Description

Introduction

Nexstar Media Group, Inc. (NXST) is the second largest owner of local television stations in the US. The company owns, operates or provides services to 170 television stations which reach 100 separate markets (out of a total of 210 generally recognized television markets). Its stations cover 39% of all US households reaching nearly 44 million people. Of Nexstar’s portfolio of local stations, 82% are affiliated with the “big four” of CBS, ABC, NBC, and Fox. Other affiliations include stations broadcasting the CW or MeTV. Nexstar is the #1 CBS affiliate group, #2 NBC, and #3 ABC, FOX, and CW. These affiliate relationships give Nexstar the exclusive right to broadcast primetime network content in its markets. Some of its largest stations include:

• ABC in Salt Lake City, Utah

• CBS in Las Vegas, Nevada

• NBC in Tampa, Florida

• CBS in Portland, Oregon

• ABC in Nashville, Tennessee

• CBS in Raleigh, North Carolina

• NBC in Austin, Texas

• The CW in Phoenix, Arizona

Overview

Nexstar’s core competency is the production of local news, sports, and lifestyle programming which is broadcasted in its local markets. Currently Nexstar produces and delivers over 3,500 hours per week of wholly-owned news and content such as morning, midday, evening and late-night local news. During these broadcasts, Nexstar has the exclusive right to sell advertising to both local and national ad buyers. For commercial advertisers, local news provides an avenue to reach a large audience in key demographic and regional areas. During prime-time hours, the network provides its programming exclusively to its local affiliate in each market. The local broadcasters also purchase the rights to broadcast first-run (e.g. Jeopardy, Judge Judy, Dr. Phil, Wheel-of-Fortune, etc.) or rerun (That 70’s Show, Seinfeld, King of Queens, etc.) syndicated programming during which they can sell ad space or let the content owner retain some ad time in exchange for reduced syndicate fees. Local ads are sold by local sales teams and national are typically sold by advertising agencies, to which the local broadcasters pays a commission. In markets where Nexstar owns or provides services to more than one station, there are significant cost and negotiating advantages to utilizing the same sales team.

In the past, the vast majority of revenue has come from selling ad space. Many of the largest national advertisers include automobile manufacturers, telecom companies, QSRs, and national retailers. Ten years ago, 90% of Nexstar’s revenue was derived from local (63%) and national (27%) ad selling. National ad revenue has been sensitive to the national economy. For example, national ad revenue on a per station basis declined 33% between 2007 and 2009. Local revenue has also been levered to the economy, but to a smaller extent than national. During the same period during the financial crisis, local ad revenue declined approximately 20%. Given the high proportion of ad revenue relative to total revenue, changes in revenue have been somewhat volatile which has led to volatile stock prices as broadcast expenses have a high proportion of fixed costs. Even in a poor economy, the news still has to be produced and payments to the affiliate networks must be made. Somewhat as an offset to the more volatile nature of ad revenue, the broadcasters have been able to depend on a steady stream of political ad revenue every even-numbered year.  This ranges from a low of 1% during off years to 10% during election years. The growing political divide and partisan nature of American politics has been a benefit to the broadcasters, especially those with assets in battleground states.

However, the industry has undergone significant changes in recent years. First, a new and stable stream of revenue has grown in importance. While the broadcasters have historically relied on advertising revenue, retransmission revenue has grown very significantly in recent years and has transformed the broadcasting business model. Beginning a few years ago, the broadcasters began to push back on the fact that they were receiving significantly less compensation (on a per subscriber basis) from the cable and satellite companies (multichannel video programming distributor, or MVPDs) for their content compared to the cable channels (i.e. Disney, Viacom, Discovery, Scripps, etc.) The following slide is from Sinclair Broadcasting from June 2015 so the numbers have changed somewhat since then, but the basic idea remains the same: the big four networks are by far the most popular channels in the cable bundle, yet, they receive significantly less in retransmission fees (i.e. the fees paid by the MVPDs for the right to transmit the content owned by others). It is important to note that the broadcasters negotiate on behalf of themselves and the networks with the MVPDs regarding retransmission rates and the broadcasters then pay the networks a portion of the retrans to the network. The net retransmission profit for the broadcasters is referred to as net retrans and the payment from the broadcaster to the network for their portion of the retrans revenue is referred to as reverse retrans. The following two slides tell the story:

By a wide margin, the big four networks are the most watched and highest rated channels in the cable bundle yet the retrans fees are not indicative of viewership. Though the broadcasters have made progress in receiving a higher proportion of the MVPD’s programming fees relative to cable channels, a disconnect remains. As the broadcasters have negotiated for higher rates, retrans revenues have grown at double digit rates in the past few years and Nexstar believes that growth will continue for the next few years as the gap between viewership and retrans rates narrows. The retrans agreements negotiated between the MVPDs and the broadcasters typically last for three years and are comprised of a fixed payment per subscriber. The following table reflects Nexstar’s revenue mix over the past decade.

As the chart shows, retrans revenue has gone from less than 10% of total revenue as recently as 2010 to nearly 35% in 2016. In fact, in 2016, retransmission surpassed local advertising as the largest source of revenue. It is also important to keep in mind that although retrans revenue has grown as a percent of the total, this has not been exacerbated by a decline in other sources of revenue. National ad revenue has been flattish on a per station basis but comparable local and political revenue has increased slightly. The following chart reflects revenue on a per station basis. Keep in mind that the fluctuating two-year political cycle impacts local and national ad revenue.

This changing composition of revenue has reduced operating leverage for the broadcasters and thus reduced overall risk. There will likely be less fluctuation in total revenue during the next economic contraction compared to 2008-2009 due to the fixed nature of retrans revenue even with a moderation in the rate of growth going forward.

As mentioned previously, there has been another significant development in the broadcast industry in recent years which can be seen in the Revenue per Station chart. One of the biggest criticisms of the broadcast stocks is that advertising is moving from traditional advertising mediums such as print and TV to online/mobile and the broadcasters will see a continual and accelerating decline in their broadcast ad revenue as a result. While the outlook is far from perfect, it’s likely not as bleak as some predict. For Nexstar, over the past few years, national ad revenue per station has been flattish but local and political ad revenue has increased. In addition, digital ad revenue per station has been growing at compound annual rates of 25%, 29%, and 31% over the previous seven, five, and three years, respectively, albeit this includes acquisitions. Nexstar’s digital advertising revenue in 2016 comprised 9% of the total and the company anticipates digital revenue to double within five years.

The previous chart highlights the anticipated future share of local advertising by type over the next several years. Online/digital is projected to grow rapidly, especially from growth in mobile, and print is anticipated to continue its decline. Nexstar believes it has the capacity and expertise to continue to expand its digital advertising revenue due to its ability to reach local consumers as they view local news content either through mobile, online, or TV. The company has invested in developing and improving its stations’ websites, video capabilities, and mobile apps with content optimized regardless of what type of screen it appears on. With opportunities to advertise on television and across online including multiple digital delivery platforms, Nexstar can offer local, regional, and national advertisers customized solutions to effectively market to core customer demographics. In fact, according to Sinclair, local TV news combined with digital is surpassing combined newspaper and newspaper digital as the primary source of local news. So although Nexstar’s digital revenue is relatively small today, it will likely grow at a double digit rate over the next few years, and combined with retrans, will comprise over 50% of total revenue in 2017. In Q2, 2017, digital and retrans revenue combined to total 51% of gross revenue. In addition, a recent article from the WSJ predicts that digital will surpass TV in terms of ad revenue in 2017, yet TV ad revenue is still anticipated to grow.

The article also mentions that with new technologies and data analytics, TV advertising will allow for more targeted marketing to audiences most receptive to the ad. Due to vast historical search data, digital ads have given the ability to marketers to reach very refined audience segments, which hasn’t been the case with the “shotgun” approach with TV. However, with the development of proprietary ad targeting systems, TV is trying to close the gap. The article goes on to state: “Credit Suisse predicts that targeted linear TV products will open up a revenue opportunity of more than $100 billion for TV networks, according to its Future of Advertising report from April.” (https://www.wsj.com/articles/tvs-next-act-targeting-ads-at-yogurt-lovers-and-home-buyers-1497778200) Likely these technological developments will help TV remain competitive with digital for advertisers’ dollars for the foreseeable future.

Acquisitions

Since its IPO in 2003 when Nexstar owned or provided services to 26 stations, it has grown through acquisitions. Just from 2011 through 2016, Nexstar acquired 60 TV stations and four digital businesses paying, on average, less than 6x EBITDA after synergies. Usually the vast majority of corporate costs can be eliminated in an acquisition. The largest acquisition in the company’s history was the January 2017 acquisition of Media General which made the combined company the second largest television broadcaster in the US with wide geographic diversity.

The industry has been undergoing a prolonged period of consolidation as scale becomes critical.  The largest broadcasters have the scale and reach to successfully negotiate with both MVPDs regarding retrans and their network affiliates regarding reverse retrans as well as negotiate fees for syndicated programming. In addition, scale leverages corporate costs. And with wide geographic reaches, broadcasters can offer advertisers customized combinations of broadcast and digital ad space that reach a large number of consumers and/or voters. There has been a tremendous amount of consolidation in the entire industry over the past decade as the broadcasters began to recognize not only the benefits, but the necessity of scale. The more stations owned by a single broadcaster, the more untenable a blackout situation becomes from the standpoint of an MVPD. And the more concentrated the overall industry becomes, the more difficult it becomes for the networks to threaten to move their affiliate agreements to other broadcasters.

Over the past five and ten years periods, during which there have been a significant number of acquisitions, Nexstar’s growth in EBITDA divided by the amount spent on acquisitions and capital expenditures indicate a pre-tax return on capital of 24.6% and 22.7%, respectively. These acquisitions were heavily debt-financed, so the lift to equity has been magnified which has been reflected in the growth of Nexstar’s stock price over time. Of course not all of the growth in EBITDA was due to acquisitions as organic net retrans revenue has grown over this time, but it’s important to note that when Nexstar acquires a station, the retrans rate is reset based on Nexstar’s existing agreement with the MVPD, if there was one. Ultimately, Nexstar has historically been a disciplined acquirer that has created significant value via acquisitions. With Nextstar now reaching 26% of US TV households (with the UHF discount) it still has room make more acquisitions.

It’s also important to note that Nexstar has been led by the same CEO since the company’s founding. Perry Sook has overseen the company’s IPO and growth strategy over the past 22 years and has proven to be a savvy acquirer. He currently owns over 1 million shares of stock and options to purchase another 1.4 million shares which are combined worth nearly $150 million. Long-time CFO, Tom Carter, owns stock and options worth nearly $13 million. While I think the stocks of the broadcasters in general will do well, I like NXST due to Perry’s track record. Capital allocation under Perry has been very strong, especially considering the acquisition program has been carried out with hardly any share issuance. In the decade prior to 2016, the share count has increased at only an annual rate of less than 0.8%. Given the size of the MEG deal, NXST issued stock but there is no question that shareholders are better off with the deal. NXST has also been opportunistic with share buybacks. During Q2 the company repurchased over one million shares at just over $58 per share.

Valuation

At a current stock price of approximately $63.65, the company’s market cap is $2.94 billion. With net debt of $4.35 billion, its enterprise value is $7.3 billion. Based on proforma EBITDA for the combined companies, Nexstar is levered over 5 times, but through EBITDA growth and debt pay down, the leverage ratio is anticipated to be in the “high 4x-range” at the end of the year and the “mid 3x-range” by the close of 2018. The leverage is high but the company has stated that debt reduction is a near-term goal and there are no significant maturities until 2022. The company paid down its term loan by $66 million in Q2.

Rather than attempting to value the company, in this case, I think the best way to assess the valuation is to look at Nexstar’s likely ongoing cash flow. As a starting point, I looked at Nexstar’s 2016 and Media General’s 2015 financial results and compared those to the current valuation. Media General’s 2017 financial results will obviously be better than those of 2015, but I think this can be a helpful data point. The following table show the operating profit for both NXST and MEG and makes a few adjustments for non-cash and non-recurring expenses.

Since 2015 was an off-year for political spend, averaging the two years should give a good picture of the “average” year. Next, in the following table the combined operating profit is adjusted to arrive at free cash flow to equity.

These adjustments results in free cash flow of over $309 million which approximates a free cash flow yield of 10.5%. The interest payments are based on the post-deal capital structure and current interest rates and a tax rate of 38.5% is applied to pre-tax profit. Historically Nexstar has paid minimal cash taxes as it’s been able to shelter income using NOLs. However, those NOLs will be mostly used up by the end of 2018. The capital expenditure number was provided by NXST management on the Q4 2016 conference call for the combined company going forward. Additionally, even under this extremely conservative scenario, interest expense is covered nearly 3x and there is significant cash generation which can be used to delever, by either paying off debt or growing EBITDA through acquisitions.

As mentioned, just looking at the 2015 results for MEG and 2016 results for NXST results is a very conservative (or unrealistic) number for free cash flow. Due to growing retrans (including a step up for legacy MEG as it moves into NXST’s retrans agreements) and digital revenue for both companies as well as cost synergies estimated at $81 million in the first year and tax sheltered income, average free cash flow for 2017/2018 will likely be substantially higher. Including the cost synergies in the previous table would have resulted in free cash flow of $390 million, or a free cash flow yield of over 13%.

While this may be somewhat aggressive, NXST has guided for average free cash flow of $574 million in the 2017/2018 cycle. Based on the current stock price, this represents a free cash flow yield of 19.5%. This estimate doesn’t include the $55 to $60 million of one-time expenses related to synergy realization, doesn’t reflect the future payment of taxes at the full rate due to the NOLs, and doesn’t factor in changes in net working capital, so I think reality will be something less than this. However, even after adjusting for these factors, ongoing free cash flow is likely in excess of 15% of the current market cap. Based on the current price and assuming no increase in the multiple, I believe the stock can compound at a mid-teens rate based simply on its current cash flow and the ability to delever over the next few years. Additionally, there is likely upside as the multiple would very likely rerate higher due to reduced risk to the equity from outright debt reduction.

Considering that Nexstar’s two subordinated note issues due in 2022 and another due in 2024 trade at or above par, there is a wide disconnect between the price of the equity and fixed income. The most liquid of Nexstar’s notes is the 5.875% of 2022 and it currently trades at $104. That the bond market appears so sanguine about a debt that doesn’t mature for five years and is subordinated to over $2.9 billion in term loans is very difficult to reconcile with an equity valuation that seems to question the ongoing viability of the business.

Risks

While I think Nexstar’s stock price is overly discounting the risks involved, there are concerns:

• Historically the broadcasting business has been cyclical as ad dollars, especially national, have been highly levered to the economy. While this dynamic still exists, the growing dollar value of fixed retrans revenue has mitigated this somewhat. Going forward, retrans revenue will likely be near 40% of total revenue. Nevertheless, a sharp recession would lead to declines in ad spending.

• In the past few years, the trend of customers cancelling their cable subscriptions or younger people never signing up for cable in the first place has garnered much attention in the media. Disney brought this to the forefront in August of 2015 when it announced subscriber losses for ESPN and the stock fell over 6%. If chord cutting accelerated and subscriber numbers fell, that would lead to reduced retrans revenue and lower advertising dollars (to the extent overall viewership declined). I believe the market fears that a combination of the two (i.e. a recession leading to reduced ad spending coupled with an acceleration in cord cutting) could lead to a meaningful decline in revenue within the next few years and, combined with the leverage, the equity could get wiped out.

These risks are certainly valid, however, thus far cord cutting has been relatively slow and any near-term declines are estimated to be in the LSD range. It’s also important to remember that many of the MVPDs have responded to the threat by promoting slimmed down cables bundles in order to curtail subscriber losses; and the local broadcast channels are always carried on the most widely distributed tiers. This is evidenced by the fact that the two largest broadcasters, Sinclair and Nexstar, have indicated that their subscriber numbers have been flat over the past couple of years. On the recent Q2 call, NXST indicated that for the first half of 2017, total subscriber losses were less than 0.5%, and this number excludes recent OTT agreements.

There are also risks posed by Netflix, Amazon Prime, Sling TV and other OTT (over-the-top) internet-based services. Obviously Netflix and Amazon Prime do not offer live TV, yet at least so far they have typically been used in conjunction with other offerings, especially since they don’t offer live sports or news programming. The big four networks also offer OTT services, such as CBS All Access, and they all include the broadcaster’s local programming. For example, last month Nexstar renewed its affiliate agreement with ABC and came to an agreement regarding OTT: “In addition, the Company has reached an over-the-top (“OTT”) master agreement with ABC, for new internet-delivered programming services from DirecTV Now, Sony PlayStation Vue, YouTube TV, CenturyLink and ABC's TV Everywhere.” As far as other OTT options, Sling TV carries local Fox, NBC, and ABC channels only in select markets and it encourages its subscribers to use antennas to pick up local stations. Hulu offers local channels for all big four networks in select markets and it plans to roll out local channels in additional markets as “quickly as possible.” Ultimately, many consumers value local news content and MVPD and OTT providers want to be able to provide that content to their customers.

• The biggest draw to live TV is sports. Approximately 80% of all TV households in the US view at least a portion of an NFL game annually. As long as sports stay on the cable bundle, many consumers will continue to pay for cable. However, in the future it’s not hard to imagine that one of the OTT providers or a large technology company could pay up for the broadcasting rights for a major sport. We saw this to a limited degree with Twitter and Amazon and the NFL. If the big four networks were to lose the NFL or college football or March Madness etc., then that could have dramatic implications for the entire pay TV ecosystem. However, while this is certainly possible in the future, I believe it’s unlikely in the near future for a few reasons. First, the various broadcasting rights are long-term agreements and many of them are locked up for years. For example, ESPN has secured the rights to the college football playoffs through 2025. CBS, Fox, and NBC have a deal with the NFL through 2022. Each network has the right to three Super Bowls under the agreement. CBS and Turner Broadcasting have a deal with the NCAA to broadcast March Madness through 2032. Second, definitely the networks and likely the cable companies themselves understand the importance of live sports and would likely put up a strong fight to keep a large portion of those broadcasting rights. Also, although viewing live sports on the internet will undoubtedly grow in the future, at the current time and likely over the intermediate term, viewership, and thus ad rates, would likely be lower for events solely broadcast on the internet or on a subscription OTT service as compared to cable/over-the-air TV. I think it is also important to consider how the NFL, NBA, NCAA, etc. would feel about their product being broadcast on a platform with a potentially smaller audience (like a subscription OTT service) as compared to TV. This is certainly a risk and I do not want to minimize it; however I think it is more of a longer-term issue and the stock price seems to be adequately discounting it.

• There has been some concern in recent years about the relationship between the broadcasters and their affiliate networks. As retrans revenues have grown, negotiations over how to divvy up those revenues have become more important. This came into focus in August 2014 when CBS stripped the local Indianapolis station of its CBS affiliation and gave it to another station over a disagreement regarding reverse retrans payments. We have also seen this with the recent dispute between Fox and Sinclair (although this may have more to do with Sinclair’s potential political ambitions than anything else). This raised concern over the broadcasters’ negotiating leverage and the resulting future of reverse retrans payments. However, since the 2014 CBS issue, a number of affiliate agreements have been renewed and those agreement have generally been viewed as positive by both sides. Net reverse retrans has continued to grow for the broadcasters and Nexstar is projecting continued double digit growth through 2019 with a high level of confidence as most MVPD and affiliate agreements are completed through that time. Plus, it’s important to remember that the networks and broadcasters have a symbiotic relationship. The broadcasters need the prime-time content and live sports and the networks need the non-primetime programming and strong local news broadcasts to lead into primetime. Plus, ongoing broadcaster consolidation increases negotiating leverage.

Conclusion

I believe at the current price, Nexstar can compound at a mid-teens rate going forward. The current low price provides a margin of safety and significant cash flow will provide for ongoing delevering with the company committed to actually reducing outstanding debt. The sector is out of favor at the moment and Nexstar’s equity is priced like it’s in distress. The way in which consumers view entertainment is changing and the ecosystem will continue to evolve; however, I expect the pace of change to be manageable for the broadcasters and they will continue to remain relevant so long as consumers place value on local news content. Plus, any positive developments regarding tax reform or a relaxation of FCC rules would be beneficial. Plus, the potential rewards from ATSC 3.0 may become more apparent in the next few years. Nexstar has been well managed for many years and historically capital allocation has been strong and I believe this will likely continue with ongoing opportunities for acquisitions and/or stock buybacks. Nexstar is a decent business and the stock is unjustifiably cheap.

Catalyst

• Strong free cash flow generation
• Debt paydown
• Regulatory relief
• Additional acquisitions