Overview

“It (value investing) has always worked – because when you make your buy list, you want to throw up”

            -Richard Pzena, Columbia Investment Management Conference, February 1, 2008

Citadel Broadcasting Corp. (“Citadel”, “CDL” or the “Company”) is a special situation media story, which certainly makes you want to vomit: an incredibly highly-levered small-cap stock, in a secularly declining industry with a management team that has failed to meet expectations.

So why do we think that this would make a good investment?

CDL is attractively priced as it has been hit with a number of negative events stemming from three key areas: (i) the ABC Radio acquisition and associated leverage, (ii) industry weakness, (iii) overall investor distaste for highly-levered small cap stocks, and as a result the stock has been severely punished, and (iv) market confusion over true pro forma numbers.  The stock, at $1.32, is off ~85% over the last twelve months and ~40% year to date.  At a ~47% 2008 free cash flow yield to equity (“FCFE”) or 8.3x 2008 EBITDA, CDL is trading at a significant discount to historical trading and precedent transaction comps and priced as an option given the perceived bankruptcy risk.  The details are complicated but the investment thesis is simple; we believe that the cash flows at Citadel make the possibility of a bankruptcy remote and think shares are worth $3.50 to $5.00+ under a number of scenarios / exit multiples.  The key points are highlighted below.

Background

CDL was previously written up by bedrock346 in late 2006, please refer to that for additional details on the base business.

Citadel was formed by Forstmann, Little & Co. (“Forstmann Little”) in January 2001 as an LBO of mid-market radio assets; Forstmann Little took CDL public in 2003 at $20 per share for a partial realization.  In February 2006, CDL announced the acquisition of the ABC Radio assets from Disney for $2.4bn ($750mm in stock), which at the time implied ~12.5x 2007E EBITDA.  Now, CDL is the third largest terrestrial radio company in the US, operating 165 FM and 58 AM radio stations in 46 markets across 24 states.  ABC Radio consisted of large Demographic Market Area (“DMA”) stations and nationally syndicated radio shows, so the acquisition of ABC Radio was meant to diversify the business by gaining exposure to content, geography / large DMAs and to create a true nationwide advertising platform.  Large DMAs have seen overall performance suffer since 2006 as ad dollars have shifted to new & alternative forms of media (online advertising) and a general economic slowdown / recession.  As this industry weakness became evident at ABC Radio, CDL renegotiated the deal in November 2006 to allow for more favorable terms (including the distribution rights for ESPN’s radio content, providing CDL with 20% of net sales, an attractive incremental cash flow stream); however, it appears that these concessions were largely inadequate given the magnitude of the deterioration.  Oddly, the delay in timing may actually prove to be beneficial for prospective CDL shareholders as the acquisition closed in June 2007, near the height of the leveraged lending boom.

It is clear that this transaction has been destructive to existing shareholder value given the price, focus (large DMAs) and timing. Additionally, this stock has been punished by overall weak industry fundamentals, poor operating performance and shareholder preferences / turnover.

o        Industry Weakness – New media continues to gain market share of ad dollars at the expense of traditional media channels, mainly broadcast TV and radio.  This advertising shift is being compounded by shrinking overall spending as economic weakness continues to become more pronounced on a daily basis. As such, radio stocks have sold off dramatically with WON off 80%, CXR off ~25%, SBSA off  ~65%, and ETM off ~60%.  While these short-term pressures should persist for some time, it is unlikely that broadcast radio will disappear as an advertising medium, especially for small / mid-sized DMAs.  PWC’s 2007 Media Report (a respected industry publication) forecasts domestic radio advertising revenue growing by a 5.0% CAGR from 2007 – 2011 (which we view as unlikely, although it would be a home run for CDL).

o        Operating Performance / Integration Issues – Weakness in the broader industry has translated into revenue / EBITDA declines at CDL (and others).  CDL generated $945mm and $325mm of pro forma (“PF”) revenue and EBITDA in 2007, off from $978mm and $344mm in 2006, respectively.  So 2007 PF revenue declined 3.5%, gross margins contracted, and EBITDA fell by $20mm (5.5% decline).  These numbers are on par with the industry, as large DMAs have suffered more than small / mid-sized DMAs (just when CDL was buying exposure to the large markets).  The largest business risk is an eroding top-line and mgmt has initiated aggressive cost-cutting measures across the board that are geared for ‘zero revenue growth’.

o        Investor Preferences – Levered equities, small-caps and story / special situation stocks have sold off as investors have shunned these riskier plays.  CDL fits into all of these categories as a highly levered, small-cap integration story.  Another aspect of the ~85% sell-off relates to the ABC Radio merger; Disney investors were given ~125mm shares of CDL stock, dramatically increasing the size of CDL’s float.  Given that most of Disney’s investors own a mega-cap multi-national diversified media company, they likely have been uninterested in owning a levered small cap pure-play domestic radio operator, thus compounding the sell-off in 2007.

o        Market Confusion – CDL originally targeted ~$400mm in 2008 EBITDA following the ABC radio acquisition, however, due to acquisition integration issues and industry weakness CDL recently pulled back on this guidance on the 3Q07 conference call leading us to doubt this target is achievable.  Fortunately, we don’t require it as part of our investment thesis, though if CDL were to come close it would be a home run for the stock.  PF for the acquisition, CDL generated $325mm in 2007 EBITDA, and consensus estimates are showing ~$275mm in 2008E EBITDA (a stark contrast from the original guidance), owing to weakness in the broader radio markets and continued integration issues with ABC Radio.  Many data sources (e.g. CapIQ, Thomson, WSJ, Kagan, etc.) are not carrying PF 2007 numbers, hence CDL looks extremely expensive and the leverage looks ridiculous, at least at first glance.  We also doubt that most investors are valuing CDL on a PF basis given the Term Loan and Convert adjustments.  Digging through various sources lends support to ~$325mm in EBITDA (e.g. S&P / Moody’s / S&P LCD) – we’d also note that CDL would obviously be in default of their leverage covenant if leverage was ~10x, as recent research would suggest.  We concede that Q108 earnings should be rough and it is tough to handicap the stock’s reaction, however, an updated filing with more info on debt balances, covenants and true pro forma numbers should help to assuage some investors’ fears.

Investment Thesis

We believe the investment thesis is quite simple: (i) stable free cash flows, (ii) loose covenants with no near term mandatory amortization requirements or maturities, (iii) cash flow from asset sales, and (iv) opportunistic liability management combine to make bankruptcy a low probability event.  Thus, given CDL’s current leverage, the stock is effectively priced as an option; if you believe they can avoid bankruptcy the stock should appreciate considerably as it pays down debt.  We view CDL as a cash flow, not a multiple, story (any exit multiple is subjective given the current environment), however, cash flows / delevering allow this to be a wildly successful investment within a wide range of exit multiples and operating scenarios.  The investment case is outlined further below:

o        Stable Free Cash Flow – domestic terrestrial radio is a business with strong economics, with industry EBITDA margins averaging ~30%.  It is one of the larger mediums in domestic advertising, and while margins have held relatively constant over time, growth has slowed due to increased competition for advertising dollars, pressures on ad rates and declining overall advertising budgets (of late).  Despite these factors, radio remains an excellent cash flow business with minimal capex and working capital needs.  For CDL, this translates to over $150mm of FCF in 2008 in our rather conservative base case model.

o        Loose Covenants  / Debt Maturities – CDL’s timing for the ABC radio acquisition financing was ironic for two reasons; (i) CDL bit off too much with the ABC acquisition from a size and leverage standpoint and (ii) CDL purchased ABC Radio right as its performance was deteriorating (large DMAs, discussed above).  CDL is rated B+ / Ba3 due to its ~7.0x basic net leverage (~6.9x adjusted net leverage, see Opportunistic Liability Management).  The Company has 3 classes of debt: a $200mm undrawn revolver, $2,135mm of senior term loans through two tranches (the “Term Loans” or “Senior Debt”) and $330mm of holdco convertible notes (the “Converts”). CDL pays L+150 on the Senior Debt, which is mainly still on the lending banks’ balance sheets as this could not be sold before the credit markets closed in the late summer.  The Senior Debt is truly “cov-lite” as it has only one financial covenant, a max net leverage covenant currently at 8.50x through 9/30/08; stepping down to 7.75x by on 12/31/08, and to 6.75x at 9/30/2010 and thereafter. There is no LIBOR floor or cap, so a 50bps decrease in LIBOR equates to a ~$5mm decrease in pre-tax interest expense (note that we have assumed 5.0% LIBOR throughout the model). Per our model, between repurchasing debt at a discount and harvesting cash / expenses, Citadel should have adequate cushion against its 2008 leverage covenant which, almost completely dictates the success of this investment.

§         Amortization Profile – CDL has no debt maturities until 2011, and no mandatory amortization requirements until 2010 (which are nominal until 2011) which, coupled with loose covenants should allow Citadel to work through integration issues and continue to delever.  Term Loan A has accelerating amortization requirements starting in 2011, with maturity in 2013.  Term Loan B has a similar profile, with final maturity in 2014.  The Converts are due in a bullet payment in 2011.  As a result, CDL has substantial cash flow flexibility until 2011.

o        Asset Sales – CDL’s CEO has stated the desire to sell radio assets with $10mm of EBITDA in both 2008 and 2009 (it should be noted that some stations which are currently inventoried in a trust per FCC mandates, are required to be sold as a result of the merger).  While this is not a great time to be selling radio assets, precedent transactions point to EV / broadcasting cash flow of ~12.5x (EBITDA + corporate expenses). The radio M&A market has cooled considerably from the 2005-2007 peak, it is still open for middle market deals (Radio One / ROIAK recently sold stations for ~$140mm; transaction details are not available but the assets were effectively sold for stick value and were EBITDA break-even).  We suspect that well-capitalized in-market buyers will look at the current weakness to pick up incremental assets at relatively cheap prices.  CDL is trading at ~8.2x LTM EBITDA, so even asset sales at depressed prices should generate accretive returns to the equity.  We expect CDL could generate >$100mm of cash in 2008 and 2009 from asset sales that will be used to pay down debt, although this is not factored into our model.

o        Opportunistic Liability Management – the Company has been actively working with its lenders to reduce leverage. In the past two months Citadel has separately negotiated tenders with both its Senior and Convert lenders to repurchase debt well below par.  These transactions are accretive to the equity, and also signal mgmt is actively working to delever and improve the Company’s financial profile.

§         As a result of the lending banks ’captive’ status as  holders of the Senior Debt, CDL was able to negotiate an extraordinarily unique and accretive tender offer for up to $200mm of Term Loans and only had to agree to reduce the amount of the incremental Term Loans from $750mm to $350mm (which we anticipate will never be utilized).  So far, Citadel successfully tendered $113.3mm at 80 cents and has another 90 days to tender the remaining $86.7mm authorized under the amendment.  The Term Loans are currently pricing at 82 (up from 75 a few weeks ago) as CDL is currently in the market with a tender for an additional ~$85mm in Term Loans, the remainder available under the amendment.  PF for the completed Term Loan tenders (as of 4/1/08), CDL has $1,961mm of net Senior Debt or 6.0x net senior leverage.

§         CDL has $330mm in 1.875% Converts (busted with strike at $25), trading at 85.75, due in 2011.  The Convert holders filed suit against CDL in 2006, claiming it breached a negative covenant with regard to change of control provisions as a result of the ABC Radio merger.  The Company recently entered into a forbearance agreement which resulted in the repurchase of at $55mm (par value) at $0.90 by June 2008 and increased the interest rate to 4.0%.  Citadel has an option to repurchase an additional $110mm of Converts in the remainder of 2008 at 90 cents, or simply repurchase the Converts in the open market (at whichever price is lower, the $0.90 is a cap).  The forbearance agreement is complex and provides an incentive for CDL to take out additional Converts quickly; to avoid punitive interest rate hike if there are >$165mm outstanding on 1/1/09.  Additionally, the Converts now have an effective sweep on any asset sales going forward (this is quite odd given the structural and contractual subordination).  We expect CDL to repurchase $110mm in Converts during 2008, once they have completed the aforementioned Term Loan tender.  PF for the completed Term Loan and Convert tenders, CDL has $2,237mm in total debt or 6.9x net leverage.

Other Notes:

o        Forstmann Little –  owns ~30% of the Company, as a result of an investment that they made in 2001, which has not worked out well.  Forstmann Little controls the board, and though they will want to exit at some point, presumably it will not be now or anytime soon given the share price.  CDL has a nine person board, notably including three Forstmann Little directors and a JPMorgan TMT investment banker.  One Forstmann Little director, Michael Miles, former CEO of Phillip Morris and a current operating partner at Forstmann Little, has purchased ~$1.4mm in CDL shares during March 2008.  This is the only time Miles has purchased a meaningful amount of shares on the open market.   Thomas Reifenheiser (the aforementioned banker) was appointed in Dec 2007, presumably to help the Company work through the anticipated financial / leverage issues.  Reifenheiser is a managing director in JPMorgan’s TMT group, and also sits on the boards of Lamar, Mediacom and Cablevision (JPMorgan is a lead lender in the Senior Debt)

o        Share Buyback – Management has stated that they believe their stock is undervalued and hinted that they would like to do a large share buyback. However, as they need to maintain “maximum flexibility” we anticipate that this will not occur until 2009 at the earliest as mgmt is currently focused on the 2008 leverage covenants.  We do not assume any share buybacks in our model.

o        Conservative Base Case Model – we’ll shortly find out how conservative our base case is (or isn’t).  Of note; (i) the actual operating assumptions include constant annual revenue declines, with consistent margin erosion, without any benefit to a turnaround or change in operating strategy, (ii) exit EBITDA multiple of 9.0x is well below trading comps and precedent transactions, (iii) PF D&A of ~$60mm is a low estimate reflecting the ABC Radio purchase price allocation, and (iv) we assume CDL cannot sell assets.  These are further detailed below:

§         The base case assumes CDL’s revenue and EBITDA show 2007 to 2011 CAGRs of -1.8% and -2.2%, respectively.  This contrasts with industry research showing mid-single digit growth and discredits any operating synergies between CDL and ABC Radio (which management and analysts estimate to be ~$35 / $40mm).  Terrestrial radio’s long-term future is debatable however, mgmt has several growth initiatives (internet radio, HD radio, ESPN radio sales) which could yield positive results.  We believe CDL is ‘managing the covenants’, with a close eye to the only thing that can impair the equity.  They have initiated an aggressive cost-cutting measure and are managing for ‘zero revenue growth’; while this may cause a reduction in future growth / multiples, we believe that we have accounted for that and are more focused on the covenants.  2008 should see a pick-up in terrestrial radio advertising due to the elections; however, while investors may disregard this as a one-time event it provides further assurance that CDL will make its 2008 net leverage covenant.

§         While we do not view this as a multiple play, radio stocks have historically commanded high EBITDA multiples given the excellent operating economics and returns (last 5 years’ average of 13.9x, last three years’ average of 11.3x), and while some multiple compression is warranted given the uncertainty in the economy and advertising trends, we expect any transactions to occur at multiples of greater than 9.0x. 

§         PF D&A of ~$60mm is a low estimate reflecting the purchase price allocation of the ABC Radio assets. Once CDL allocates the purchase price from the ABC Radio acquisition, they will likely write-up a large amount of intangible assets with finite lives (e.g. customer-related assets) which will provide a major tax / cash flow benefit for CDL.

§         The assumption of no asset sales is unrealistic; as discussed, CDL will be forced to sell some stations currently inventoried in a trust, and will look to sell assets with ~$10mm in EBITDA in late 2008 & 2009,  generating ~$100mm in asset sales to pay down debt each year (2008 / 2009).

Valuation / Capital Structure:

At $1.32 per share, CDL’s market cap is $349mm and TEV is $2,586mm; note that the TEV has been adjusted for the completed Senior Debt tender and the first part of the soon-to-be completed Convert tender.  This implies a TEV 2008 EBITDA multiple of 8.3x, and 47% 2008 FCFE on our estimates.  The float is ~180mm shares and average daily volume is ~3.5mm ($5.0mm).

The unique thing about this investment is the leverage and capital structure, so a share price of $1.32 equates to ~47% FCFE.  We think there will be a liquidity event  by 2012 given the debt structure, and using conservative assumptions (e.g. $260 / $270mm of 2012 EBITDA) CDL’s equity should be worth $1.0bn by then, which implies a share price of ~ $3.00, a ~125% gain / ~2.3x multiple of money.  Note that for every EBITDA multiple turn, you create ~$250 / $300mm of incremental equity value (~75% of current equity value), which further illustrates the asymmetric risk / return profile. 

·         We (again) note that we do not view CDL as a multiple play and it is difficult to predict where multiples will stabilize, however, CDL is trading at a discount to comps at 10x LTM EBITDA.  Precedent transactions point to low teens EBITDA multiples (~12.5x over the past three years).  Using a 9.0x TEV / EBITDA exit multiple on projected 2011 EBITDA of $270mm, CDL’s equity is worth $750mm. 

·         Upside case – As noted, on the 3Q07 call, mgmt pushed back on the ~$400mm EBITDA guidance, and guided to ~$200mm in broadcasting cash flow from core CDL stations, ~$40mm in BCF from the radio network business, and ~$200mm from the ABC Radio markets business by 2010; which equates to >$400mm in EBITDA.  It is really too early to gauge the validity of these claims, however, this mgmt case yields a ~$10 share price, with meaningful cushion to the covenants.  The key to this investment is cash flow, as CDL can create meaningful equity value within a wide range of exit multiples and operating scenarios, barring bankruptcy, even with anemic / negative organic growth.

Risks:

• Covenants / Bankruptcy – This is the central risk to our investment thesis, a covenant breach which would bring CDL back to the table with its lenders who would look to renegotiate a market deal.  2008 is the key year, as the year-end max net leverage covenant drops to 7.75x (it is an LTM test, and drops from 8.50x at 9/30/08).  Between debt repurchases at less than par and the core business not deteriorating meaningfully from 2007, we believe CDL should make it through unscathed.  Management is aware of CDL’s precarious financial situation and seems focused on protecting shareholders (mgmt owns ~2% and members of the board have been active buyers recently) by harvesting cash and managing the covenants throughout the year.  S&P assumes that CDL ends 2008 with ~6.5x net leverage, whereas the Street’s consensus estimates of $275mm implies the Company brushes right up against the covenant (again we view the Street’s estimates as not accurate for leverage purposes). Our base case shows 2008 net leverage of 6.7x, well below the 7.75x covenant.
• Industry Trends – traditional mediums for advertising continue to lose share to new / emerging alternatives, which are generally more targeted and offer more detailed feedback / ROI info regarding the effectiveness of advertising.  Traditional radio continues to lose share to satellite and internet radio, and the recent XM / SIRI merger may accelerate this trend.
• Macroeconomic Trends / Recession – CDL’s revenues are completely (directly and indirectly) tied to advertising spending, which is obviously cyclical and will fluctuate with trends in the broader economy.  The retail and automotive sectors have seen pronounced weakness, and it is unclear when these trends will reverse. 

Catalysts:

• Continued Debt Repurchases / Delevering – this is central to the investment thesis; and has gone relatively unnoticed by the street (it only made Bloomberg headlines in late March).  CDL creates ~$1.20 in equity value for every $1.00 they repurchase at $0.80, which also frees up covenant capacity.  The same can be said for the Converts, where CDL will be repurchasing at $0.90, and has an incentive to take out more as the interest rate resets depending on the amount of Converts outstanding on various future dates. 
• Asset Sales – CDL will be looking to sell ~$100mm in radio assets per year in (late) 2008 and 2009.  A completed sale would likely be accretive to the equity via (i) multiples (ii) the acceleration of additional debt paydown at less than par, which would give further cushion to the leverage covenants.  We understand that in-market buyers are still able to pay premium prices in the current market environment (historically can pay 1.5x – 2.0x higher due to operating synergies).  We are not modeling or relying on an accretive sale, although it would not be difficult to achieve given current trading levels.
• Improvement / Stabilization in Performance – We believe that investors are looking for a bottom in performance, which is admittedly impossible to pick.  2007 EBITDA declined to $325mm from ~$345mm in 2006 and investors are wondering how much further CDL can fall.  We do not claim to know what this bottom is, however, EBITDA of $275mm feels light.  Victor Miller, the well-respected Bear Stearns analyst, pegs 2008 EBITDA of $325mm.  The consensus numbers for 2007 seem off, as $275mm EBITDA is difficult to reconcile after sifting through the individual estimates (note the above point on stock-based compensation).  Mgmt stated (on the 4Q07 call) that they’ve seen improvements in the business from 4Q07 to 1Q08 as a result of programming changes and increased advertising from the elections (an amount we expect to be quite material especially as the primary election drags on).

Conclusion:

In conclusion, we believe the decline in CDL's stock price as led to an asymmetric risk / reward payoff that should reward investors with a >100% return in 2-3 years as Citadel continues to generate strong cash flow returns and delever its balance sheet, while giving investors the option of outsized gains (>400%) should operating performance improve.  We’d note that CDL reports Q108 results on Thursday May 8, and we do not expect stellar results.  Recent news and research suggest further weakness across the board in the terrestrial radio sector.  The stock is obviously extremely volatile given the leverage, share price and sector – and this is a different investment at $1.20 / $1.30 than at $1.90 / $2.00. Given sentiment in the sector and this specific name – it would appear that weak operating performance is priced in; a positive catalyst from Q108 results could be through the clarification of certain numbers (e.g. debt tenders, covenant compliance, LTM numbers, directional guidance on the business).  We’d note that in the past week we have seen several industry / wall street notes that peg CDL’s leverage in the double digits, suggesting there is still significant market confusion here.