Radio Value Opportunity Beckons: Calling Warren Buffett

As I was reading Warren Buffett’s latest annual letter to Berkshire Hathaway, Inc. (BRK.A) (BRK.B) shareholders (to anyone who hasn’t, it’s a must-read), I was fascinated by his description of what types of companies he looks to acquire. He categorizes companies into three groups that he dubs “The Great, the Good and the Gruesome”.

Of the “Great Ones”, Mr. Buffett says he and his longtime partner, Charlie Munger, “look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.”

He further adds, “We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.”

As I read that description and the explanations that followed, what jumped out most to me is how tailor made an investment in the radio industry is for a company like Berkshire Hathaway right now. I realize every prognosticator and their brother has a suggestion for Mr. Buffett, and that Mr. Buffett is a man who certainly doesn’t need suggestions, least of all from me. Still, as I read his letter further it seems to make a whole lot of sense for his company to take a look at this beaten down sector.

Most CEO’s in the radio industry will tell you that the single most frustrating aspect of their jobs of late is that the good stories just don’t seem to get any attention, and that they just don’t seem to get any credit on Wall Street for the things that the radio industry does right. Instead, the radio industry has been called a “dead industry” by Jim Cramer, and the few analysts who still cover the sector seem to focus entirely on the industry’s lack of top line growth.

This has forced many companies in the space to invest heavily in new media and interactive initiatives that hold great promise for future revenue generation, but take radio sales people and management at the local level out of their comfort zone with little to no interactive ad sales training. This has further led to questions of whether broadcasters are now spending too much time chasing too few dollars, and not “sticking to their knitting” with their core business.

Radio broadcasters, it seems, just can’t get a break, and the stock prices of solid companies have seen significant declines over the past twelve months. Perhaps the problem is that these companies aren’t broken, they just have the wrong financial partners. Instead of the public markets or private equity groups that demand accelerated growth and heavy debt loads to fuel premium returns, perhaps the industry should be looking to the likes of Warren Buffett and his “slow and steady wins the race” style of investing as an alternative and better fitting source of capital.

To address Mr. Buffett’s first required quality, radio is a business that is very easy to understand. One would be hard pressed to find anyone in the United States or any other developed nation that did not understand the concept of a radio broadcast. The business model is simply to aggregate as many listeners as possible within a targeted demographic and then use that audience to sell an advertisement to an appropriate client for the highest rate possible. While it can be a challenging model to execute effectively, it’s definitely not rocket science.

Buffett says in his letter, “A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.”

The Radio industry has that wide moat in its free, over the air signal and almost 1 billion installed receivers already in the marketplace. Satellite radio operators Sirius (SIRI) and XM Radio (XMSR), are finding it challenging to compete in this 80+ year old industry where they are attempting to charge a subscription rate for a product that is already widely available for free to consumers. Not to say that satellite can’t carve out its own niche based on music choice and commercial free programming, but to most of America “free” is a pretty compelling price point and ultimately provides a very wide moat for competition to try to cross.

Buffett further says in his letter that “Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.”

This addresses one of the more interesting conundrums that radio now faces. The industry has largely remained the same for most of its tenure in the media landscape, but is now being told it must change to adapt to modern times to compete with digital media platforms. It’s this lack of change that has the Cramer’s of the world counting it out, but maybe what is “dead” to Cramer would be viewed as “enduring” and stable by a man like Buffett.

Buffett summarizes his ideal acquisition candidate by saying

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Organic growth is the issue that the radio industry has had the past 7 years. The industry has not lost much ground at all revenue-wise, though based on the stock charts one would think it has seen massive declines over that time. It just has not gained any ground during that period, and has been severely penalized as such. The industry generates tons of cash for its corporate parents that have used these proceeds to fund heavy share buybacks, dividend payments and debt service payments, but still most saw their shares plummet. It is not uncommon for a well run radio operator to see gross margins in the 40-50% range. There are some operators who achieve even higher- results most other industries would covet.

A company like Berkshire Hathaway could buy a well run radio operator (or several) and continue to reap the benefits of a very high cash flow, indefinitely. This cash flow could fund the acquisitions of numerous other companies for its parent company, even though its growth rates remained relatively flat and otherwise unsexy to the broader market.

In discussing his third requisite of a great company—management—Mr. Buffett says, “Additionally, this criterion eliminates the business whose success depends on having a great manager”. Further, “if a business requires a superstar to produce great results, the business itself cannot be deemed great.” He uses the example of the doctor’s office, “A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”

This further expansion of his concept of a great business also hits radio’s button. One of the things I’ve always enjoyed about working in the broadcasting business is that there truly is no one person in a local station that is the “most important” person. Radio is a collaborative effort that requires great on-air talent and program managers, aggressive and well connected ad sales people, smart promotion minds, and skilled engineers that keep the signal transmitting. Every position in a radio station is equally as important as the next, and while a great manager is needed to keep it all together, there are lots of talented managers out there to do it. It is really an assembly line business, and no matter how good the manager is, a station must have people who know what they are doing at every step in the process for the whole thing to work.

Finally, to his fourth acquisition benchmark—price—what would seem most appealing to a value investor like Warren Buffett would be the current price tags of most radio operators. Long gone are the days when a broadcaster could fetch high double digit multiples in an asset sale. Valuations in the public sector are now beyond reasonable as the pendulum has now swung too far to the down side from its previously lofty highs.

This presents a tremendous buying opportunity for savvy investors with long term outlooks. Billions of dollars of market capitalization has evaporated across the industry this past year alone, and to a long term value investor a better time to buy has not been seen in recent memory.

Berkshire Hathaway has owned broadcast companies before, most notably Capital Cities/ABC, and Buffett elaborates in his letter on missed opportunities to buy others. The company also currently owns a large position in the Washington Post Company (WPO) which owns broadcast assets in addition to its publishing businesses, so Mr. Buffett is not completely unfamiliar, or even out of, the broadcasting sector. However, a pure play radio broadcaster that could be acquired cheaply right now and used as a platform company to consolidate the stable, but stagnant sector seems like a perfect acquisition for his remarkable, time-tested, and highly successful acquisition strategy.

Disclosure: None

Disclaimer: This article reflects the individual views of Mr. Hannan and may not be attributed to any person, company or other entity with whom Mr. Hannan is affiliated.

Comments

[TonyC-SA]

I am not in radio but I do have half my investment capital in Berkshire, and having travelled extensively, I would add another point to that radio moat: It isn't just the license; it is the content. A strong station playing oldies, or acid rock, or talk, or religion, or whatever seems hard to tackle, to me. People find their station in a new town and seem to stick with it for life. I'm in Texas now, but I remember even ten years after leaving Illinois I could still recite the call sign and dial position of a radio station I had not heard in a decade. The only thing that ever prompted me to switch radio stations was a blatant racist comment (no, not that Imus one recently) by a disc jockey. I found another station, and even that idiot was fired, they eventually went out of business. So they are not invulnerable to complete idiocy, but no business is, and I think that whatever human psychology it is that gets people stuck on one frequency for LIFE is a moat in itself.

[Robert E.Richer]

Absolutely right on the money. And in addition, there are virtually no new licenses being added, meaning that radio's quasi-monopolistic status will endure. Well-managed radio companies that focus on their core business continue to throw off amazing amounts of free cash flow.

[CE]

the old saying goes you get what you pay for. FM radio is free but it's unlistenable now. The commercials are endless, the choke on free speech, those 7 dirty wurds that can't be said, if they slip up, the FCC stomps on em, cus' you know we need to protect peopel from the spoken word..... that's been done in otehr dictatorships, it works for a while, then it fails. sattelite is teh future, FM is now what AM is when FM was born in teh 60's. Does AM still exist? With all that static, noise low fidelity. FM is teh new AM, as far as programing, it all sucks. Unlistenable. Let's all hope SIRI and XM merge so they continue to offer real radio, with real people, talking liek REAL PEOPLE. Not having to talk like everything is a violation in this "free" country. If FM radio is so embedded, with a BILLION receivers, why is the FCC and the gov't staling and claiming SIRI/XM merger is a monopoly, buffet says terestial radio is forever, someone is wrong.....And both are actually. Satelites have changed tv, telephone, why not RADIO? I do own SIRI stock, cus' it's the future, FM radio is the rotary phone of broadcasting, lame programing, mindless blather, censorship too.

[4truth]

Wishful thinking. BBGI at 11.5x EV/EBITDA is cheap? SBSA at 9.5x? CMLS at 10.6x? The only thing left is asset value, and subtracting out the debt even from that these companies are still expensive. Add in management (who still think its 1996) with super voting control and it's no wonder why no one wants to touch the float. Don't waste your time.

[J.P. Hannan]

Thank you everyone for the feedback, especially the flood of emails I received this morning. Please keep it coming.

[Road Jockey]

I have seen the same comments made in the past about free TV and how people are not going to pay for something they already get for free. My thought is with companies like Sirius and XM that you done just get music and non stop commercials, but you get content. Sporting events,music,talk radio while your on a long trip that wont all of a sudden cut out on you because you are out of the range of the radio tower is a huge advantage to the sattelite based business. So in my humble and non Warren Buffet like opion I think sattelite radio like cable television is here for the long run, or until the next great unforseable technology comes along. Dont get me wrong though free radio like our five free TV channels, should always have a place in a free society.

[RichardSchweitzer]

You are on the "money" in the valuation of cash-flow business.

This particular one requires a "holdings Company" concept to realize the optimum "value" (basically re-use) of the cash flow.

In the case of B-H, the units are too small for the necessary attention to the value generators (particularly programing adjustments and demographics adaptations). But they would fit inside the shells of older "news" and "entertainment&qu... enterprises.

What seems to be missing is the ability of the aggregated broadcasters to deploy their cash flows for optimum base growth. That kind of "stall-out" in optimum deployment is seen to some degrre in other cash generators such as Ebay, MSFT, and some lessser players. The use to buy back shares (retire capital from earned surplus) shows one of the deficiencies of the class and level of managements in broadcasting.

What is the most nearly optimum deployment for such cash flows?
Would it be into asset acquisitions at depressed cycles? Other operations that require cash infusion whilst the utimate product is in process (a la motion pictures; realty development; mining?)?

Apparently missing is that extra level of "management,"... basically proprietary management, that deals with using the "milk" from the cash cow - above and beyond the operating managers that make the cow produce cash.

[gordo]

Dont you think this industry suffers from what the newspaper industry suffers from: poor economics. That is to say would radio have even existed if satellite radio and ipods and on demand media existed first? Buffet does not own a radio station to my knowledge. I would say the long term earnings power of a radio station is not as knowable as say the future earnings power of say gillette... so why invest in it. Do you have an investment in radio?