ETM valuation : Undervalued Radio Company

December 23, 2010

Entercom (ETM) is a significantly undervalued radio company operating 110 radio stations in 23 markets in the US. It is the fifth largest radio company, behind Clear Channel Communications (894 stations), Cumulus Media (314 stations), Citadel Broadcasting (224 stations), and CBS Radio (130 stations). Despite a low PE ratio, ETM has attracted a moderately high short interest. The main bear case is that ETM will have to refinance its large debt in 2012, and depending on the terms of the refinancing, may see nearly all of its cash flow diverted to bondholders. Below, I briefly explain how things have gotten to where they are today, and paint several possible future scenarios and valuations.

A Brief History of Radio

Entercom was founded in 1968 when Joseph Field purchased three FM stations in Philadelphia, the most he could prudently afford, because he believed that FM radio is going to eclipse AM radio. Over the years, the company grew slowly, using minimal leverage. In 1996, the Telecommunications Act lifted the national ownership cap for radio stations, and a wave of consolidation and merger mania swept the radio industry. In 1999, ETM drank the Kool-Aid and IPOed for $236M, using the cash raised as seed equity to go into debt so as to purchase 46 radio stations from Sinclair Broadcasting for $824M, bringing its radio station count to 88. A two-class share structure was put in place, with equivalent economic rights for both Class A and Class B shares, but with Class B shares having 10 times the voting power of Class A shares when they are voted by Joseph Field or his son, David Field. In the years since then, Entercom has used most of the cash flow to acquire more radio stations, until it has reached its current station count of approximately 110. Today, the radio industry is clearly over-leveraged and ill-equipped to handle the economic downturn. As a result, several prominent bankruptcies have hit the major companies. Citadel Broadcasting has just emerged from bankruptcy in June 2010, and privately-held Clear Channel Communications narrowly staved off a bankruptcy by issuing a large amount of debt in its publicly-traded subsidiary Clear Channel Outdoors, and remitting the cash back to the parent company. On the bright side, revenue has clearly begun to recover from its lowest point in 2009, costs have been cut dramatically during the recession, and analysts expect much better profitability in the near future.

Entercom is a Good Radio Operator

Operationally, Entercom is clearly an above-average company in its industry. It concentrates on dominating medium-sized radio markets, and prefers to be a small player in the big markets, allowing larger companies to set the advertising rates there. Entercom’s program offerings are biased towards sports radio and local news with a conservative streak, which are less subject to displacement by MP3 players and nationally syndicated news programs. Entercom stations have a below-average staff count, and profit per station runs significantly higher than at larger companies, although this increased profitability comes at the cost occasionally pissing off the on-air talent (e.g. see the Howie Carr incidents). Still in the current state of the radio industry, where ferocious cost-cutting is the norm, I don’t think that a mass exodus of talent is likely.

ETM’s earnings before interest and taxes (EBIT) has ranged from $150M 2007, to a low of $100M in 2009. Free cash flow (after taxes and interest) have ranged from a high of $95M in 2008, to a low of $60M in 2009. ETM’s current debt is around $675M, owed to a syndicate of 33 banks. The debt has a floating interest rate of only 1.5%, but ETM has purchased interest rate swaps to convert that to a collared rate that fluctuates around 3-4% to hedge against sudden rate spikes. While ETM has been furiously paying down debt in recent years, it will not clear the debt before it matures in June 2012. The interest rate obtained in the refinancing, as well as the revenue growth of the company, strongly determines the end-point valuation for ETM.

Entercom valuation scenarios

Pessimistic scenario valuation. Assuming that EBIT comes in at $100M for 2011 and 2012, with an interest rate of 4% ($27M interest expense), and a 35% corporate tax rate. FCF for the two years will come in at around $50M annually, which will reduce debt to $575M. If the $575M debt is refinanced at a 10% interest rate, and assuming a $100M stable EBIDTA, FCF will go down to $27.5M. Applying a multiple of 10, this works out to a market capitalization of $275M, or a per share value of $7.64.

Most likely moderate valuation. Assume EBIT comes in at $120M for both years, with an interest rate around 3.5% ($24M interest expense). FCF for 2 years comes in at around $62.5M annually, reducing debt to $550M. If the debt is refinanced at an 8% interest rate, and assuming a $120M stable EBIDTA, FCF will be around $50M. Applying a multiple of 10 brings market cap to $500M, or $13.89 per share.

Optimistic scenario. Assume EBIT is $140M for both years, with an interest rate of 3% ($20M interest expense). FCF for 2 years comes in at $78M, reducing debt to $520M. Assuming EBIT is stable at $140M and refinancing interest rate is 6%, FCF will be around $70M. With a multiple of 10, that brings market cap to $700M, or a per share value of $19.44.

Of course, one can argue that ETM has no choice but to refinance in 2012, and lenders will use that weakness to lock in some punitive interest rate, like 15% or 20%. However, I believe that the possibilities of that are quite slim. Firstly, the current lenders are a syndicate of 33 banks, and not a couple of hedge funds, and each individual player in the syndicate has only a diluted interest in jacking up the interest rate, so a refinancing with the same bank syndicate at reasonable rates is a distinct possibility. Secondly, the size of the required loan is quite modest, and the pool of possible lenders should be quite large. Therefore even if the same syndicate balks at extending the loan, I believe that many other lenders will jump at the opportunity to reap an 8% interest rate from a loan secured on substantial real properties and valuable FCC licenses, not to mention a healthy underlying cash flow from these assets.

Acquisition possibility

Recently, Cumulus Media made a unsolicited bid for Citadel Broadcasting at $31 per share, or about $1.5B in cash or shares, plus the assumption of $1.1B in liabilities offset by a net working capital of around $0.2B, or an enterprise value (EV) of around $2.4B. I estimate EBIT at Citadel to be around $150M-200M. Assuming a EBIT of $200M, this is an EV/EBIT ratio of 12. If we reduce this ratio to 10 and apply it to ETM (the reduced ratio is probable due to reduced market power gained because ETM is smaller than Citadel), assuming ETM has an EBIT of $125M, this gives ETM an EV of around $1.2B. Removing the $760M in liabilities (working capital offset is minimal) leaves $440M in market cap for shareholders, or about $12.22 per share. The possibility of a takeover for ETM has never been seriously entertained by ETM shareholders, because the Field father and son team effectively control the company, and they have never shown any signs that they are amendable to a sale. However, Joseph Field is now nearly 80, and for estate tax planning purposes, the family may be more willing to entertain a sale. Furthermore, any sale is likely to retain or perhaps even elevate the current competent management, thereby preserving the leadership role of David Field and making the sale more palatable. And of course, an acquisition by a well-capitalized group will remove the current uncertainty discount on the share price due to the refinancing event in 2012.

Speculations on short-term price movements

In the recent year, ETM has seen vigorous insider buying by the Fields at share prices of around $6.50 to $7.50. In a distressed market scenario (Korean war, Greece default etc.), share prices might well tank to that level. However, I believe that for anyone who can take a decline of that magnitude, holding ETM shares at current prices presents a favorable risk-reward profile in the long term. In economic scenarios short of a full-blown double dip recession, ETM’s value will end up higher than its current market capitalization. Because of the inherent operational leverage, even in a modestly growing economy, ETM’s revenue and earnings is likely to skyrocket, whereas in a depressed climate, ETM’s value is buttressed by its valuable FCC licenses and antenna towers/radio stations despite the loan overhang.

Disclosure : I own shares of ETM.

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