Radio One ROIAK
September 07, 2005 - 1:31am EST by
hubie90
2005 2006
Price: 13.64 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,444 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Radio One shares (ROIA and ROIAK) present a rare opportunity to buy an excellent business at a great price. Radio One is the primary media vehicle in the U.S. geared towards African-Americans, as over 30% of African-Americans tune into the company’s 69 radio stations weekly. With both the strongest business plan and management team in the radio industry, Radio One has leveraged the superb, low capital expenditure, advertiser-driven economics of the radio business more successfully than any of its peers.

The intrinsic strengths of the radio business and the quality of Radio One’s management team have created an eye-popping ROC, which is currently in excess of 100% and is even higher on a marginal basis (projected 2005 EBIT of $163 million, divided by Net Working Capital and PPE of roughly $50 each). The radio industry’s low capital intensity and intrinsic moat position place make it one of the more attractive U.S. industries, and I believe that Radio One is by far the strongest company in the U.S. radio industry. Furthermore, Radio One management has begun to capitalize on the strength of its radio assets to create other valuable media assets, most notably its 36% ownership stake in the cable channel TV One (co-owned by Comcast, DirectTV and others), which was launched in January 2004 and will have 40 million subscribers by 2007.

Amazingly, despite the enduring strength of its business, Radio One is very cheap. Radio One should produce $0.95 - $1.00/share of FCF in 2005 and $1.20/share of FCF in 2007. Because FCF is such an abused and misused term, I’ll beg your patience to define it for the sake of this writeup: FCF is the CASH that it is available for distribution to shareholders after ALL expenditures to grow the business (which means both capex and incremental net working capital increases) have been made. So, with that said, let me take you through how I came up with $1.20 in FCF for 2007.

$198 million in 2007 EBITDA (based on 6% increases in both 2006 and 2007)
- $13 million in capex (DA is currently $13 million and capex is predictable and has consistently been around $12 - $13 million)
- $3 million in incremental net working capital needs (based on the assumption of unchanging Revenue/NWC relationship)
- $55 million in interest on debt
- $11 million in taxes (please see detailed explanation below)
- $7 million in minority interest (Reach Media)

EQUALS $109 million in 2007 FCF

Radio One currently has 105 million shares. In June, a $150 million, 18-month share buyback program was instituted. Over a million shares were purchased in June, and, as I will discuss later, I believe that management will actually buyback the full $150 million worth of stock. Given that Radio One is currently producing about $100 million in FCF/year, the current buyback plan still leaves $150 million in extra FCF from 2006 and 2007 (roughly $300 million in FCF from 2005-2007 minus an approved buyback program of $150 million). For the sake of simplicity, let’s assume that this FCF also goes toward stock repurchases. Assuming an average purchase price of $17, share count would be reduced to 88 million shares. $109 million/88 million shares equals $1.24 FCF/share.

Current broad market P/FCF is 24 (source: Morningstar), which is also the broad market’s historical P/FCF (i.e. FCF/{.10 expected return - .06 long-term FCF growth rate} equals a 25 P/FCF, as per pre-1980 historical dividend yield of 4%, when share repurchases were under 5% of earnings as opposed to over 50% currently). Radio One currently trades at 11x projected 2007 FCF. The market’s current valuation of Radio One shares treats the company as if it were on its deathbed. In reality, the company is thriving.

So, let’s go through the perceived “catches” that would explain what would seem like a huge bargain. The most obvious concern would be Radio One’s long-term organic growth rate. I believe that the market’s misperception of this very issue is the cause of Radio One’s depressed share price. In a nutshell, the terrestrial radio industry’s recent slump has transformed it from a favorite of “growth investors” to the ranks of the hated.

Although the radio industry is still mired in a slump (although one not terribly different from past slumps), Radio One has consistently outpaced overall radio industry growth in a big way. Even in the very lean years of 2002-2004, Radio One’s same-station revenue growth rate was 4.5% - 5%/year, about 150-200 basis points higher than broad industry revenue growth during that period. In the most recent quarter, Radio One’s same-station growth rate was 6%, 500 basis points over the industry average. Nevertheless, Radio One has been tarred by the radio industry’s tough patch over the past 4-5 years. With that in mind, it bears mentioning that radio industry’s long-term revenue growth has been 7-8%/year, and its operating earnings and FCF have grown even more quickly than revenues and still do so because of continuing consolidation. In any case, suffice it to say that I believe Radio One’s long-term organic growth rate is near or above the broad market’s 6%, especially when you consider that Radio One is creating value in the form of non-radio media assets such as the aforementioned TV One, which are not yet producing gains on the bottom line but are clearly very valuable.

A second obvious concern in a P/FCF analysis is the use of leverage. Radio One currently has $920 million in net debt ($340 million of which is at floating rates), with a blended average interest rate just above 6%. With interest charges of $55 million/year, and projected 2005 EBIT of $163 million and 2007 EBIT of $185 million, Radio One has interest coverage of 3.0x in 2005 and 3.4x in 2007. As such, I would hardly describe Radio One’s FCF as the product of perilous use of leverage.

A third concern relates to Radio One’s widely misunderstood tax situation. Having read through the Wall Street research on the company, very few analysts seem to a clue about the tax basis of the company’s assets or the duration of its tax shield. As a result of acquisitions made with a written-up basis for depreciable intangibles by means of asset sales and deemed asset sales in 2000-2001, the company will be able to shield around $100 million of income/year from cash taxes for the next 10 years, at which point this amount will decline very rapidly. I should add that we have confirmed this fact with management.

But yes, this large tax shield is not permanent. However, Radio One’s TV One stake currently does not contribute FCF, but it will as early as next year according to management. While analysts’ assessment of TV One’s value varies at this point in time, a consensus number for Radio One’s 36% stake is roughly about $300 million. I believe that there is a substantial possibility that TV One will be worth far more than this estimate (a more in-depth description of TV One can be found at the end of this report), but let’s use this number as a starting point for estimating TV One’s ultimate contribution to Radio One’s FCF.

Assuming that TV One’s value grows at an extremely conservative 6%/year for the next 10 years, Radio One’s stake would be worth $540 million by 2015. At that value, TV One’s FCF yield would need be only a meager 7.4% by 2015 to make up for the $40 million/year in cash of tax savings that would drop out at that time.

So, even assuming that Radio One trades at 20x FCF in 2007, we’re looking at $25/share. If Radio One gets the broad market’s P/FCF of 24, we’re then looking at $30/share in 2007. Additionally, I believe that there exists as much as $3 – 6/share of option value/additional upside from TV One (please see the section on TV One at the end for discussion of this issue).

In terms of an EV/EBIT analysis, Radio One’s currently has a market cap of $1.44 billion and net debt of $920 million. Adjusting for roughly $300 million of FCF in 2005-2007, a present value of the aforementioned tax assets of $295 million and the 36% stake of TV One at $300 million, the current share price would make for $1.465 billion in 2007 EV of Radio One’s radio operations. Using the previous 2007 EBIT estimate of $185 million, the radio operations’ EV/EBIT would be 7.9.

To put this number in context, even in the currently very soft market for radio stations, stations of any quality at all are expected to fetch a minimum of 14-15x EBITDA, which converts to about 16-17x EBIT. Given the relative quality of Radio One’s portfolio of stations, its private market value is probably more than double the implied valuation 2007 EBIT of 7.9x. While I have no reason to believe that Radio One will be sold or even sell any radio stations, the point of this exercise is to give a sense of how cheap Radio One shares currently are. Companies with 150% ROC and organic growth rates of at least 5-6% don’t often go for 7.9x EBIT or half of private market value.


As noted earlier, the biggest cause of Radio One’s current valuation is Wall Street’s general repulsion towards the entire terrestrial radio industry. The current sentiment surrounding radio stocks is a 180-degree change from the situation just five years ago. Beginning in late 2000, the U.S. advertising market softened significantly, creating a reversal from late 1990s enthusiasm surrounding radio stocks that brought unprecedented, nosebleed valuations. With billions in stock market value lost, slow growth in advertising revenues from 2000-2004 and the threat of satellite radio, terrestrial radio stocks are now very much amongst the hated.

The question, of course, is whether this hatred is justified. One means of addressing this question is to determine whether the sources of the sentiment are valid. Regarding the first issue, the fact that billions have been lost as a result of stock purchases at absurd valuations has absolutely nothing to do with the current value of radio stocks in particular and Radio One specifically. However, I believe that it has very much colored Wall Street’s views on the real issues facing the terrestrial radio industry. More to the point, the evidence does not corroborate current views regarding radio.

These issues will be explored in greater depth in the body of the report, but I will include some highlights here to consider. First, the slow growth in advertising revenues during the 2000-2004 period is not terribly different from the previous advertising slowdown from 1990-1993. Overall, advertising revenues for terrestrial radio have grown at 7%/year over the past 15 years. Second, the concern regarding the impact of satellite radio seems wildly overdone. XM’s and Sirius’ business plans are fraught with dubious assumptions regarding operations and financing that are currently being ignored with the enthusiasm surrounding their stock prices’ momentum. Further, it bears mentioning that even the biggest satellite bulls/terrestrial radio bears project long-term low single digit advertising revenue growth for terrestrial radio overall and mid-single digit advertising revenue growth for Radio One’s existing stations. With this being the assumed worst-case scenario, Radio One’s current valuation is nonsensical.

Led by co-founder/current Chairperson Catherine Hughes and her son/current CEO Alfred Liggins, Radio One has grown by acquiring under-performing stations, reprogramming them to fit the company’s African-American focus and consolidating sales, technical and business functions. Radio One continually towers over its peers in terms of EBITDA margins (48% in 2004). Its traditional turnaround expertise is coupled with a focused programming approach that has allowed the company to more successfully execute the station “clustering” strategy than any other company in the industry.


RADIO ONE’S HISTORY IN BRIEF

Radio One is lead by founder and Chairperson Cathy Hughes (8% ownership) and her son, CEO Alfred Liggins (10% ownership). The company was founded in 1980 when Hughes, a former broadcast lecturer and station manager at Howard University, bought a Washington D.C. station for $1.5 million in a FCC distressed property sale. With lenders highly weary of the radio industry because of profit-killing FCC restrictions on multiple station ownership, Hughes was turned down 32 times before receiving a loan approval. Shortly thereafter, Hughes and Liggins, her teenage son, literally took up residence at the radio station’s office, with Hughes working as both on-air host and station manager.

After the success of its initial station, Hughes sought to purchase undervalued and under-performing stations in the Maryland/D.C./Virginia area that could benefit from Radio One’s efficiency in managing costs and ability to increase ratings by aiming programming towards African-Americans. Radio One’s turnaround expertise became the company’s hallmark during the late 1980s and early 1990s. By this time, Hughes had begun to turn over the reins to Liggins, who had worked at the company since its inception, with breaks only for college and getting a M.B.A. at Wharton.

In 1996, the radio industry was turned upside down by the passage of the Telecommunications Act. Previously, strict federal restrictions on multiple station ownership had made the radio industry unattractive to lenders and investors. While the FCC slowly began to ease some restrictions in the 1980s and early 1990s, forced fragmentation remained the rule. The Telecom Act quickly unleashed massive consolidation within the radio industry by allowing the ownership of up to as many as 8 stations in a local area by a single company. In the wake of the Telecom Act, Radio One was forced to pick up the pace of its acquisitions. The company also installed multiple share classes, so as to protect the Hughes and Liggins from a takeover and to allow management to run the company with a long-term focus. Hughes and Liggins control 18% of the company’s economic value, but 56% of the company’s voting rights.

At the time of its May 1999 IPO, Radio One had expanded to 26 stations from just 9 stations at the beginning of 1998. The company’s continued success in integrating acquisitions and the general euphoria surrounding radio’s annual double-digit gains in advertising revenues during the late 1990s made for a hot IPO. The IPO however only set the stage for more important events to come. In late 1999, the FCC required that Clear Channel divest over a hundred stations in order to receive approval for its merger with AMFM. Upon the news of the FCC order, Radio One stock soared to over $90 ($30 split-adjusted) in anticipation of station purchases from Clear Channel.

In the end, Radio One acquired 12 stations from Clear Channel for $1.3 billion, roughly doubling the size of the company. The deal was radically different from anything that the company had attempted before. First, while almost all of Radio One’s previous acquisitions were based on the company’s turnaround strategy, the Clear Channel stations were highly valued properties with seemingly little room for operational improvements. Second, Radio One’s geographic scope broadened into the Los Angeles, Houston, Miami, Dallas and Cleveland markets. Management’s ability to execute its strategy in such far-flung markets would be greatly tested. Finally, the company also had the task of integrating the acquisition of another 29 radio stations purchased in the same February 2000 to February 2001 timeframe.

Despite its faltering stock price, Radio One’s operations during the 2000-2004 period have been a tremendous success. Radio One has actually boosted its industry-leading EBITDA margins during this period, and individual stations’ ad revenue growth has consistently outpaced the overall industry. Nevertheless, despite the operating successes, the decline of Radio One’s stock price, in line with other radio stocks, has suppressed enthusiasm regarding the company’s growing strength.


RADIO ONE’S SUPERIOR BUSINESS OPPORTUNITY

Radio One is now the primary media vehicle serving the African-American population, with all of its 69 stations located in top 60 African-American markets and 39 of its stations clustered in 14 of the top 20 African-American markets. It is first or second in terms of numbers of American-American listeners in every market it serves with multiple radio stations in markets programmed in different formats such as Urban (18-34), Urban Adult Contemporary (25-54), Urban Talk (25-64) and Gospel (25-54) to serve varied tastes within the African-American community.

The advantages of Radio One’s strategy are many. First, the African-American population remains highly concentrated, with 70.3% of the African-American population located in just 60 radio markets. This allows Radio One to reach their target market with fewer stations and fewer formats. Acquisition activity has significantly slowed since 2001, as only 6 radio stations have been added in the last 4 years.

Nevertheless, Radio One’s focus allows it to generate significant growth without expanding its station portfolio. The African-American population is growing at a faster pace than the overall U.S. population. During the 1990s, the African-American population grew 21.3% versus non-African-American population growth of 12%. The U.S. Census Bureau expects this trend to continue in the current decade, with African-American population expected to grow 9.9% versus non-African-American growth of 6%.

Further, African-American income growth continues to significantly outpace the overall population. From 1980-2003, African-Americans’ income grew 55% versus overall population income growth of 41.3%. African-Americans’ buying power has increased to 8.5% of the nation’s buying power in 2004 from 7.4% in 1990. Most importantly, consumption profiles and patterns for the African-American population differ from non-African-Americans, requiring corporations with large advertising budgets to avail themselves of media outlets that offer a critical mass of African-Americans. The results of this sea change are already apparent. By 2004, advertising targeted to African-Americans had reached $2.5 billion from only $803 million in 1993. There is reason to believe that we are only in the beginning of a major change, as major U.S. advertisers generally still devote 2-4% of their advertising budgets to African-Americans, who comprise 14% of the U.S. population.

Of course, all the positive demographics in the world would not mean a thing unless Radio One holds a defensible niche that will allow it to benefit. On this point, there are the company’s roots in the communities it serves and the important function that African-American radio stations have held in African-American communities throughout time. With coverage of the African-American community lacking in mainstream newspapers and television, radio has been the traditional provider of news and information for the African-American community. This is the reason why surveys find that African-Americans listen to the radio 15-20% more on a weekly basis than the overall population. As will be discussed in the reports section on satellite radio, the ability of a single proprietary national radio network to replace this traditional function seems almost absurd.

On the basis of the foregoing analysis, it is very hard to rationalize Radio One’s depressed valuation. Wall Street has extrapolated terrestrial radio’s slow growth into eternity, despite little evidence that it truly varies significantly from previous advertising slowdowns. Additionally, while Wall Street research widely agrees that Radio One’s existing stations should provide mid-single digits growth with close-to-nil in necessary capital investments, there has been no attempt to distinguish Radio One’s prospects and valuation multiples from other radio stocks. It almost seems as if repulsion has turned to complete indifference.


IS SATELLITE RADIO A THREAT?

The decline of terrestrial radio stocks coincides with the meteoric rise of satellite radio providers XM and Sirius. Despite having only a combined 5 million subscribers and large continuing losses even before financing costs, Wall Street has valued the two companies at $15 billion- premised on the belief that the satellite providers will take a huge chunk of the current terrestrial radio audience. The assumptions that support the stratospheric valuations of satellite stocks and depressed valuations of terrestrial radio stocks deserve some examination.

The key assumption is rapid subscriber growth that will make the satellite companies financially viable. JP Morgan has done a number of reports on this issue, and projects that subscriber count will reach 35 million by 2010. The basis for this and other projections of rapid growth is that satellite radio is basically akin to the internet, and will grow at the same pace. This assumption seems bizarre- there is no significant network effect that makes satellite radio a necessity for consumers and businesses. Furthermore, there is already 8% customer attrition for satellite radio services- and these customers are the “early adaptors” of the new technology. Finally, JP Morgan’s research surveys show strong price sensitivity amongst non-subscribers. 79% stated that they would not consider paying more than $10/month and 91% would not consider paying more than $15/month. With Sirius currently priced at $13/month and XM priced at $10/month and both companies still suffering large operating losses, how will these companies be able to fund programming that compels price-sensitive consumers to pay for radio?

A large part of satellite radio’s appeal has derived from proprietary niche offerings such as Sirius’ Howard Stern Show (for which they will pay $100 million/year beginning next year) and out-of-town NFL broadcasts and XM’s former NPR host Bob Edwards and out-of-town Major League Baseball broadcasts. This is the basis for rapid growth assumptions? How does this seriously challenge Radio One’s hold on its audience?

To be safe, let’s look at what could happen if I am wrong for doubting these growth projections for satellite radio. JP Morgan assumes that its high-growth scenario will cost terrestrial radio annual listener losses of 2%/year, based upon the mixed use of satellite versus terrestrial radio and the blend of car, home and office listening. Audience loss is countered by projected ad pricing growth per listener of 5.5%, adding up to total growth of 3.4%/year. On this point, it strongly warrants mentioning that network television has increased ad revenues at 6%/year during the last 10, 20 and 30-year periods, a time in which it has lost over 40% of its audience to cable. The lesson being that even if audiences become more fragmented, media outlets that offer critical mass to advertisers become increasingly more valuable.

NOTE: THE END OF THE WRITEUP WAS CUTOFF BY SPACE LIMITATIONS FOR THE VIC'S SOFTWARE PROGRAM. THE REMAINING PARTS ("TV ONE" AND "CONCLUSION") CAN BE FOUND ON THE MESSAGE BOARD.

Catalyst

-Greater awareness of Radio One's superior performance to its terrestrial radio peers.
-An broad rebound in advertising revenue growth for terrestrial radio companies.
-Continue success of TV One
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