knicks franchises were put up for auction.
Forbes 2013 Valuation ($MM)
NY Knicks NY Rangers Sport $146 $95 Market $652 $382 Stadium $425 $263 Brand Management $191 $119 Total: $1,414 $859 Total Excluding Stadium $989 $596 Notes: Sport: Portion of franchise's value attributable to revenue shared among all teams. Market: Portion of franchise's value attributable to its city and market size. Stadium: Portion of franchise's value attributable to its stadium. Brand Management: Portion of franchise's value attributable to the management of its brand. Source: Forbes
Forbes estimated that the value of the Knicks and Rangers increased by 29% and 13% respectively during 2013. Over the past 12 years the value of the Knicks and Rangers has increased at an 11% and 10% CAGR, respectively.
Knicks Historical Valuation Rangers Historical Valuation
1414 Value ($mil) Value ($mil)
1100
850 780 750 655 592 608 613 586 543 507 494 461 411 416 392 398 401 365 306 277 263 272 282
NA
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Note: Data are when valuations were published; figures for most recently completed season Source: Forbes
Real Estate - As we noted previously, MSG is believed to hold ~1 million square feet of air/development rights directly above Madison Square Garden (based on current Floor Area Ratios (FAR) for zoning purposes). In addition, we believe the Company also holds up to an additional 2.0 million-2.5 million square feet of air rights/development rights that could be unlocked if the area surrounding Penn Station is redeveloped. In deriving a real estate value we have valued the Company’s two major arenas (Garden and Forum) at 75% of the projected renovation cost ($1.2 billion). In valuing the air rights, we have assumed the Company controls 3 million buildable square feet of air/development rights and have valued these rights at a ~$175 per buildable square foot. We believe this is conservative considering the city was looking to sell the air rights around - 29 - The Madison Square Garden Company
Grand Central Station at a price tag of around $250 per square foot, an amount some industry observers believed understated their true value. Miscellaneous – In deriving our valuation we have reduced the equity value by approximately $150 million, which reflects the remaining renovation expenses to be paid in cash for the Forum and Garden. In addition, we have not given any credit to the Company’s future cash generation in the overall valuation (note: a large portion of MSG’s cash generation is accounted for in our DCF component for the Media segment valuation) for the amount of future free cash flow and have assumed the current shares outstanding remain unchanged from current levels. We believe that this represents a conservative approach and would not be surprised if the Company returns a significant amount of cash to shareholders in the coming years, which would provide further upside to our intrinsic value estimate.
Risks Risks that MSG may not achieve our estimate of the Company’s intrinsic value include, but are not limited to, general economic weakness, especially within the New York Metropolitan region where the Company generates the vast majority of its revenues, adverse capital allocation moves (e.g. large acquisitions) with the Company’s overcapitalized balance sheet, conflicts of interests arising from the Dolan Family Group’s ownership of other media/entertainment properties, ineffective management of personnel costs at the Company’s sports franchises and uncertainty associated with the Company’s zoning permit to conduct operations at Madison Square Garden.
Analyst Certification Asset Analysis Focus certifies that the views expressed in this report accurately reflect the personal views of our analysts about the subject securities and issuers mentioned. We also certify that no part of our analysts’ compensation was, is, or will be, directly or indirectly, related to the specific views expressed in this report.
- 30 - The Madison Square Garden Company
THE MADISON SQUARE GARDEN COMPANY CONSOLIDATED BALANCE SHEETS (in thousands)
December 31, 2013 June 30, 2013 ASSETS (Unaudited) Current Assets: Cash and cash equivalents $ 154,529 $ 277,913 Restricted cash 12,402 8,413 Accounts receivable, net 149,953 145,728 Net related party receivables 26,413 18,565 Prepaid expenses 53,525 41,215 Other current assets 25,215 20,339 Total current assets 422,037 512,173 Investments in and loans to nonconsolidated affiliates 150,405 — Property and equipment, net 1,293,156 1,135,180 Amortizable intangible assets, net 85,506 90,705 Indefinite-lived intangible assets 158,636 158,636 Goodwill 742,492 742,492 Other assets 94,958 93,028 TOTAL ASSETS $ 2,947,190 $ 2,732,214
LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable $ 29,092 $ 16,006 Net related party payables 1,122 283 Accrued liabilities: Employee related costs 59,785 70,663 Other accrued liabilities 246,869 221,405 Deferred revenue 328,977 237,537 Total current liabilities 665,845 545,894 Defined benefit and other postretirement obligations 58,872 59,726 Other employee related costs 40,974 45,370 Other liabilities 57,040 58,536 Deferred tax liability 553,403 543,753 TOTAL LIABILITIES 1,376,134 1,253,279 Stockholders' Equity: Class A Common stock, par value $0.01 639 639 Class B Common stock, par value $0.01 136 136 Preferred stock, par value $0.01 — — Additional paid-in capital 1,077,151 1,070,764 Treasury stock, at cost (13,200) (14,179) Retained earnings 522,171 437,794 Accumulated other comprehensive loss (15,841) (16,219) TOTAL STOCKHOLDERS' EQUITY 1,571,056 1,478,935 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,947,190 $ 2,732,214
- 31 - The Madison Square Garden Company
MSG APPENDIX
Regional Sports Networks - Precedent Transactions Date Acquirer Seller Value** Properties Acquired Subs (MM)* Value Per Sub 2007 Comcast Cablevision $581 60% of FSN Bay Area 50% of FSN New England 4.4 $134 FSN Pittsburgh, FSN Northwest, 2007 Liberty Media News Corp $785 FSN Rocky Mountain 7.8 $100 Average: $117 * Subs for Comcast's Acquisition of Cablevision's RSNs are Pro Rata At Acquisition: FSN Bay Area Subs = 4MM; FSN New England Subs = 3.9MM **Value Per Grant Samuel's Independent Expert's Report In Connection with Liberty Media's Transaction With News Corp (DirecTV for News Corp Swap) At 12/31/06: FSN Pittsburgh Subs = 2.3MM; FSN Northwest Subs = 3.0MM; FSN Rocky Mountain Subs = 2.5MM
Precedent Cable Network Transaction Analysis Year Target Acquirer Seller % Purchased Enterprise Value ($MM) EV/EBITDA 2012 A&E Networks Disney/Hearst Comcast 16% $ 19,200 15x 2009 Discovery Kids Hasbro Discovery 50% $ 600 19x 2008 Weather Channel NBCU/Private Equity Landmark 100% $ 3,500 15x 2008 Sundance Channel Cablevision Consortium 100% $ 496 14x 2007 Oxygen Network NBCU Consortium 100% $ 925 NM 2007 Travel Channel Cox Discovery 100% $ 684 18x 2006 Court TV Time Warner Liberty Media 50% $ 1,470 18x 2005 CSTV CBS CSTV 100% $ 325 17x 2003 USA Networks GE Vivendi Universal 80% $ 8,725 17x 2002 Bravo GE Cablevision 100% $ 1,250 24x Average: $ 3,712 17x Median: $ 1,088 17x
MSG Media DCF Valuation FY FY FY FY FY FY FY FY FY FY FY 2012 FY 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E Revenues $614.2 $677.7 $691.3 $718.9 $747.7 $811.3 $843.7 $877.4 $912.5 $949.0 $987.0 $1,026.5 % change 3.5% 10.3% 2.0% 4.0% 4.0% 8.5% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% Capex $9.4 $11.7 $13.8 $14.4 $15.0 $16.2 $16.9 $17.5 $18.3 $19.0 $19.7 $20.5 Cap ex as % of Revenue 1.5% 1.7% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% AOCF $258.6 $349.5 $331.8 $352.3 $373.8 $413.7 $434.5 $456.3 $479.1 $503.0 $528.1 $554.3 AOCF Margin 42.1% 51.6% 48.0% 49.0% 50.0% 51.0% 51.5% 52.0% 52.5% 53.0% 53.5% 54.0% Fuse Improvement $0.0 $2.5 $5.0 $7.5 $10.0 $12.5 $15.0 $17.5 $20.0 $22.5 AOCF Including Fuse Improvement $258.6 $349.5 $331.8 $354.8 $378.8 $421.2 $444.5 $468.8 $494.1 $520.5 $548.1 $576.8 AOCF Margin with Fuse Improvement 48.0% 49.3% 50.7% 51.9% 52.7% 53.4% 54.1% 54.8% 55.5% 56.2% Depreciation & Amortization $24.6 $16.4 $24.2 $25.2 $26.2 $28.4 $29.5 $30.7 $31.9 $33.2 $34.5 $35.9 D&A % of Revenue 4.0% 2.4% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% Share Based Compensation $5.6 $4.6 $4.5 $4.5 $4.5 $5.0 $5.0 $5.0 $5.5 $5.5 $5.5 $6.0 Operating Income $228.3 $328.6 $303.1 $325.1 $348.2 $387.8 $410.0 $433.1 $456.6 $481.8 $508.0 $534.9 Tax Rate 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% Net Income $137.0 $197.1 $181.9 $195.1 $208.9 $232.7 $246.0 $259.8 $274.0 $289.1 $304.8 $320.9 FCF: Net Income + D&A + Stock Comp - Capex $157.9 $206.4 $196.7 $210.4 $224.6 $249.9 $263.6 $278.0 $293.2 $308.8 $325.1 $342.3
Tax Rate Assumption 40.0% Discount Rate 10.0%
NPV $1,577.12 NPV of Terminal Value $1,639.76 $3,216.88 Terminal Growth Rate 2.5%
- 32 - February 28, 2014 Volume XL, Issue II Time Warner Inc. NYSE: TWX
Dow Jones Indus: 16,321.71 Initially Probed: Volume XXVIII, Issue VII @ $13.06 S&P 500: 1,859.45 Last Probed: Volume XXXIX, Issue XI & XII @ $65.82 Russell 2000: 1,183.03 Trigger: No Index Component: S&P 500 Type of Situation: Business Value, Consumer Franchise
Price: $ 67.13 Shares Outstanding (MM): 901.9 Fully Diluted (MM) (% Increase): 924.3 (2.5%)
Average Daily Volume (MM): 5.4 Market Cap (MM): $ 62,048 Enterprise Value (MM): $ 80,351 Percentage Closely Held: Insiders <1% 52-Week High/Low: $ 30.48/15.95
Trailing Twelve Months Price/Earnings: 17.1x Introduction Price/Stated Book Value: 2.1x Time Warner Inc. (“TWX” or the “Company”) is Long-Term Debt (MM): $ 20,099 a leading media and entertainment conglomerate. Time Implied Upside to Estimate of Warner’s stable of businesses include the leading film Intrinsic Value: 46% and TV production studio (Warner Bros.), the dominant premium pay TV network (HBO), a collection of top Dividend: $1.17 cable networks (including TNT, TBS, CNN), and the Payout 29.8% largest domestic print magazine portfolio (Time Inc.). Yield 1.7% Asset Analysis Focus last profiled Time Warner in January 2011. At the time, we highlighted Time Net Revenue Per Share: Warner’s attractive sum-of-the-parts valuation, which 2013 $ 31.61 we believed reflected a conglomerate discount as well 2012 $ 29.43 as the extreme negative investor sentiment toward 2011 $ 27.21 traditional media companies prevalent at that time.
TWX shares have rallied 140% over the Earnings Per Share: subsequent 3 years, reflecting strong double-digit 2013 $ 3.92 annual EPS growth as well as improved investor 2012 $ 3.00 sentiment. However, in our estimation TWX still trades 2011 $ 2.71 at an unwarranted discount to peers considering its
dominant franchises. The upcoming spinoff of Time Inc. Fiscal Year Ends: December 31 (“Time” or the “Spinco”), set for 2Q 2014, could provide Company Address: One Time Warner Center a catalyst for closing this discount by separating the un- New York, NY 10019 loved, declining publishing business from TWX’s more Telephone: 212-484-8000 attractive assets. Pro forma for the separation, TWX will Chairman/CEO: Jeffrey L. Bewkes generate approximately 80% of revenue from Clients of Boyar Asset Management, Inc. own 57,465 shares of Time subscription and content sources. The Company will Warner Inc. common stock at a cost of $28.01 per share. also generate close to 30% of revenue internationally. Analysts employed by Boyar’s Intrinsic Value Research LLC own In addition to international distribution of Warner Bros. shares of TWX common stock. content, TWX’s footprint includes ~84 million - 33 - Time Warner Inc. international subscribers at HBO and distribution of Turner content in over 200 countries. Management expects TWX to grow EPS by double digits again in 2014, and the Company has a tremendous platform to continue that growth going forward. In our sum-of-the-parts analysis, we apply higher multiples to the premium HBO (12.5x 2016E OIBDA) and Turner Networks (11x) business units than to the low-growth Warner Bros. filmed entertainment division (10x) to derive an estimated intrinsic value of approximately $92 per share. Notably, these multiples still represent discounts to the divisions’ respective peers. Adding in Time Inc. at a discounted 6.5x 2013 OIBDA, TWX shares have 46% upside to our estimate of intrinsic value looking out over the next 2-3 years.
While the Time Inc. spinoff may not be meaningful enough to move the needle at TWX, it is the third spinoff and just the latest in a string of shareholder-friendly corporate actions at TWX under CEO Jeff Bewkes. In February 2014, TWX also began separately reporting results at HBO and Turner Networks. At the least, this could be a catalyst for investors to begin to properly ascribe a premium multiple to HBO. More optimistically, we would not dismiss the possibility that TWX eventually considers a separation of Turner and/or HBO. We believe either business would command a premium valuation as a standalone company, and would also present an attractive acquisition target. Absent further deconsolidation, TWX should continue to create shareholder value via aggressive return of capital. TWX has repurchased ~20% of its shares over the past 3 years alone (at a 37% average discount to the current price), and the Company is boosting its target leverage ratio to a still-moderate 2.75x OIBDA (currently 2.4x leveraged) in conjunction with the Time spinoff.
Assessing the Time Inc. Spinoff When Asset Analysis Focus last devoted a full profile to Time Warner in January 2011, we discussed our hope that the Company would consider a sale or spinoff of the Publishing Business. Time Warner Chairman and CEO Jeff Bewkes had already taken several steps to streamline the Company since taking the helm in 2008. Most notably, this included the spinoffs of Time Warner Cable in March 2009 and AOL in December 2009. More than three years later, our wishes are set to come true. In March 2013, Time Warner announced another iteration of the Company’s spinoff strategy: TWX will distribute the Publishing Business to TWX shareholders during 2Q 2014, creating an independent publicly traded company to be renamed Time Inc. Each of TWX’s previous spinoffs proved rewarding for TWX shareholders and for ongoing shareholders of the newly-created companies, and we believe this iteration offers a similar opportunity.
Business Description Time Inc. publishes 23 print magazine titles in the U.S. including People, Time, Sports Illustrated, and Southern Living. Time’s U.S. operations contributed approximately 82% of the Spinco’s revenue in 2012. The Spinco generates 13% of revenue in the United Kingdom, primarily through subsidiary IPC Magazines Group and its portfolio of over 60 media brands. Time publishes over 10 titles in Mexico through subsidiary Grupo Editorial Expansion (GEX). In October 2013, Time acquired American Express Publication Corporation from American Express. Renamed the Time Inc. Affluent Media Group, the portfolio includes Travel + Leisure and Food & Wine magazines.
Time Inc. generates approximately 85% of revenue from magazine publishing, including greater than 50% from advertising sales (mostly print advertising as well as digital magazine and online advertising and advertising services provided to third parties) and ~1/3 from circulation. Approximately 60% of circulation revenue is subscription-based, with the remainder from newsstand sales. Time also licenses over 50 titles for international publication and generates other ancillary revenue such as brand licensing, TV extensions (This Old House; People TV specials, etc.), hosted conferences, outsourced publication management services, book publishing and equity income.
- 34 - Time Warner Inc.
Principal U.S. Magazine Titles Magazine title Rate Base(a) Frequency(b) Category Related magazine titles Related websites People 3,475,000 52 Celebrity Weekly People en Español (U.S.) People.com People StyleWatch (U.S.) PeopleenEspanol.com Time 3,250,000 48 Weekly Time for Kids (U.S.) Time.com Newsmagazines Time (Europe) Life.com Time (Asia) TimeforKids.com Time (South Pacific) Sports Illustrated 3,000,000 52 Sports: General Sports Illustrated Kids SI.com (U.S.) FanNation.com SIKids.com Southern Living 2,800,000 12 Regional SouthernLiving.com Real Simple 1,975,000 12 Womens Lifestyle RealSimple.com Cooking Light 1,775,000 11 Epicurean MyRecipes.com CookingLight.com Entertainment Weekly 1,725,000 44 Entertainment EW.com Money 1,700,000 11 Personal Finance Money.com InStyle 1,700,000 13 Womens Fashion InStyle.com All You 1,500,000 12 Womens Service AllYou.com Golf 1,400,000 12 Sports: Golf Golf.com Health 1,350,000 10 Womens Health & Health.com Fitness Sunset 1,250,000 12 Regional Sunset.com What’s On TV (U.K.) 1,083,198 51 Entertainment WhatsOnTV.co.uk Essence 1,050,000 12 African American Essence.com This Old House 950,000 10 Shelter ThisOldHouse.com Travel + Leisure 950,000 12 Travel TravelandLeisure.com Food & Wine 925,000 12 Epicurean FoodandWine.com Fortune 830,000 18 Business: Corporate Fortune (Europe) Fortune.com Fortune (Asia) (a) Circulation level guaranteed to advertisers for regular issue U.S. magazines in 2013 or ABC reported first-half 2013 circulation for U.K. magazines, as applicable. (b) Number of physical issues, including regularly published special issues, delivered to subscribers in 2013.
Best-in-Class Publisher By nearly all measures, the print media business is in the midst of a long-term secular decline. Nonetheless, Time remains highly profitable and we believe Time’s portfolio is among the better-positioned in the magazine publishing industry to maintain healthy profit levels for the foreseeable future. Time Inc. has the largest magazine circulation in the U.S. across a diverse portfolio of targeted brands (documented in the preceding table) that we believe are more durable than the broader print business. Below, we detail some of Time’s attractive business characteristics and key competitive advantages. Leading Scale: Time Inc. is the #1 domestic print magazine publisher based on readership and print advertising revenue, with approximately 100 million domestic print customers each month according to the Company. Time had 7 of the top 25 magazines in the U.S. in 2013 based on advertising revenues, including the number 1, 3, and 4 titles People, Sports Illustrated, and InStyle. Time is also the #1 magazine publisher in the U.K. based on print newsstand revenue, with IPG’s portfolio reaching almost 26 million adults including 49% of all mass market women, according to IPG. Time Inc.’s leading scale affords the Company considerable cost savings and revenue synergies across magazines and divisions. Customer Database: A corollary of Time’s scale advantage is its leading customer database covering over 150 million U.S. adults. Time’s national reach enables the Spinco to attract increased advertising dollars via national ad campaigns as well as targeted advertising across geographic and demographic segments. This is reflected in Time’s 23.7% share of domestic print magazine advertising spending in 2013, according to the Publishers Information Bureau (PIB).The Company’s vast database also provides a marketing advantage for building and maintaining its magazine circulation as well as providing third-party marketing and advertising services.
- 35 - Time Warner Inc.
Iconic and Targeted Lifestyle Brands: Time’s collection of titles includes several iconic, premium brands that we believe should prove more durable than the broader print industry. For example, People dominates the celebrity entertainment category and that one brand alone generated almost 20% of Time Inc. revenue in 2012. Like People, many of Time’s brands (the namesake notwithstanding) are directed at targeted audiences like women’s leisure, affluent homeowners, fashion, regional, etc. and skew toward audiences with higher household income. In the U.K., IPC’s portfolio of over 60 brands are organized in 3 publishing divisions based on targeted audiences: IPC Connect (women’s mass market, with titles including Now, Chat, and Woman); IPC Southbank (upmarket women with titles including MarieClaire via an unconsolidated JV, InStyle, and Ideal Home) and IPC Inspire (men’s leisure and lifestyle, e.g. Nuts, Mousebreaker, NME). The values of these brands are reflected in average subscription prices ~2x their closest competitors for magazines like People, InStyle, and Real Simple. Time’s targeted magazines should also hold up better than broader news magazine weeklies and newspapers in the face of growing free, Internet- delivered competition. Strong Online Presence: Time also has a robust online presence of its own, including over 45 websites and an improving mobile and digital magazine presence. Time estimates its global digital/mobile footprint reaches 116 million customers. Time.com, People.com, and SI.com (linked to cnn.com) are all top-250 ranked websites in the U.S. according to Alexa Internet. IPC websites also engage over 25 million users/month in the U.K. Time generates a growing, double-digit percentage of advertising revenue from digital channels. Just in February 2014, Time announced a partnership with Google to launch a programmatic ad exchange across Time’s digital properties globally.
Historical Performance Despite its strong brands, Time Warner’s Publishing Business has failed to avoid the fate (secular decline) of the broader publishing industry. The business’s total revenues declined 2.4% in 2012 and 3.3% in 2013 and have declined at a 5.5% CAGR since 2005. On the positive side, we would note that advertising and subscription revenues have actually held up fairly well to date, averaging low-to-mid single-digit declines on an annual basis. This has been counterbalanced by newsstand revenues, which have been free-falling at double- digit rates in recent years likely due to the rapid growth of mobile-delivered content alternatives.
Time Inc. Historical Revenue by Source Revenue: 2010 2011 2012 2013 Advertising $1,935 $1,923 $1,819 $1,807 Subscription $735 $754 $748 $723 Newsstand $538 $498 $447 $389 Other $18 $19 $15 $17 Total Circulation $1,291 $1,271 $1,210 $1,129 Other $449 $483 $407 $418 Total Revenue $3,675 $3,677 $3,436 $3,354
Despite the declines, Time’s advertising performance across its principal magazine titles still has fared meaningfully better than the broader industry, as illustrated in the following table. According to PIB, U.S. print advertising dollars increased by 1.1% in 2013 across 207 tracked magazines, versus a 4.0% increase for Time across 22 of its largest titles. In 2012, Time’s core U.S. portfolio declined 1.0% versus 4.1% for the industry. Time’s ad page count also held up modestly better than the industry. Time’s advertising outperformance was led by its premiere women’s entertainment and fashion brands like People, Entertainment Weekly, and InStyle, each of which averaged mid-single to low double-digit annual print ad dollar increases over the past 2 years. Unfortunately, this has been partially offset by the more daunting secular challenges faced by Time’s magazines in categories such as news weeklies (Time magazine ad dollars down ~6% in 2012-2013), business publications (Fortune up ~2% but Money down an average of 5% in 2012-2013) and other men’s categories (Sports Illustrated down 5.5% in 2013).
- 36 - Time Warner Inc.
Time U.S. Magazine Ad Dollars, 2013 vs. 2012 2013 2012 2013 2012 2013 2012 2013 2012 CONSUMER MAGAZINES Ad Dollars Ad Dollars %Chg %Chg Ad Pages Ad Pages %Chg %Chg All You 36,528,466 35,662,043 2.4 -8.2 696.42 725.73 -4 -24.3 Cooking Light 129,746,024 124,121,159 4.5 -7.9 944.25 960.9 -1.7 -13.2 Country Weekly 6,331,638 7,061,686 -10.3 0.8 716.91 845.05 -15.2 -3.4 Entertainment Weekly 210,479,417 188,235,841 11.8 -4.7 1,070.41 1,011.39 5.8 -8.8 Essence 101,708,206 110,412,175 -7.9 -10.3 920.49 1,063.48 -13.4 -15.5 Food & Wine 103,228,368 98,453,091 4.9 0.6 999.2 1,006.77 -0.8 -5.5 Fortune 213,474,027 208,441,655 2.4 2.2 1,408.77 1,464.18 -3.8 -4 Golf Magazine 188,167,872 162,048,623 16.1 3.6 895.49 798.81 12.1 -4 Health 76,765,009 71,151,598 7.9 -17.9 629.33 613.15 2.6 -22.4 In Style 483,830,082 435,274,675 11.2 11.6 2,810.83 2,683.70 4.7 5.4 Money 104,127,065 116,864,546 -10.9 -0.1 462.68 514.73 -10.1 -5 People 1,065,943,779 993,275,045 7.3 -0.4 3,183.46 3,155.50 0.9 -6 People En Espanol 82,260,386 81,010,316 1.5 18.6 1,022.07 1,066.95 -4.2 12.1 People Style Watch 120,204,620 111,096,459 8.2 12.1 1,376.03 1,352.82 1.7 3.8 Real Simple 262,382,612 242,046,792 8.4 -13.1 1,307.89 1,277.79 2.4 -17.8 Southern Living 190,196,189 183,358,186 3.7 1 861.83 880.84 -2.2 -6.5 Sports Illustrated 545,175,908 576,764,608 -5.5 0.1 1,327.20 1,411.50 -6 -5.5 Sports Illustrated Kids 7,946,498 6,612,246 20.2 18.1 111.42 96.88 15 11.7 Sunset 69,225,973 65,609,149 5.5 -6.6 520.91 530.77 -1.9 -12.3 This Old House 50,093,864 51,138,914 -2 -2.4 466.87 506.77 -7.9 -7.2 Time 372,219,522 396,044,849 -6 -5.6 1,066.65 1,203.49 -11.4 -12.2 Travel+Leisure 139,951,991 121,838,752 14.9 -10.3 1,050.49 967.48 8.6 -15.5 Time Inc. – Principal Titles 4,559,987,516 4,386,522,408 4.0 -1.1 23,850 24,139 -1.0 -7.1 CONSUMER MAGAZINES TOTAL 19,738,668,006 19,519,118,181 1.1 -3 145,712.93 151,942.76 -4.1 -8.2 Source: The Association of Magazine Media and Publishers Information Bureau via www.magazine.org
Management expects the recent revenue trends to continue as the industry headwinds persist. We are cautiously optimistic Time’s print magazine advertising revenue will continue to outperform the industry by a couple percentage points per annum given its composition. The growing adoption of tablets should also continue to buoy advertising revenue going forward. According to the Publishers Information Bureau (PIB), ad units increased by a whopping 16% across 69 iPad magazine titles in 2013. In terms of circulation revenue, the drag from newsstand sales should become progressively less material to Time, as newsstand sales already account for less than 12% of total revenue. From a profitability standpoint, in recent years, the Company has been moderately successful in containing production and editorial costs. Total costs of revenue were 38.4% in 2013, up just over 2 percentage points from 2010 levels. However, this does not reflect restructuring charges, which have been an ongoing cost of business at Time for several years. Time took $63 million in restructuring costs in 2013 primarily related to headcount reductions. Total SG&A expenses have also remained stubbornly high at 42%-44% of revenue over the past several years. As a result, the combination of modest margin declines and revenue losses has led adjusted OIBDA to decline from $675 million in 2010 to $531 million in 2013. Although also declining somewhat, Time continues to throw off a large amount of cash flow. Free cash flow totaled $427 million in 2012 vs. $472 million in 2010, and was close to $400 million in 2013.
Financial Outlook: New Management Set to Attack Costs Going forward, better cost discipline will be essential if Time is to maintain profitability over the long term. Importantly, we believe Time has two major catalysts in a new management team and the pending spinoff. During summer 2013, Time replaced both the CEO and CFO. New CEO Joseph Ripp is a seasoned executive who formerly worked at Time Warner including progressive stints as CFO of Time Inc., Time Warner, and finally AOL between 1993-2002. In the months following Mr. Ripp's hiring, Time made a rash of additional management changes including a new Chief Content Officer, Chief Technology Officer, EVP of Advertising Sales, EVP of Consumer Marketing, General Counsel, and Editor of People. The managerial shakeup reached the editorial operations, which were decentralized and the Time Inc. Editor-in-Chief position was eliminated. Norman Pearlstein (Time Inc. Editor-in-Chief from 1995-2004 and most recently Bloomberg L.P. Chief Content Officer) will have editorial oversight in the newly created role of Chief Content Officer.
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Regarding cost cutting, we believe there is plenty of low hanging fruit for the new management team. Editorial costs are roughly flat in recent years despite the revenue declines and restructuring initiatives. Furthermore, Time’s SG&A expenses were a bloated 43.9% of revenue in 2013. Despite laying off 500 employees in the 1Q 2013 restructuring initiative, Time still has roughly 5,000 U.S. employees and another 2,800 in international operations. We believe the new management team, combined with the separation from Time Warner, will provide a catalyst for more aggressive financial management. To put it lightly, the new executives will be highly incentivized via stock and options/RSUs in the newly-created independent entity. CEO Ripp received restricted stock and options covering approximately 267,000 TWX shares, which will be converted into Time Inc. equity following the spinoff. New CFO Jeff Bairstow also received approximately 36,000 TWX restricted shares and options to be converted into Time Inc equity. Other employees’ outstanding stock options and RSUs will also be converted following the spinoff. Going forward, cash bonuses will also be linked directly to adjusted income and free cash flow.
In fact, the new team already appears to be acting quickly. A complete strategic and financial review was initiated upon their arrival in late 2013 and is still ongoing. As part of the review, in February 2014 Time began a new restructuring program that includes “streamlining its organizational structure to enhance operational flexibility, speed decision-making, and spur the development of new cross-brand products and services.” Time expects to take ~$150 million of restructuring charges in 1H 2014 primarily tied to cost initiatives and real estate consolidation (lease exit costs) as well as the American Express Publishing integration, including ~$100 million in 1Q 2014 (prior to separation from TWX). Part of Mr. Pearlstein’s stated role will also be bridging the gap between the business and content sides of the Spinco, which we interpret as introducing cost discipline and financial accountability to the editorial side.
On the revenue side, the strategic review is also aimed at re-evaluating investment priorities with an aim to returning to growth. The new management team has emphasized a focus on digital and cross-device initiatives. Enhancing the Spinco’s digital platforms and strategy could lead to new revenue sources as well as improving the cost structure by reducing physical production costs (print, paper, distribution).
Real Estate: Hidden Assets Real estate offers another prime opportunity for cost savings and one source of potentially hidden value is Time’s real estate portfolio, listed below. Time’s vast utilized office space includes a majority of the 2 million square foot Time & Life Building in New York as well as substantial space in London, Alabama, Florida and New Jersey. Time’s current net rental expense is approximately $90 million per year, and the Spinco also utilizes close to 1 million additional square feet of owned real estate. The dissolution of Time’s operating clusters (announced as part of the new restructuring plans) will likely include meaningful rationalization of this real estate footprint. Time’s leased real estate at the Time & Life Building alone likely accounts for an estimated ~$70 million per year. Reducing this occupancy by even ½ could result in meaningful value creation for Time equity holders given the Spinco’s size.
Additionally, we would note that Time owns a large portion of its office space including the Blue Fin Building in London (completed next to the Tate Modern in Southwark in 2007), which has been rumored to be under consideration for sale.1 Of course, with ~40% of the building sub-let and the remainder currently utilized by Time, a sale would represent financial engineering as much as value creation. But based on the capital value per square foot implied by the sale of two adjacent buildings (part of the same project) in September 2013, the Blue Fin building would command £343 million or $571 million (€687 million/sq. foot or 5.25% net initial yield)—a material source of low-cost capital for the Spinco (16.5% of estimated Spinco enterprise value).
1 http://www.costar.co.uk/en/assets/news/2013/September/MG-swoops-to-buy-312m-RBS-campus/ - 38 - Time Warner Inc.
Principal Real Estate Properties Approximate Leased or Expiration Date, Description / Location Principal Use Square Footage Owned if Leased Time & Life Building Rockefeller Center Executive, business, 2,000,000(a) Leased 2017 1271 Avenue of the Americas administrative and editorial offices New York, New York Blue Fin Building Executive, business, 110 Southwark Street 499,000(b) Owned — administrative and editorial offices London, United Kingdom 2100 Lakeshore Drive Executive, business, 398,000 Owned — Birmingham, Alabama administrative and editorial offices 135 West 50th Street Business and editorial offices 240,000(c) Leased 2017 New York, New York 3102 Queen Palm Drive Warehouse and distribution facility 230,000 Leased 2020 Tampa, Florida Hippodrome Building 1120 Avenue of the Americas Business and editorial offices 143,000 Leased 2015 New York, New York(d) 3000 University Center Drive Business offices, call center 10419 N 30th Street 133,000 Leased 2020 and distribution facility Tampa, Florida 260 Cherry Hill Road Business offices 132,000(e) Owned — Parsippany, New Jersey One North Dale Mabry Highway Business offices 70,000 Leased 2020 Tampa, Florida (a) The current tenant is Historic TW Inc., a subsidiary of Time Warner. Time Warner expects to transfer the lease to Time Inc. as part of the Internal Reorganization. Approximately 548,000 square feet are subleased to unaffiliated third-party tenants. (b) Approximately 210,000 square feet are leased to unaffiliated third-party tenants. (c) Approximately 4,000 square feet are subleased to unaffiliated third-party tenants. (d) Lease acquired on October 1, 2013 in connection with our acquisition of American Express Publishing Corporation (e) Approximately 24,000 square feet are leased to Time Warner.
Outlook and Valuation Time Inc. is unlikely to be a significant determinant of value for long-term TWX shareholders given the former’s modest enterprise size in relation to the parent. On the other hand, for this same reason there could be intense selling pressure on Time Inc. shares initially, as is so often observed with spinoffs. This could lead to a mis-pricing scenario worthy of opportunistic investors’ attention. In assessing Time’s estimated intrinsic value, we are not positive on the business regaining top-line growth anytime soon. On the other hand, Time Inc. should be somewhat insulated from the worst of the broader industry’s long-term challenges given Time’s scale, premier/niche brands, and online footprint. At the same time, the new management team is highly incentivized to cut costs and explore all strategic alternatives. This could entail folding Time’s less productive product lines as part of the de-clustering initiative; we suspect there is a vast disparity in cash flow production between parts of Time’s strongest and weakest divisions.
Alternatively, larger strategic moves could be in the works. As noted, management is conducting a full strategic and financial review, and we believe this could entail much more than just layoffs, real estate footprint rationalization, and other traditional cost cutting measures. Time Warner reportedly discussed a sale of U.K. subsidiary IPC in 2010-11. IPC Magazine Group was acquired from private equity firm Cinven for £1.15 billion in 2001. While its value is likely much lower today, we suspect a sale of IPC and the Blue Fin Building in London could net upwards of $1 billion for Time. It was also widely reported that Time Warner and Meredith Corporation explored a merger of some or all of Time’s assets into Meredith in 2012-early 2013 before talks broke down, triggering TWX to initiate the spinoff. Nonetheless, following the decision in March 2013, Meredith CEO Steve Lacy reiterated his company remained “open to continuing a dialogue on how our companies might work together on future opportunities.” A combination of Meredith’s 18 magazine portfolio with Time could offer attractive revenue synergies, and the transition of Time’s editorial and administrative footprint from New York City into Meredith’s Des Moines, Iowa headquarters (sounds like an easy way to implement voluntary redundancies) could translate to huge cost savings.
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Barring a break-up or outright sale of the Spinco, Time still throws off a valuable cash stream. Time Warner currently intends to spin Time Inc. with approximately $1.3 billion in debt, or just under 2.5x 2013 adjusted OIBDA. Pro forma for incremental leverage, we estimate Time still produced ~$300 million in free cash flow in 2013. Assuming some success with restructuring initiatives while core earnings continue to decline at low single-digit rates, and adding in estimated excess real estate value, we estimate the Time Inc. Spinco’s intrinsic value is approximately $2.28 per TWX share assuming a discounted 6.5x 2013 adjusted OIBDA trading multiple. This translates to a conservative single-digit free cash flow multiple. By comparison, based on recent industry transactions, we estimate Time could command upwards of 8-10x OIBDA in a transaction, implying a private market value of $3-$4 billion or ~$3-$4 per TWX share. For example, in 2011 Hearst acquired 102 magazine titles including Elle from Lagardère for €651 million or a reported 13x EBIT.
Time Inc. Estimate of Intrinsic Value ($ millions) Time @ 6.5x 2013 OIBDA $3,452 Less Assumed Net Debt at Spinoff ($1,300) Equity Value $2,152 Estimated Intrinsic Value per TWX Share $2.28
As an independent company, the spinoff will also allow Time more flexibility to deploy its cash to improve its competitive position (whether via investments or strategic acquisitions) and/or return cash to shareholders. Discussing the proposed $1.3 billion initial leverage, Time Warner CFO Howard Averill noted during the Company’s 4Q 2013 conference call, “We think that level will allow sufficient flexibility to both invest in the business and provide direct returns to stockholders, while also optimizing its cost of capital and delivering attractive levered equity returns to investors.” Similarly, Time CEO Ripp noted last July, “Their [Time’s] subscription unit generates a lot of cash. In the past, they were restricted with how to use that, and cash flows flowed to Time Warner. Now we have opportunities to reinvest in making the Web better and the iPad app better and into different industries as well.” 2
Content is King. Long Live Time Warner. In the eyes of many investors, the U.S. video programming industry is fully mature at best, and at worst, facing a long-term secular decline from cord cutting. Contrarily, we have detailed the favorable characteristics of the programming business in many Asset Analysis Reports in recent years, and the continued outsized growth across Time Warner’s business units also suggests the pessimistic narrative is less than fully accurate. In particular, we believe growing competition for viewership across platforms is only increasing the value of high quality content. In our view, Time Warner is arguably the best-positioned company of scale in the world to take advantage of this trend. Time Warner generated a startling $22.6 billion or 76% of revenue from content and subscription sources in 2013, and features the leading production studios, the dominant premium TV network, and the highest-rated cable networks. Pro forma for the Time separation, TWX generates ~80% of revenue from content and subscription. Below, we provide a brief update on Time Warner’s dominant assets and recent performance/outlook.
Time Warner Inc. Components of Revenue ($ millions) 2011 2012 2013 Subscription $9,523 $9,997 $10,379 Advertising $6,116 $6,121 $6,326 Content $12,635 $11,832 $12,240 Other $700 $779 $850 Total Revenues $28,974 $28,729 $29,795
2 http://www.nytimes.com/2013/07/23/business/media/joseph-ripp-named-new-head-of-time-inc.html?_r=0 - 40 - Time Warner Inc.
Warner Bros. Time Warner’s Warner Bros. business unit (formerly titled Theatrical Entertainment) includes the Company’s feature film and television production and distribution businesses as well as related home video, videogame, and ancillary licensing operations. Warner Bros. generates ~50% of revenue from feature film production under the Warner Bros. and New Line titles. While the film production business is volatile and requires heavy investment, Warner’s leading scale and franchises provide a unique advantage. Warner Bros. released 18 movies in the U.S. in 2013 following 17 titles in 2012, protecting the Company from exposure to the results of any one particular feature. Warner’s portfolio of world-recognized franchises also insulates its studios against excessive volatility. Enhanced by the DC Entertainment comic book division, Warner’s leading stable of owned or licensed franchises/characters include Batman, Superman, Green Lantern, Wonder Woman, Lord of the Rings/The Hobbit, and Harry Potter. TWX typically uses co-financing arrangements to further reduce financial exposure; only 3 films were wholly-financed in 2013. Warner Bros. again produced industry-leading results in 2013, setting a record with over $5 billion in global box office revenues. Looking forward, Warner Bros. is set to release another 18 films in 2014 including The LEGO Movie ($330 million global box office revenue YTD vs. $60 million production budget), Batman vs. Superman, and the third installment of The Hobbit. The Company also recently reached an agreement with Harry Potter author J.K. Rawlings to develop a new film series and TV mini-series. Warner Bros. also includes the industry’s largest television production studios. Warner produced 32 shows for broadcast television in 2013, including the #1 rated comedy (The Big Bang Theory) and #1 rated non-scripted series (The Voice). Warner is also producing another ~30 shows for cable networks this season.
Overall, Warner Bros. produced decent growth in revenue (2%) and operating income (8% to $1.3 billion) in 2013. Going forward, Warner is ideally placed to benefit from the rapidly-escalating investment in original programming that is taking hold throughout the television industry. Warner Bros. results should also benefit from stabilization at the Home Entertainment segment. Long thought to be in a perpetual decline due to DVD obsolescence, industry-wide home video and electronic delivery revenue actually increased 1% in 2013— the first annual increase in 9 years. Warner’s results declined 3%, attributed to difficult comparisons against Batman: The Dark Night Rises in 2012. Revenue is benefiting from Internet video adoption, including subscription video services like Netflix as well as higher video on demand (VOD) and electronic sell through (EST) revenue. Warner is exploiting new licensing models including accelerated licensing windows, whether via off-network video (e.g. subscription streaming deals with Netflix prior to/during regular syndication windows) or EST of feature films shortly after theatrical release. Warner also maintains rights to an increasingly valuable, high quality library of over 6,000 films from Warner and third-party studios. Warner’s EST revenue increased nearly 40% in 2013, aided by further adoption of the UltraViolet cloud-based electronic copy standard. Overall electronic-delivered revenue increased double digits to greater than $1 billion.
Turner Networks At Turner Networks, TWX is well placed with a portfolio of 6 leading cable networks with broad distribution. This includes the #1 cable network (TBS) in prime time and among adults 18-49 in 2013. TNT is also consistently a top-5 rated cable network, and CNN regained the #2 cable news network position in 2013 based on total day part viewership. At Cartoon Network, Adult Swim ranked #1 in total day part among adults 18-34 for the 9th consecutive year, with record ratings in 2013.
Turner has been a beneficiary of the long-term viewership transition from broadcast to cable networks, which should continue to be a theme going forward. Turner continues to boost investment in original programming and sports rights across its networks in order to maintain their dominant position. Original programming investment will increase ~20% in 2014, and Turner has secured long-term sports agreements including NBA basketball, NCAA men’s college basketball tournament, and MLB baseball. TWX recently began reporting Turner Networks as a separate business unit, providing direct evidence of its progress. Turner Networks’ compelling content and ratings is evident in subscription (affiliate fee) growth. Subscription revenue has been growing at mid-to-high single digit rates annually, reaching $4.9 billion in 2013. Combined with slightly lower advertising growth, this has enabled Turner to expand margins all while boosting original and sports programming expense, as illustrated in the following table. Turner recently signed extensions with 2 of the top 5 MVPDs, providing good revenue visibility going forward; the Company expects to average double-digit annual affiliate fee growth over the next 3 years.
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Turner Networks: Revenue and Margin Growth Continues ($ millions) 2011 2012 2013 Subscription $ 4,398 $ 4,660 $ 4,896 Advertising $ 4,196 $ 4,315 $ 4,534 Content $ 417 $ 369 $ 363 Other $ 155 $ 183 $ 190 Total Revenue $ 9,166 $ 9,527 $ 9,983
Programming costs: Originals and sports $ 2,392 $ 2,498 $ 2,647 Acquired films and syndicated series $ 906 $ 890 $ 946
Adj. OIBDA $ 3,306 $ 3,597 $ 3,788 Margin 36.1% 37.8%37.9%
International Growth: TWX Ideally Placed as Leading Content Provider, Premium Network Putting domestic growth prospects aside, we would highlight the tremendous long-term opportunity afforded to content producers by international markets. As illustrated in the following table, international pay TV uptake remains far below full penetration or even U.S. levels. In large developing countries, pay TV penetration ranges from as low as 28% in Brazil to 83% in India. Digital pay TV penetration is much lower, ranging from ~25%-40%. Even large developed countries like Japan, Italy, Australia, and the U.K. have pay TV penetration rates of only ~30%-50% as many households are still content with free-to-air programming. As cultural barriers break down and the increasingly high quality video content being produced today makes its way around the globe, we expect pay TV penetration to steadily advance. Furthermore, and perhaps counter-intuitively, the long-term growth in high speed Internet could also facilitate pay TV/premium video adoption by building consumer awareness/demand for global video content and facilitating the marketing of bundled video and data services.
Pay TV Monthly Video ARPU, 1995-2009
Source: Screen Digest (January 2013), MPA, Discovery Communications estimates (Japan). Via Discovery Communications. Russia excludes Tricolor FreeSat.
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Time Warner is ideally positioned to capture these long-term trends across each of its business units. Pro forma to exclude Time Inc., TWX already generated approximately $8.4 billion or 32.5% of consolidated revenue outside the U.S. in 2013. Including unconsolidated JVs at HBO, this figure is greater than $10 billion. TWX also holds various other minority equity positions and unconsolidated JVs internationally through Turner and Warner Bros. as well as at the Company level. Warner Bros. is TWX’s biggest international presence, generating close to half of revenue internationally. Warner recorded over $3 billion in gross box office revenue internationally in 2013, while international TV revenue was close to $1.5 billion in 2013. As the world’s leading movie and TV studio, Warner is ideally positioned to benefit from the secular growth story of global adoption of Western entertainment viewing habits and pay TV.
Turner Networks is also well positioned. Turner already reaches over 200 countries across 130 brands in 27 languages, and the division has been aggressively pursuing new expansion opportunities both organically and via acquisition/JV. Turner Networks grew international subscription revenue by double-digits in 2013 excluding foreign exchange fluctuations and a similar growth rate could be sustainable for the foreseeable future. Turner is particularly well positioned in Latin America with several regional network brands of scale, including a strong presence in Brazil as well as Chile’s leading free-to-air station, Chilevision (purchased in 2010 for ~$150 million). As of 2009 (more recent figures not disclosed), Turner generated 33% of international revenue in Latin America with a favorable margin profile (est. 20%-plus). TWX recently singled out Turner’s strong Latin America performance in 2013, noting double-digit revenue growth and profit growth above 25% for the year. Turner also has a strong presence in the Asia Pacific region including India and Japan. The region contributed 23% of Turner’s international revenue as of the last report in 2009. CNN has a particularly strong international presence. CNN International is the largest English language news brand in the world with distribution in over 200 countries and Turner has also launched several local language CNN stations.
TWX also holds a strategic stake in Central European Media Enterprises (CME). TWX invested $246 million to acquire a 31% equity position in 2009, and subsequently invested another $504 million in equity and convertible debt between 2011-2013, raising its voting interest in class A shares to 49.9%. CME has an attractive broadcast footprint in 6 Central and Eastern European countries, but has come under balance sheet pressure recently as the weak macro economy deeply cut into its advertising revenue—particularly in the Czech Republic. With additional capital needed to get through 2014, in February 2014 CME announced a $397 million refinancing and capital raise, with TWX participating in the rights offering as well as a private placement that could ultimately increase TWX’s equity stake to as high as 78.5%. TWX also agreed to provide CME with a $115 million credit facility and a $35 million term loan or bridge financing in lieu of the rights offering. TWX’s investments in CME are not without risk, but we believe CME could have significant long-tem upside if CME’s new co-CEOs (including Michael Del Nin, previously Time Warner Senior Vice President, International and Corporate Strategy) can right the ship and capitalize on the company’s dominant market position. CME anticipates returning to positive cash flow in 2015.
Last but certainly not least, we believe HBO’s international platform has long been overlooked. HBO has been building its international distribution since the 1970s, providing a huge leg up on the competition. Today, HBO/Cinemax video networks are distributed in over 60 countries, with content distributed in over 150 countries. Historically, HBO’s international networks were operated as JVs built around movie services. As a result, the networks were often under-managed. The JV equity holdings were not consolidated on TWX’s financial statements either, which made it easy for investors to discount the value of HBO internationally. In recent years, the Company has been steadily consolidating these JVs and transitioning to more active management with a greater focus on local original content. For example, HBO now airs ~90 hours of local original content annually in Brazil. The following table lists HBO’s recent international transactions. Notably, the large HBO Latin America Group (LAG) is still accounted for as an equity investment. HBO also launched a premium pay TV network in the Netherlands in 1Q 2012 and in India in 2013.
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HBO International JV Consolidating Transactions ($ millions) JV Acquisition Date Price JV Share/Notes HBO Asia 2007- 2008 $275 20%-30% incremental, to 75% (south Asia) -80% HBO Latin America Group (LAG) Dec-08 combined 20%-30% incremental, to 60% HBO Latin America 1Q 2010 $217 increased to 80% LBO LAG 1Q 2011 NA Increased to 88% HBO Central Europe Jan-10 $155 Increased from 33% to 100% HBO Asia 2013 $37 Increased to 100%
HBO’s existing distribution network and the business’ top-quality content also position HBO as a primary beneficiary of pay TV growth internationally. Historically, HBO original content was often released on an extended delay (e.g. 1 year) internationally, if at all, and sometimes through free-to-air partnerships. Today, HBO is increasingly providing immediate access to new content while monetizing it through its controlled premium channels. The results of this strategy and ongoing global pay TV adoption are already evident. Remarkably, HBO international subscribers grew over 15% in 2013 after climbing at 25%-plus per annum in 2011-2012. Inclusive of unconsolidated JVs, HBO has over 84 million international subscribers, contributing ~25% of segment revenue. HBO is also positioned to benefit from high speed Internet adoption internationally via its highly-regarded HBO GO authenticated Internet SVOD platform. The platform is available in 23 countries and counting and HBO already reported over 2 million international SVOD/mobile subscribers as of 2013. This includes the December 2012 launch of HBO Nordic as a combination premium TV/SVOD offering. Launched as a JV with a regional cable provider, HBO acquired 100% of the venture in June 2013.
HBO: Crown Jewel Unveiled Albeit only a modest profit contributor from the perspective of the parent, the separation of the publishing business may serve as a catalyst for closing TWX’s conglomerate discount to the sum-of-the-parts intrinsic value of its best-in-class operating businesses. Time Warner also recently took another major step in enabling the Company’s underlying value to come to light: Concurrent with the release of 4Q 2013 financial results in February 2014, TWX disaggregated HBO from its Networks segment into a separate reporting segment. We have long viewed HBO as Time Warner’s crown jewel, but believed its opaque financials (none released since basic figures in 2009) prevented investors from properly valuing the subsidiary—a problem no longer. Asset Analysis Focus has discussed our favorable opinion of the U.S. premium pay TV industry several times, and we would reference last month’s Starz report for our detailed thoughts. In short, we are attracted by the premium pay TV model’s economies of scale/high barriers to entry; superior brand value; premium, high quality original content; unbundled pricing model which aligns incentives with MVPDs while also more easily enabling Internet-delivered distribution; and household under-penetration leaving room for subscriber growth even in mature markets. As a highly profitable yet distant #3 player in the field, we view Starz as an undervalued asset with attractive long-term upside. However, HBO is the industry paragon whose lead we can only hope Starz imitates. We would cite Netflix CEO Reed Hastings’ recent commentary to emphasize HBO’s attractive position:
“We believe that once a subscription video service has achieved profitability and scale in a market (20% to 30% of households), it is very likely to be able to sustain that profit stream for many decades. At that percentage of households, our advantages in content acquisition and member acquisition are considerable.” – Reed Hastings, April 2013 letter to shareholders
With 43 million domestic and ~127 million global subscribers (including unconsolidated international JVs), suffice to say HBO is comfortably beyond Mr. Hasting’s threshold for economies of scale. Just looking domestically, HBO dominates the premium pay TV/SVOD segment with the second-most subscribers (just behind Netflix, comparing across flagship multiplexes), highest ARPU, largest original programming budget and original programming hours, highest ratings, most Primetime Emmy Awards of any network for 12 years running (108 nominations in 2013), and top-quality first window film content (~60% of top 20 box office movies historically).
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Premium Subscription Video Category Comparison- 2013 HBO NFLX Showtime Starz Domestic (Dom. Streaming) (CBS Cable Network) Networks Subscribers (domestic, flagship channels) ~29 33.4 ~23 22.0 Subscribers (domestic, total multiplex) ~43 NA 76.6 57.0 Est. Revenue per Sub (core network) ~$12 $7 ~$6-$6.50 $4.98 Est. Revenue per Sub (total subscribers) ~$8 $7 ~$2 $1.93 Peak Same Day Views—T op Rated Show 5.5 MM NA 2.9 MM 2.6 MM Original Scripted Content Hours (2013E) 83 53 80 36 Source: AAF estimates based on public company filings, management public commentary, Nielsen TV Ratings.
Netflix Comparison Revisited When AAF last featured a full profile of TWX in January 2011, we advocated pairing our long TWX thesis with shorting Netflix. The pair trade was based on the discrepancy between Netflix and HBO valuations (implied by a TWX sum-of-the-parts), combined with Netflix’s daunting task of transitioning from a DVD-by-mail to Internet subscription video on demand (SVOD) service. The Netflix short thesis played out well in the short term, with NFLX shares declining 70% to their trough in November 2011. However this did not hold long, with NFLX shares sharply climbing since 2012 and now 111% higher than at our initial report date (although still underperforming TWX shares’ 140% climb). In the interim, Netflix has executed virtually flawlessly on all the areas of potential upside we originally highlighted as risks to the thesis: Rapidly gaining the scale (paying subscribers) necessary to fund premium streaming content acquisition; a successful move into original programming (14 Emmy nominations in 2013); and aggressively entering international markets to vastly expand Netflix’s addressable market. Although shares may be priced to perfection, we know better than to test our luck on the short side again. However, we believe it is worthwhile to revisit the Netflix/HBO comparison to shed light on HBO’s potential standalone value, now that the disclosure of HBO’s financials makes the comparison possible with precision.
HBO Subscriber Growth Unimpeded by Netflix’s Ascent
140 140 HBO NETFLIX 120 120
100 100
80 80
60 60
40 40 Year-end Subscribers (millions) Year-end Subscribers (millions) Subscribers Year-end 20 20
0 0 2011 2012 2013 2011 2012 2013
Domestic HBO Domestic Cinemax International HBO Domestic NFLX Streaming Domestic NFLX DVD NFLX International
Note: HBO subscriber counts are estimates based on management commentary. Source: Company filings.
To begin, it is clear that the rapid emergence of Netflix as the largest SVOD player has not disrupted HBO by any means. While TWX does not consistently report HBO subscribership levels, management stated HBO added 1.9 million domestic subs (HBO/Cinemax) in 2012—a record—and another record ~2 million in 2013. With only ~29% of U.S. pay TV households subscribing to HBO (plus ~12 million Cinemax subscribers;
- 45 - Time Warner Inc. likely largely overlapping), there should be plenty of room for similar growth rates going forward. As detailed later, international subscribership has also boomed thanks to renewed management focus and consolidation of JVs. In fact, we believe both companies are benefiting, and should continue to benefit, from an ongoing surge in consumer appetite for highest-quality original programming. As Netflix CEO Reed Hastings described in his April 2013 letter to shareholders,
“While we are passing HBO in domestic members in 2013, it will be several years before we are peers with them in terms of original programming, Emmy awards, and international members. It wouldn’t be surprising to us if HBO does their best work and achieves their highest growth over the next decade, spurred on by the Netflix competition and the Internet TV opportunity.” – Reed Hastings, April 2013 letter to shareholders
From a financial perspective, HBO’s growth has been even more impressive. Revenue has compounded at a 5.7% annual rate over the past 5 years despite the macroeconomic drag, while OIBDA margins expanded nearly 400 bps to 36.4%. We would also note HBO’s capital expenditure requirements are de minimis ($45 million in 2013). Returning to the Netflix comparison, Netflix has compounded revenue at an astounding 26.2% annual rate over this time frame—albeit from a lower base, especially excluding the legacy DVD-by-mail business. However, OIBDA margins remained at a scanty 6.3% in 2013. Netflix has been paying through the nose to get its hands on higher quality first run content, with the expectations of recovering the cost over the long term via subscriber growth. Netflix is also in the early, investment stage internationally which is depressing margins ($274 million international contribution loss in 2013). Netflix management likes to cite the “contribution margins” of the domestic streaming business, which expanded 574 bps to 22.63% in 2013 ($623 million contribution profit). However, we would emphasize that NFLX’s reported contribution profit excludes all technology and development and general and administrative costs. In 2013, these totaled $559 million or 71% of contribution profit! In our view, technology and development costs are a core component of Netflix’s streaming service. Furthermore, we would note that HBO’s OIBDA margins do include segment level G&A expenses. Adding HBO’s pro-rata share of TWX corporate expenses ($403 million in 2013) would reduce reported operating margins by only ~100-200bps. Last but not least, Netflix’s consolidated financial results continue to benefit from the highly-profitable ($439 million contribution profit; 48.2% margin) but rapidly declining domestic DVD business.
HBO Unveils Impressive Historical Financials ($ millions) 2008 2009* 2010E** 2011 2012 2013 Subscription Revenue $ 3,768 $ 4,010 $ 4,231 Content Revenue $ 730 $ 676 $ 658 Revenue (total) $ 3,703 $ 3,900 $ 4,188 $ 4,498 $ 4,686 $ 4,890 OIBDA $ 1,208 $ 1,300 $ 1,389 $ 1,485 $ 1,639 $ 1,778 OIBDA margin 32.6% 33.3% 33.2% 33.0% 35.0% 36.4% *2009 approximations based on management revenue commentary and stated $1,228 operating income. **2010 figures not reported; estimates represent interpolation of 2009-2011 financials.
Looking forward, we believe both companies have plenty of room to run. Similar growth rates to the past 5 years look easily achievable over the next 5 year span for HBO. Netflix is likely to grow its subscriber base faster than HBO for several more years, at least domestically. The company has reached a critical subscriber base, features a top-of-class interface and Internet delivery system, and continues to improve its content offerings. Reed Hastings recently estimated full penetration for Netflix domestically could be 60-90 million subscribers. 90 million may be overly ambitious for an unbundled subscription service considering this represents ~90% of pay TV households, but 60 million may be possible.
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Netflix Historical Financials: Misleading Margins ($ millions) 2008 2009 2010 2011 2012 2013 Domestic SVOD Revenue $ 2,185 $ 2,751 contribution profit margin 16.9% 22.6% Dom DVD Revenue $ 1,137 $ 911 contribution profit margin 47.3% 48.2% Intl. SVOD Revenue $ 83 $ 288 $ 712 contribution profit margin -124.5% -135.3% -38.5% Total Revenue $ 1,365 $ 1,670 $ 2,163 $ 3,205 $ 3,609 $ 4,375 Total contribution margin 0.0% 0.0% 0.0% 8.3% 14.4% 18.0% OIBDA $ 155 $ 232 $ 322 $ 429 $ 95 $ 277 OIBDA margin 11.3% 13.9% 14.9% 13.4% 2.6% 6.3%
In the Netflix bull case, Netflix’s margins should migrate toward HBO levels over time. However, we are skeptical the company can ever reach HBO-type margins. Netflix does remain under-priced, especially compared to HBO’s full sticker price (~$14-$18), and recent management commentary suggests a price increase may be in the works in 2014-2015. However, Netflix still has a lot of work to do to match the quality of HBO’s film content and the breadth (and quality) of its original programming—which may be necessary if Netflix is ever to raise prices near HBO levels without facing mass subscriber losses. Netflix’s content acquisition costs continue to grow and this will only accelerate when the Disney agreement (estimated $300-$400 million per year) begins in 2016. Additionally, HBO’s margins benefit from the MVPD distribution model, with promotional rates and MVPDs’ consignment fees accounted for above the line as contra-revenue. This boosts margins, but we also suspect it is a more efficient consumer acquisition model; HBO’s advertising and marketing expenses per subscriber ($705 million total SG&A on 77 million average subs in 2013) are well below Netflix ($504 million marketing spend on 46.4 million average subs). While neither company breaks out churn (Netflix last reported monthly churn of 5.3% in 4Q 2011 before discontinuing disclosure), we also suspect HBO has lower churn considering a customer can un-subscribe from Netflix with one mouse click; Netflix may not match HBO’s demographic skew toward higher-income households; and the churn roughly implied by HBO’s reported revenue vs. customer’s sticker price (i.e. relatively low sub count in promotional pricing periods), especially compared to its premium pay TV peers as illustrated in the table on page 45.
Netflix Valuation Summary HBO @ NFLX NFLX Enterprise Value Share Price $445.63 Market Cap $27,319 Enterprise Value $26,618 $26,618 EV/OIBDA (TTM) 96.2x 15.0x Price/FCF (TTM) 625.3x 24.8x EV/Revenue (TTM) 6.1x 3.1x EV/Sub (TTM) $519 $210
Netflix currently trades at lofty valuations including 96x 2013 EV/OIBDA, 625x 2013 FCF, and $519 EV per sub. By comparison, placing Netflix’s enterprise value on HBO (assuming no debt) implies much more modest multiples: 15x 2013 EV/OIBDA, 25x unlevered 2013 FCF (assuming 38% tax rate), and $210 per sub. Essentially, Netflix is being valued to grow into HBO, and then some. In our view, the valuation discrepancy is undeserved given HBO’s market position and business model. HBO is currently producing outsized free cash flow for TWX, while Netflix has yet to produce meaningful free cash flow. While Netflix may grow into its valuation over an extended time frame, we expect domestic subscriber growth rates to converge within the next few years. Internationally, HBO is still far more developed and continues to add subscribers at a faster rate. Longer-term, while we like the dynamics of HBO’s MVPD distribution model, HBO is also ideally positioned to go over-the-top a la Netflix when/where it is economical. Alternatively, HBO could continue to develop a hybrid
- 47 - Time Warner Inc. authenticated model with its highly-regarded HBO GO Internet streaming platform. HBO and Time Warner Cable recently began experimenting with a “skinny stack” bundle of high speed Internet plus HBO GO (no cable subscription). While unlikely to gain broad adoption in the near term, this bundle creates the opportunity for HBO to reach a younger demographic that is not subscribing to video and protects HBO against a broader cord cutting threat longer term. Nonetheless assuming recent revenue growth rates continue while margin growth slows (cumulative 100 bps expansion from 2013-2016 ), we estimate HBO’s intrinsic value could approach $26 billion looking out 2-3 years based on a 12.5x 2016E OIBDA multiple. We are comforted that this is still slightly below Netflix’s current enterprise value.
HBO Valuation Summary ($ millions) Revenue – 2016E $5,550 Assumed OIBDA margin 37.4% OIBDA – 2016E $2,076 EV/OIBDA multiple 12.5x Implied Enterprise Value $25,948 per TWX share $28.07
Balance Sheet/Capital Deployment Time Warner continues to be a free cash machine as well as a tremendous steward of capital under Chairman/CEO Jeff Bewkes. Free cash flow increased 20% to $3.5 billion in 2013 (excluding external M&A- related costs and adding tax benefits from equity investments) or $3.73 per share. Excluding Time Inc., free cash flow was approximately $3.1 billion. In addition to strong top-line growth, TWX is growing free cash flow via careful expense controls. Operating margins expanded ~600 basis points over the past 5 years, and expenses increased only 3% in 2013. Notably, TWX has been returning cash to shareholders in excess of free cash flow recently. Over the trailing 12 months through January 2014, TWX spent $3.9 billion to repurchase 64 million shares or nearly 7% of initial shares outstanding at an average price of ~$60 per share. Over the past 3 years alone, TWX has repurchased 276 million shares or approximately 25% of initial shares outstanding at an average price of ~$42/share or nearly 37% below the current share price.
TWX Free Cash Flow ($ millions) 2012 2013 Adjusted Operating Income $6,126 $6,599 Depreciation and Amortization 892 886 Working Capital/Other (940) (1,044) Cash Interest, Net (1,220) (1,158) Cash Taxes (1,274) (1,165) Capital Expenditures (643) (602) Free Cash Flow $2,941 $3,516 Free Cash Flow per Share (avg. DSO) $3.01 $3.73
Accelerated return of capital to shareholders should continue to be the default going forward. Net debt stood at $18.3 billion or a reasonable 2.4x TTM adjusted OIBDA at December 31, 2014, providing the Company with financial flexibility. As noted, TWX expects to spin out Time Inc. with approximately $1.3 billion in debt. This will have minimal impact on TWX’s consolidated leverage ratio, but the removal of a more cyclical/declining business gives TWX management more comfort to run a leveraged balance sheet. In fact, in February 2014 management boosted its targeted long-term leverage ratio from 2.5x to 2.75x. The board authorized a new $5 billion share repurchase program in January 2014 and also increased the quarterly dividend 10% to $0.3175 per share (1.7% yield) in February 2014. While TWX will also continue to pursue M&A, this is likely to be smaller bolt-on transactions like the recent CETV capital injection. Mr. Bewkes and TWX management have repeatedly voiced their disinclination toward executing transformative M&A given the Company already has scale and repurchasing its own shares represents a high hurdle rate. In fact, TWX continues to move in the opposite direction toward deconsolidation, as most recently illustrated with the pending Time Inc. spinoff.
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Valuation and Conclusion Time Warner shares have rallied 26% over the past 12 months, slightly outperforming the S&P 500’s 23% return. The outperformance has been much more remarkable over the ~3 years since AAF last featured Time Warner in January 2011; TWX shares are up 140% versus 43% for the S&P (both returns price only). Time Warner’s outperformance has been driven by a combination of ongoing operational growth and improving investor sentiment. Three years ago, TWX shares traded at only 7.8x EV/OIBDA, a ~25% discount to its closest peers. In our estimation, TWX’s depressed valuation reflected extreme investor concern toward over-the-top (OTT) competition from the likes of Netflix. HBO, and to a lesser extent TWX’s cable networks, were viewed as particularly vulnerable given their premium market positions. Warner Bros.’ television production and DVD businesses were also exposed to the Internet-delivered content threat. However, over the subsequent years these fears have proved unfounded as both HBO and Turner Networks have recorded some of their strongest growth rates. Warner Bros. has also posted more consistent results than its major studio competition, bolstered by its serialized franchises, persistent broadcast/cable TV production demand, and international markets.
TWX shares are currently valued at 10.7x TTM EV/OIBDA or approximately 10x 2014E OIBDA. Backing out Time Inc., TWX currently trades at a reasonable ~16x forward P/E based on management’s 2014 guidance. Despite the multiple expansion in recent years, TWX still trades roughly in line with its historical pre-recession average multiple and at a meaningful discount both versus major studio/network peers and our estimate of intrinsic value. Closest peers Viacom, Disney, and Fox currently trade at 11.4x, 12.3x, and 13.9x EV/OIBDA (TTM), respectively. In our view, TWX shares still reflect a meaningful holding company discount and the discount to peers is unwarranted considering the Company’s high-quality assets. Pro forma for the Time Inc. spinoff, TWX will generate ~80% of revenue from subscription and content sources. By contrast, peer Viacom generates ~40% of revenue from more volatile advertising sources, and Disney generates only ~35% of revenue directly from subscription and content. As detailed below, a sum-of-the-parts method helps uncover the extent of the discount at TWX.
In estimating Warner Bros.’ intrinsic value, we conservatively project revenue and operating income remain roughly flat going forward. Applying a 10x EV/OIBDA multiple, we estimate the studio’s intrinsic value is approximately $17.5 billion. This is roughly in line or a modest discount to Warner’s major studio peers. Given its leading scale, consistent financial performance, and valuable franchises, Warner Bros. arguably deserves a premium multiple. Viacom’s Paramount studio has faced challenges in recent years and recorded AOI margins only ~1/2 Warner Bros.’ levels in 2013, at 5.5% vs 10.8%. Disney suffered its own bumps along the road in recent years, and Disney responded with several studio acquisitions including $4.1 billion for Lucasfilm in December 2012, $4 billion for Marvel in 2009, and $7.4 billion (16.5x forward EBITDA) for Pixar in 2006. These were transacted at much higher multiples, and primarily reflected brand/franchise values. For example, the Marvel transaction represented approximately 15x forward EBITDA; we would note TWX subsidiary DC Comics has an arguably superior franchise portfolio to Marvel’s. Our multiple also represents a large discount to smaller publicly traded studios such as Lions Gate (18x EV/OIBDA) and Dreamworks (34x).
At Turner Networks, the key networks have continued to hold audience share despite increased competition, aided by strong sports rights and originals investment. While not quite the powerhouse of an ESPN, Turner Networks’ affiliate agreements remain somewhat underpriced. This should drive double-digit average annual subscription revenue growth over the next several years. International revenue should also grow at a similar pace as Turner gains scale and pay TV gains penetration. As AAF has frequently detailed, cable networks have historically commanded outsized, mid-teens average EV/EBITDA multiples in transactions. This reflects their strong network effects/barriers to entry, relatively predictable dual revenue stream, and attractive cash flow profiles. Nonetheless valuing Turner Networks at a discounted 11x OIBDA given its relative maturity, we estimate Turner’s intrinsic value could reach $52 billion in 2-3 years. In terms of pure-play cable publicly traded comps, Discovery currently trades at 15x EBITDA, Scripps is valued at 11.4x EBITDA, and AMC at 13.7x.
As detailed, we believe HBO is TWX’s crown jewel network with a premium brand and pricing model, unrivaled content, highly-regarded online platform, and 127 million global subscriber base. Under conservative growth assumptions, we estimate HBO’s intrinsic value will approach $26 billion at 12.5x 2016E OIBDA. We are comforted that this is still less than Netflix’s current enterprise value. Adding up the parts and subtracting corporate expenses at 8x, our sum-of-the-parts intrinsic value for TWX is approximately $92 per share. Adding
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Time Inc. at an estimated standalone enterprise value of $3.5 billion or $2.28 equity value per TWX share, this implies approximately 46% upside from current levels over the next 2-3 years.
TWX Valuation ($MM) Warner Bros. @ 10x 2016E OIBDA $17,453 HBO Networks @ 12.5x 2016E OIBDA $25,948 Turner Networks @ 11x 2016E OIBDA $52,088 Less 8x 2016E Corporate Expenses ($2,760) Total: $92,729 Net Debt 2016E ($23,394) Equity Value $69,335 Shares Outstanding (MM) 2016E 750 Standalone TWX Estimated Intrinsic Value per Share $92.45
Time @ 6.5x 2013 OIBDA $3,452 Less Assumed Net Debt at Spinoff ($1,300) Equity Value $2,152 Time Inc. Estimated Intrinsic Value per TWX Share $2.28
TWX Estimated Sum-of-the-parts Intrinsic Value $94.73 Implied upside 45.7%
The spinoff of Time Inc. during 2Q 2013 could serve as a catalyst for closing TWX’s discount to intrinsic value. Although not a huge contributor to TWX’s bottom line, the business’ secular challenges have likely weighed on the multiple ascribed to Time Warner. TWX could attract a new investor base as a pure-play content producer and TV network. At the same time, the separation of Time will transfer $1.3 billion in debt and allow TWX greater flexibility to utilize its stable free cash flow to return capital to shareholders, including via modestly increasing leverage. With the share count down by ~20% over the past 3 years, we are confident TWX management will continue to be aggressive as warranted. Finally, we would not discount the possibility that Time Warner continues the process of deconsolidation. We have long advocated for Time Warner to separate its businesses, and the Company has done a commendable job of this to date under Mr. Bewkes’ leadership— with tremendous results for shareholders. The Time separation is another step, but a separation of Turner Networks and/or HBO would be much more impactful. While some investors (and management) may be averse to severing HBO’s link to a major studio, much of this concern could be resolved via long-term extensions of the existing film output agreements. We believe Turner and HBO would each command a premium multiple as a standalone entity or in a transaction. Management has shied away from any such possibility historically, but the decision to begin separately reporting HBO and Turner Networks in 4Q 2013 does raise the question whether this could portend a change somewhere down the line.
Risks Risks that Time Warner may not achieve our estimate of the Company’s intrinsic value include, but are not limited to, general economic weakness impacting the Company’s businesses; lost distribution or failure to reach distribution agreements on favorable terms; increased competition for network programming; failure to achieve success in studio content production and original programming; loss of third party content at HBO; and loss of key management personnel.
Analyst Certification Asset Analysis Focus certifies that the views expressed in this report accurately reflect the personal views of our analysts about the subject securities and issuers mentioned. We also certify that no part of our analysts’ compensation was, is, or will be, directly or indirectly, related to the specific views expressed in this report.
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TIME WARNER INC. CONSOLIDATED BALANCE SHEET (in millions)
ASSETS Dec. 31, 2013 Dec. 31, 2012 Current assets Cash and equivalents $ 1,862 $ 2,841 Receivables, less allowances 7,868 7,385 Inventories 2,028 2,036 Deferred income taxes 447 474 Prepaid expenses and other current assets 639 528 Total current assets 12,844 13,264 Noncurrent inventories and theatrical film and television production costs 6,699 6,675 Investments, including available-for-sale securities 2,024 1,966 Property, plant and equipment, net 3,825 3,942 Intangible assets subject to amortization, net 1,920 2,108 Intangible assets not subject to amortization 7,629 7,642 Goodwill 30,563 30,446 Other assets 2,490 2,046 TOTAL ASSETS $ 67,994 $ 68,089
LIABILITIES AND EQUITY Current liabilities Accounts payable and accrued liabilities $ 7,322 $ 8,039 Deferred revenue 995 1,011 Debt due within one year 66 749 Total current liabilities 8,383 9,799 Long-term debt 20,099 19,122 Deferred income taxes 2,642 2,127 Deferred revenue 482 523 Other noncurrent liabilities 6,484 6,721 Commitments and Contingencies Equity Common stock, $0.01 par value 17 17 Paid-in-capital 153,410 154,577 Treasury stock, at cost (37,630) (35,077) Accumulated other comprehensive loss, net (852) (989) Accumulated deficit (85,041) (88,732) Total Time Warner Inc. Shareholders’ Equity 29,904 29,796 Noncontrolling interests — 1 TOTAL EQUITY 29,904 29,797 TOTAL LIABILITIES AND EQUITY $ 67,994 $ 68,089
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