To his credit, Emmis Communications (NASDAQ:EMMS) CEO Jeff Smulyan was upfront about his company's third quarter report on Thursday, opening his prepared remarks on the Q3 conference call by admitting, "This is certainly a disappointing quarter." It most certainly was: Radio revenue declined modestly, with Emmis badly underperforming its measured markets. That performance was particularly troublesome given that Emmis was supposed to benefit from lapping difficult comparison in the Los Angeles market after a departure of a popular DJ in early CY 2015.
Publishing revenues were down as well, even pro forma for the sale of Texas Monthly during the quarter, and positive signs from newer businesses like dynamic pricing platform Digonex and Emmis' NextRadio were either too early and/or too small to offset the weakness in the legacy business.
I wrote in October, with shares at $3.79, that I was intrigued by EMMS after a buyout offer at $4.10 per share, by a group led by Smulyan, was pulled. But with the stock at $3.28 as of this writing, the concerns coming out of Q3 more than offset a ~13% cheaper price. The long-term bull case here isn't necessarily damaged by Q3, but two straight quarters of underperformance and a pending debt covenant change in May both augur near-term concerns at the least. And I think a ~20% pullback from levels right at the offer price last summer may continue into 2017.
The Legacy Business
The headline revenue numbers don't look good, to be sure. Overall radio revenue decreased modestly (0.2%), but per Miller Kaplan figures, Emmis said its radio revenues declined 1.8% against a 2.5% increase in its markets. The major driver, according to the 10-Q, was the Los Angeles market (ex-LA, revenue increased 0.9% against market growth of 0.6%). That's a concern because Q3 was supposed to be better in that market: Smulyan had said on the Q2 call that Q3 revenues were pacing "flat to up slightly," and the company was lapping the negative impact of DJ "Big Boy" leaving for a rival station.
In publishing, revenue was down 6% even excluding Texas Monthly, with the Los Angeles market again the cause, according to the 10-Q. That's not helpful, given that Emmis is trying to sell the rest of its publishing assets (excluding Indianapolis Monthly), and Los Angeles Magazine seems like the crown jewel of that portfolio.
From a sales standpoint, this is the second straight quarter that has disappointed, and a closer look at Q3 shows more concerns. While political advertising demand disappointed, it still added ~1.3 points of overall revenue growth in the quarter. Emmis spent up to promote its stations in New York and Los Angeles, which impacted margins significantly: By my calculation, Adjusted EBITDA fell about $5 million year-over-year, with only ~20% of that coming from the asset sales.
I'm not quite ready to call FY17 as the beginning of the end for Emmis' legacy businesses, but with the company lapping early CY16 layoffs in Q4/Q1 FY18, and the fixed-cost model amplifying any further top line weakness, there has to be legitimate concern about the health of the radio business, in particular. And that could cause some near-term issues.
The Covenant Step-Down
The biggest short-term problem with the earnings weakness is that Emmis has to get its leverage ratio down to 4x by May 31 under the terms of its credit agreement. The Texas Monthly sale was supposed to be a help on that front, with net proceeds of ~$24 million (after adjustments) against a minimal annual EBITDA contribution. But because of the Q3 profit weakness, Emmis' leverage ratio hasn't really budged: As defined by the credit agreement, it ended Q3 at 5.53x against 5.62x after Q2 and 5.47x a year ago.
Smulyan said on the Q3 call the company still was targeting 5x by the end of Q4, and "the mid 4s" after Q1 (when the covenant must be satisfied). But in a scenario where asset sale proceeds disappoint and the LA radio market, in particular, continues to struggle, that figure could be above 5x or even near current levels by the time Emmis has to negotiate.
To be sure, I don't believe that implies EMMS shareholders will be wiped out by the end of CY17, but it likely does mean concessions will need to be made in terms of interest rate. Emmis currently has a 7% rate. I'm skeptical it will be able to keep that rate in an environment where Fed rates are expected to rise, and with its leverage ratio plateauing at 5x+.
Post-Q3 figures imply ~$33 million in Adjusted EBITDA underpinning $185 million in Credit Agreement debt (Emmis has other, non-recourse, liabilities). Something like $30 million and $175 million by the end of Q1 isn't terribly extraordinary, and gets the leverage ratio closer to 6x. That leverage in this environment is not going to keep the rate at 7% - and each 100 bps increase wipes out 6-7% of that EBITDA.
Again, I'm not arguing that Emmis is going to collapse, or even necessarily that Q2 and Q3 imply weak performance in Q4 and Q1. But there is a not-unreasonable outcome here where Emmis is negotiating with lenders from a position of significant weakness. For a stock with a ~$40 million market cap, it doesn't take much of a change in interest rates or profit expectations to have a significantly negative impact on the share price.
The Rest Of The Business And Valuation
To my eye, the bull case for EMMS is based on the legacy business staying stable enough - and driving enough free cash flow - to pay down a chunk of the credit agreement debt, allowing the company to transition to NextRadio, potentially benefit from Digonex, and perhaps garner some additional value from 98.7FM in New York, currently operated by Disney's (NYSE:DIS) ESPN under a Local Marketing Agreement that expires in 2024.
The weakness in the legacy business undermines that case a bit, but management was more optimistic toward the newer businesses. Digonex revenue has been down sharply this year ("Emerging Technologies" sales in total were barely $200K in Q3) as a major customer was lost. But booked business heading into CY17 is nearly triple that of a year prior, and building that business into a multimillion-dollar revenue stream could offset potential weakness in radio.
As for NextRadio, it remains the major part of the bull/bear case here (in fact, the unit was one key reason why major shareholders balked at the go-private), and the news was reasonably good in Q3. NextRadio now has agreements with the five major U.S. carriers, and among manufacturers, only Apple (NASDAQ:AAPL) remains to be brought onboard. Smulyan said in the Q&A of the Q3 call that the company still was working on that front, though he didn't mention any specific progress. But Latin America seems a potential opportunity for the business, and Smulyan remained optimistic toward the business.
All that said, I'm not sure NextRadio is a guaranteed winner. Smulyan highlighted two milestones reached in the quarter: 10 million downloads and 25 million listening hours. On average, that's about 2.5 hours per download. In 2015, Pandora (NYSE:P) averaged over 100 times that figure - 260 hours - per users, per its 10-K. That's not an apples-to-apples comparison, to be sure, but there's still a major question as to whether NextRadio is a legitimate competitor to Pandora and Spotify (as well as the myriad other music streaming services).
In terms of valuation, I'll admit there's a wide range here. It's difficult to accurately value NextRadio given that it still is driving little in the way of sales, and given that it's unclear when or even if the project will be successful. For Emmis itself, EBITDA declines imply a potentially significant re-rating downward, given the relatively small equity slice relative to overall enterprise value.
A 7x EV/EBITDA multiple at the moment isn't terribly attractive relative to peers - but it's also not really the point. The question really is what NextRadio is worth, and if Emmis' terrestrial radio business can generate enough cash flow to keep the company afloat until NextRadio starts showing that value.
And so the problem from my standpoint relative to the Q3 report is that the risk of the company stumbling before NextRadio gets firmly established seems to have risen. Again, I'm not predicting near-term insolvency, but Emmis does have a difficult path to walk. I argued after Q2 that I didn't think the company could manage any sort of macro downturn in the U.S., given its leverage and fixed-cost structure.
There's also a possibility that it may not be able to manage another 3-4 years even if macro trends hold up reasonably well. The chart certainly seems weak, and EMMS traded at $2 as recently as May, before the buyout offer sparked the stock. It's not out of the realm of possibility that the stock could find itself back there in 2017 - and after Q3, it'd probably have to be close to those levels for me to be enticed.
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