Emmis Communications: Undervalued Thanks to a Recent Acquisition

Thesis

Emmis Communications (EMMS, Financial) is hated, beaten down, and incredibly cheap on both an asset and cash flow basis. The market is focusing on CEO Jeff Smuylan, a ruthless majority owner who many believe screwed over preferred holders and attempted to take the company private at low valuations in the past. Investors who look back will see a hopeless battlefield, but investors who look forward will see a much clearer strategy and a more shareholder friendly use of cash flows. Emmis now has a simplified capital structure and robust cash flows that the market has failed to recognize. The acquisition of two New York radio stations will enable the company to produce more than $0.50/share in free cash flow by 2015. The primary intentions for all that FCF is to pay down debt, capital allocation that should accrete back to shareholders over time.

Based on the asset value and FCF of $0.50/share in a low case, I believe that shares of EMMS are worth at least $5/share and, depending on macro factors, could be worth more than to $6/share. This compares favorably to a price of $2.69 as of June 13, 2014 and represents almost 100% upside.

Overview

Emmis is a radio and publishing provider with operations around the United States. The bulk of the companies revenue is generated from advertising revenue from their radio stations. Their owned radio stations can be seen in the table below.

Table 1. Emmis Radio Stations Source: 2013 10K

Altogether the radio segment generates $198.8 million in revenues during the 2014 fiscal year. The publishing assets generated $6.3 million of revenue in 2014.

Emmis has been in the process of selling off non-core assets and paying down debt. The company entered the Financial Crisis woefully unprepared and went through very difficult times. They were able to get through and pay down debt, bringing the company back from the brink. As of February 2014 the company had $54 million of recourse debt, a fraction of what they had four years ago. The company is also in the process of getting rid of the preferred shareholders who didn’t understand the distinction between Indiana corporate law and Delaware corporate law.

Indiana Ain’t Delaware

The title above is somewhat obvious, however, many investors failed to understand the distinction when they purchased Emmis preferred shares. Lawyers of Emmis did understand that distinction, and with a few creative strokes, eliminated the preferred shares dramatically reducing debt and interest expense. The mechanism has been discussed ad infinitum, and I have no urge to re-hash it in gory detail. Instead, I will focus on what happens going forward.

The main concern is that Jeff Smuylan will try to take the company private at a valuation only he likes. He has tried this twice before, once in 2006, and once again in 2010. Both times he failed, for different reasons. While the preferred shareholders stood in his way the second time, the first time he was rejected by the Board of Directors.

While an investor should never say “never”, it seems unlikely that a going-private transaction is in the cards. Smuylan testified under oath that he had no intention of taking the company private. Should Smuylan try to take the company private at a low valuation, there will be considerable legal challenges for Emmis based on his testimony.

Second, the mechanism to get rid of the old preferred holders required the issuance of 400,000 preferred shares to an Employee Retention Plan Trust. According to court documents, “although Plantiffs [sic] accuse Defendants of nefarious motives in creating the Retention Plan Trust, the evidence shows that Emmis employees have been told that the shares placed in the Trust were placed there for their benefit and will be available for distribution to employees who remain with the company for at least two years.” (Page 26)

Sure enough, two years later those preferred shares were available for distribution. The preferred shares, all 976,000 of them, were converted to common shares and distributed on a pro rata basis based on salary. When all was said and done, 598 employees received $3.24 million, as long as they made less than $50,000. What those employees did with their stock award was up to them. I believe this employee ownership could be a significant part to the Emmis story, especially when it is ~3% of shares outstanding. The aspects of a going private transaction at any price under $3.32/share would result in a loss for any employee still holding shares. While it is impossible to gauge who owns shares or when they may/will sell them, Smuylan needs to consider the potential morale hit that this could cause. He now has a price target, and I have mine that I will not buy above.

Luckily (or unluckily if you bought the common) for common shareholders, management has serious skin in the game. The table below shows share ownership for executives.

Table 1 Insider Ownership Source: 2014 DEF14A Page 11

Collectively management or directors own 16.7% of Class A shares outstanding. Jeff Smuylan owns 100% of all Class B shares. Their ownership of shares may prove fruitful after the acquisition announced earlier this year.

2014 Acquisition of WBLS and WLIB

In February of 2014 Emmis announced the acquisition of two radio stations in New York for a total consideration of $131 million. The company took out their old debt and financed the acquisition with a $185 million term loan. The expected financial impact can be seen in the table below.

Table 1 Original Pro Forma Financials

Some of the numbers above do not add up but there are good reasons why. The EBITDA line benefits from $3 million of synergies. These synergies are simply layoffs of redundant management positions, so I am confident that they will be achieved.

The free cash flow calculation doesn’t seem as straightforward because $4.3 million and $8.2 million only add up to $12.5 million, well short of the pro forma $22.7 million. The difference is largely due to debt amortization. Emmis generates $4.3 million of free cash flow after $8 million of debt repayments. However, the pro forma calculations include a 1% mandatory debt amortization payment. On $185 million of debt this works out to $1.85 million, $6.15 million less than Emmis currently applies to debt amortization. Add back $3 million of synergies and you are in the ballpark of the $22.7 million of free cash flow.

While that is technically “free cash flow”, its sole purpose is to pay off debt. In the old credit agreement EMMS had to pay off $8 million per year. In the new credit agreement Emmis has to hit certain leverage targets based on EBITDA. Originally, JP Morgan gave this term loan with the expectations that debt would eventually drop to 3X EBITDA, down from a current pro forma 4.58X. In order to get there Emmis will be required to pay 50% of excess cash flow until the company hits 3.75X Leverage/EBITDA, and 25% of excess cash flow until the company goes below 3X debt/EBITDA.

Fortunately, (or unfortunately, depending on your perspective) the term loan covenants were tightened and EMMS is now required to pay off debt much more aggressively. This was caused by some fluctuations in the high-yield market and will have an impact on Emmis’ cash flows. Overall, the company will pay more interest expense but they will be forced to pay more debt down quicker. The table below shows the updated term loan agreement. I estimate that the company is currently paying 5.85% interest expense.

Table 2 Term Loan Agreements

This is very important for equity holders because any debt payoff should directly benefit those holding equity and it limits poor decisions by management. The table below shows my expectations for debt repayment and the ensuing value that could be created for equity holders. The assumptions below are based on 43.05 million shares outstanding and a share price of $2.69, the closing price as of June 13, 2014. Equity values were computed using a stable 8.7X EV/EBITDA calculation, slightly above the value the market is currently ascribing to Emmis, but below other radio companies.

Table 2 Debt Repayment and Potential Accretion to Equity Holders, Author’s calculations

I believe that looking four or five years into the future is a poor way to invest. However, I think the key takeaway is that debt will reduce and there is a good chance that the savings will accrue to equity holders without any need for multiple expansion. Equally important, the amount of FCF being generated should increase, simply from debt repayment. While it is tough to accurately predict fair value, I believe that stable cash flows can demand an 8-10X FCF multiple and growing cash flows can demand 10X or more. Fair value for Emmis, simply based on the cash flows, could be $4.21-$5.94 depending what multiple (8-11X) an investor feels is appropriate.

A significant portion of the cash flows come from the acquisition and therefore, the acquisition needs to work. The dynamics present make this integration more likely to be successful than not. More than 40% of the employees used to work at Emmis and an Emmis radio station, Hot97, current shares operation and studio space with WBLS/WLIB. Finally, Deon Levingston is the general manager of WBLS/WLIB now and will become the general manager for the Emmis’ New York radio cluster. Mr. Levingston started working in radio with Emmis out in Indianapolis. The numerous parallels should be comforting for investors of Emmis.

It is also worth mentioning is that Mr. Levingston believes WBLS should have increased pricing power going forward. In the cited article “he (Levingston) argues that the station should be getting higher ad rates and feels that urban stations are often overlooked by companies advertising their wares.” Competitor Clear Channel charges advertisers at least 20% more. Given the high fixed costs embedded in radio the extra 20% would be very beneficial to Emmis’ bottom line.

Other Assets

Emmis has several other assets (already included in the FCF calculations) that may have separate value on their own. They have a publishing division that generates $1.5 million of EBITDA. While it’s tough to nail down a good value, newspapers are selling for 5X EBITDA. Maybe this division sells for 4X and generates $6 million of proceeds.

Another potential source of value is NextRadio, Emmis’ radio app. I will admit that I have little skill in evaluating ventures like this. However, the company is working towards monetizing the app and it has seen enormous growth. Furthermore, management noted on page 26 their 2013 10K “most wireless carriers in the United States do not permit the FM tuner to receive the free over-the-air local radio stations it was designed to receive. Furthermore, in many countries outside the United States, enabled FM tuners are made available to smartphone consumers; consequently, radio listening increases.” Maybe this is worth a lot, maybe not. Right now, investors are getting this for free. As long as management doesn’t start plowing money and resources into this I consider this potential upside.

Concerns

There are a few things that are potentially concerning.

1. Much of this thesis depends on debt repayment accruing back to equity holders and/or the market valuing the equity at a FCF multiple that is higher than it currently is.. This may not happen on a 1:1 basis, or at all.
2. Radio is cyclical and a drop in ad rates could occur quickly. Given the high fixed costs associated with radio this will have a disproportional impact on EBITDA and FCF.
3. Interest rates could rise and may rise rapidly. If so, Emmis’ variable rate debt would be very expensive. Discussions with Emmis indicate that they are actively considering whether or not to hedge their debt. The choice to hedge will be based on how quickly they think they can pay off debt. It could be argued that management is bullish if they decide to not hedge the debt.

Conclusion

It is easy to understand why the market hates Emmis given the history, industry, and leadership. However, the recent acquisition should make investors more comfortable for two reasons.

First, there will be a material increase in cash flows and EBITDA. While investors are free to use any metric they deem important, with the company trading at 8.7X EV/EBITDA and 6.4X FCF to market capitalization on a pro forma basis, it doesn’t take much imagination to see the company is undervalued on an absolute and relative basis. Again, how an investor slices and dices a fair value is up to them. I believe that equity holders should only be concerned with steady-state FCF but others may feel better using EBITDA.

Even if investors want to use a different metric, recent changes in loan covenants will eliminate any doubt that shares are undervalued. Investors now know where cash flow will be going. Capital allocation and grandiose delusions from Mr. Smuylan are significantly less likely because the senior debt holders are demanding that the majority of cash flows be used to pay down debt. While not as accretive to equity as buying back stock, the returns are simple to compute. Emmis should reduce debt by more than $15 million per year saving more than $750,000 in interest expense each year. As debt and interest expense drop the resulting savings should accrue to equity holders.

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