Radio Companies: Untapped Value at Apocalyptically Low Levels

by: J.P. Hannan

Much has been made of radio's troubles of late, with most radio stocks now sitting at 5 year lows. Station operating costs are rising dramatically and yet revenues are projected to be relatively flat again in 2008, even with the surge quadrennial political advertising usually brings.

Many companies have cut research, marketing and other key investments in their product beyond a point they feel comfortable with just to limit the damage to the bottom line. Many corporations over leveraged themselves in order to consolidate in the earlier part of this decade, and now they are unable to make needed investments to grow their business and compete in the digital age due to debt service and restrictive covenants. Most of the economic benefits of that consolidation are now baked into the financials, so there is very little in cost efficiencies to be had by most major groups, and they have little capacity to take on more leverage to acquire additional stations.

Consumers now have more devices to listen to radio content than ever before including PCs, mobile phones, and iPods and other nonlinear devices, but they also receive competing content sources on those devices as well. The mainstay of the radio dial, music, can now be listened to virtually anywhere, anytime, for little to no cost and no matter how niche one's musical tastes are there is someone in the digital world ready to scratch that itch- commercial free in most cases. To offer more choice to local listeners, radio broadcasters have introduced a great new technology in HD Radio, but this has been bashed by many due to the low penetration of receivers, particularly in vehicles.

Further, while this has the potential to triple the FM capacity of stations and greatly enhance overall sound quality of the music heard, it also has the detrimental consequences of radically furthering market fragmentation, lowering ratings, and lowering rates. Adding insult to injury, there is a growing movement afoot by the Recording Industry to do away with radio's exemption from paying a performance copyright royalty. If these efforts are successful, the toll to the bottom line could be substantial according to some industry analysts.

The circumstances of the radio industry certainly seem pretty bleak. Operating margins are still relatively high compared to most other businesses, but unfortunately so are debt loads that eat up a great deal of those cash flows in interest payments. What cash is left over the past several years has primarily gone to buying back stock and funding dividends to shareholders, largely to make up for the lack of performance elsewhere in these stocks.

With all of those issues on the table one has to ask, particularly before becoming an investor in the sector, is there anything positive about the current state of the broadcast radio industry? Of course, the answer is resoundingly, YES.

According to the Radio Advertising Bureau, radio stations still reach 72% of all consumers, each and every day. The radio industry still books more than $21 billion dollars of revenue annually, an estimated $15.5 billion coming from local advertisers which is an area still largely untapped by the new media players. There are close to a billion analog radio receivers already installed in the marketplace giving it a wider distribution platform than virtually any other medium. There is an extremely high barrier to new entry into the marketplace since these broadcast licenses are heavily regulated by the Federal Communications Commission, and few new licenses, if any, are granted these days. HD Radio technology will enable broadcasters to expand choice, and if nothing else could be a great defensive tool to stem further defections to satellite services such as Sirius or XM Radio. HD Radio also holds the potential to allow for new revenue streams from wireless distribution opportunities for terrestrial broadcasters. Most recently, a deal was announced to include HD Radio technology factory installed by Ford that compliments the existing arrangements with Saab and BMW.

So what is a radio operator to do? How does the industry break from this conundrum it is in? How does an individual radio operator properly service its debt obligations, make needed investments to grow its products, invest in new technologies for the future, grow its share of the existing marketplace, raise rates, and create real shareholder value all at the same time in a marketplace that has been flat for years with little prospect for revenue growth in sight? It could be, barring some radical innovations at the local level, they just simply can't.

It may be that the larger issue at hand is that the business model has evolved and one radio company today simply can't do it all. Today, there may be just too many competing interests at hand. The real problem could be that the broadcasting industry today is actually two separate businesses with two separate sets of challenges and two separate opportunities for investors.

On one hand, broadcasters are in the content creation and exploitation business and on the other the audio distribution business. The content business (i.e. programming a radio station and selling to advertisers) requires a great deal of ongoing capital but has tremendous upside and growth potential with extremely high operating margins. The distribution business (i.e. acquiring and owning a broadcast station) requires a great deal of upfront capital, but once the asset is acquired, the upkeep is minimal. A content provider wants to get their product out through as many distribution channels as possible to reach more customers and grow sales. A distribution provider wants to maximize the investment they've already made in their assets to squeeze out more return on investment.

Put in another context, an electronics retailer needs to focus on selling the best technology at the best possible prices to the most customers. They spend heavily on advertising to make their customers aware of new products and promotions and constantly invest in new inventory. They rent their storefront from a mall operator. The mall operator on the other hand, secures the real estate, builds and maintains the building, and finds the most attractive tenants possible (such as the electronics store), collecting rents from them at either a fixed rate or by taking a percentage of its tenants' sales over a long period of time. If the location doesn't suit the needs of the retailer or the mall operator doesn't take care of its tenant, then the retailer finds a new landlord. If the retailer isn't paying its bills or another retailer can bring in more rent, then the mall operator gets a new tenant. The retailer is able to put its resources towards building its ongoing business, and the mall operator gets a steady, consistent return on the investment it has made. Investors looking for growth back the electronics retailer, while other investors seeking a more secure, lower return investment back the mall operator.

By spinning off their content business into a separate company, radio station operators could potentially address the issues they currently face and build value for shareholders. The debt would still continue to be secured by the underlying broadcast assets, and paid down from the rent they receive from the content companies. They could also seek additional tenants, potentially new entrants into the radio space (including minority broadcasters), for HD Radio channels to maximize investments there without having to invest additionally in building these new programming ventures from the ground up. They could further seek wireless tenants who want to use the spectrum for data transmission unrelated to radio, and let the tenants worry about building the receive devices or the user interface.

The spin-off, the content company, could then seek new investment and develop a capital structure more conducive to its ongoing needs. Programming investments could be made that deficit finance for some period, but pay off handsomely. Commitments to research and marketing could be maintained even during down economic periods. This would enable them to compete with the internet players who use this very strategy. The content company could also then maximize distribution on other outlets, such as cell phones, PC's and any new technologies. In a Wi-Max world, there could become a day where the over the air broadcast radio signal becomes as ancillary as the over the air television signal is today (in that most television viewers watch their local television stations via cable or satellite subscriptions- or online). Current investors could ultimately hold both shares, or sell one to focus on their individual investment needs, whether seeking income or growth, etc. The two businesses could seek opportunities individually in future that may otherwise be limited under the current structure.

This business model is frankly not unheard of today in the radio sector, as a number of stations do time brokerage and individual lease deals to third parties with great success. However, no one has done it at the corporate level in radio. It has been done effectively in other sectors of media though. The most notable example was the spinoff of Liberty Media (LCAPA), the programming arm of TCI, a cable television giant eventually acquired by AT&T (NYSE:T). While TCI helped launch a number of cable channels Liberty now owns, eventually independence was needed to allow this content company to reach its full potential and maximize value to investors. In fact, after a spin-off, the radio distribution company would look very much like a cable MSO does today- a local network of channels programmed by third parties.

The current broadcast television model isn't that far from this concept either since most television broadcasters fill the bulk of their daily programming with a network affiliation and syndicated programs. A few hours per day of news programming generally is all that is produced locally at most television stations today, and in fact many don't produce any news at all. Television broadcasters have also begun to maximize their digital television spectrum through HD multicast, sometimes programming it themselves but more often affiliating with a third party.

Only the radio sector continues to try to do it all- to be all things to all people, and right now it seems no one is happy. There is a tremendous amount of untapped value in these companies, but extracting it will require broad vision and bold actions. For investors though, the upside could be tremendous from these apocalyptically low levels.

Disclosure: none