Starz (NASDAQ:STRZA) was taken to the proverbial woodshed on Friday; shares fell a whopping -22.2%. The steep decline followed a sharp +6.9% jump that had taken place the day before on reports of merger talks between STRZA and Lions Gate Entertainment (NYSE:LGF). The drop on Friday in STRZA appeared to relate to a -27.2% decline in LGF because that same day LGF reported an uncertain outlook and earnings that missed Wall Street consensus. The declines in STRZA and LGF, respectively, came on a volatile day in media/tech; with LinkedIn (NYSE:LNKD) plummeting -43.6% and the Nasdaq down -3% overall. Monday, STRZA fell another -4.1%, but LGF managed a +3.3% gain while QQQ finished down -1.8% after touching an intra-day low of -3.3%.
So, what now? Was the market action in STRZA these past two days a warning sign that the company will never merge and live out the rest of its days in quiet, strategically disadvantaged, obscurity? To us, it looks like an opportunity to buy something statistically cheap that still has M&A prospects.
First, John Malone controls a 31% voting interest, and has been involved with the company since its formation. He's a media tycoon known for his deal making prowess. Second, AMC Networks (NASDAQ:AMCX) was reported to be in conversations with STRZA in the fall of 2015 (and those conversations may be ongoing). While LGF may have a cozy relationship with STRZA, AMCX is a better strategic fit because a combination would enhance negotiating power in carriage agreements with cable companies. Third, prospective acquirers would be more interested in a deal today because STRZA is 25.4% cheaper in the space of two trading sessions. Nothing has happened to the cash flow or business - only the market's belief in a merger with LGF. A large part of the shareholder base owned this name for a deal, and with the chances of a deal looking lower, they have headed for the exits all at the same time.
A merger between STRZA and either LGF, AMCX or Scripps (NYSE:SNI) would require all stock consideration to prevent excess debt in any newly combined entity. An all-stock deal allows for the possibility of both stocks getting taken upward if Wall Street believes the transaction accretive. Our math says that an accretive all stock deal (even before the fall in STRZA's share price) with either AMCX or SNI could be easily done at $40/share with only modest synergies (i.e. sub 3% of pro-forma revenues).
LGF and STRZA have a strategic relationship whereby LGF has a 2% economic and 13% voting interest in STRZ. This LGF/STRZB voting share relationship was a consolation prize for the failed 2014 auction of STRZA, and made decent strategic sense on the view that STRZA could syndicate content created by LGF - and LGF could make original shows for STRZA. STRZ has A shares and B shares, the B shares carry 10 votes and the A shares carry one vote. So, LGF just bought a bunch of B shares last year from John Malone, and that is how they hold their 13% voting interest. It would be straightforward for LGF to unwind its STRZB holding by tendering the B shares as would any other shareholder in response to a takeover.
The board of STRZA was reported to have held out for too high a price in the failed 2014 auction. One wonders whether the 25% fall-off will humble the board and make them more receptive to getting a deal done.
STRZA is now on 10x levered free cash flow and roughly 7.5xTEV/EBITDA. The share price reflects no merger premium whatsoever. Some say linear TV channels such as Starz/Encore are obsolete, but it's worth noting that anyone can watch the channels on demand on a tablet or smartphone. An 'over the top product' seems inevitable at this stage, given recent forays by HBO and Showtime. The bottom line is that in spite of the mix shift and dead weight subscriber losses created by cord cutting, STRZA has leading content that viewers want (thanks to long-term agreements with movie studios). The ability to monetize content and manage the mix shift from TV to mobile/OTT is the major uncertainty for all cable channels. At today's price (i.e. 10% free cash yield) the market is not baking in the assumption of any growth.
No doubt, STRZA has been taken to the woodshed as those who owned the stock in hopes of a deal have all rushed for the exit at the same time. But when others are fearful, shouldn't we be greedy?
Disclosure: I am/we are long STRZA.
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