Sinclair Broadcast Group (NASDAQ:SBGI) has been one of my better investments over the last two years, in both directions. In 2019, I was bearish on the company after its RSN acquisition and saw it go from $66 shortly after the deal closed all the way down to $12 at the heights of the COVID depression. However, I then went long in November as Sinclair continued to hover below $20 despite cutting its exposure to its RSN bet almost in half. The stock shot up to $38, doubling in just four months to just above my price target of $36. Now, it has fallen again back down below $30. I ended my long at $36, should I jump back in now?
I have considered carefully… and decided not to.
To be clear, I did not end my long because I had any insight that an over 20% drop from the peak was coming. I don’t claim to be that insightful. I ended it because Sinclair had reached the target price I set and I didn’t see much further upside in the mid-$30s. Now that it’s below $30 again I might, except that before buying I rechecked my math using Sinclair’s updated numbers, and they didn’t come out as well as they did before.
Wild Gyrations
The story of Sinclair today probably begins with its third-quarter earnings report, which came out just a week after I went bullish. In it, Sinclair took a massive write-down related to its RSNs. So massive, in fact, that after the write-down, in its third-quarter report Sinclair Broadcast Group reported net assets on its balance sheet of negative $1.6 billion.
It’s reading a little better at the moment, at least on paper, as Sinclair reported a $467 million profit in the fourth quarter. Presumably, that’s what’s got those who are still bullish so confident. While some of that was legitimate profit - largely powered by record-breaking political ad spending - a large part of it was a COVID-19 windfall. And even the true profit part represents a once-every-four-years surge that is not big enough to compensate for all the downward pressure in the other three years.
Balance Sheet Head Fake
First, just to be clear, the negative equity by itself is not a reason to be leery of Sinclair. Yes, negative equity numbers always look bad, and they can often be a prelude to a bankruptcy filing. But Sinclair’s troubles stem entirely from their RSN division, which is held in a bankruptcy-remote subsidiary called Diamond Sports Group. This subsidiary, where the entire write-down took place, is actually reporting an even more ugly balance sheet number of negative $2.37 billion in shareholder equity. This is consolidated onto Sinclair’s balance sheet, along with its other broadcast division, into a single report for Sinclair’s shareholders.
So, Sinclair can put Diamond into bankruptcy, if need be, and wipe clean almost $2.4 billion in negative equity, restoring the core, broadcast side of the business to about $600 million or so in positive equity. The management will tell you it's more like $1.2 billion, and after its banner fourth quarter, that is technically true at the moment. But as I will explain, a lot of that fourth quarter profit isn’t entirely real. The third quarter report, showing roughly $1.75 billion in negative equity on the consolidated balance sheets, is probably more indicative of the real state of the company. So the Diamond filing should turn that back into $600 million or so. So, if the balance sheet isn’t the problem, what is? Simply put, the income statement. Which only seems like it’s improving, and doesn’t currently justify even the current share price, let alone any significant upside.
COVID-19 Windfall
Let’s stay on the sports side of the business a little longer and turn away from balance sheet towards income. Officially, Diamond Sports Group reported a $663 million operating profit in 2020, excluding the write-down. That’s an amazing turnaround from the (pro-rated) $50 million or so it reported for 2019.
But the problem is how it got that number. As CFO Lucy Rutishauser detailed during the earnings call, Sinclair received a total of $697 million in rebates last year from sports leagues for unplayed games that diminished the carrying value of their RSNs. But they only accrued $420 million in corresponding rebates owed to distributors like Comcast (CMCSA) and Charter (CHTR) for undelivered games. The rest, they simply pocketed.
For those wondering how such a large mismatch could develop, it all comes back to how bad a deal the acquisition of the RSNs has been. Several major distributors, including DISH Network (DISH) and Google’s (GOOG) (GOOGL) YouTube TV as well as the Hulu Live service that Disney (DIS) shares with Comcast, have dropped the RSNs (probably permanently) even before 2020 brought such a disruption of sports over the winter. The sports contracts between Diamond’s RSNs and the various teams were written on the assumption everyone would carry the RSNs, which is why the division is now losing money.
The “upside,” if you can call it that, of this is that when something happens to completely shut down all sports in the country - like, say, a once-a-century global pandemic - everything basically resets back to zero, leaving the company that was under zero and in the red when business-as-usual prevailed comparatively better off.
Vaccine deployment, however, is only accelerating, and reports of very high efficacy continue to come in. MLB has announced that it will be playing a full season this year and there is no reason to think that, come the fall, NHL and MLB won’t do likewise.
Thus, Sinclair has a net $277 million negative “sports seasons” effect going forward. This is enough to wipe out more than half of the profit it just reported in the last quarter. This, better than anything, illustrates just what a bad bet these sports networks have become. They are Regional Sports Networks who only profit when there are no sports on networks.
Facing The Music
It was this inescapable reality which led Sinclair in the third quarter to (finally!) do something that by rights it probably should have done a bit sooner: cop to the falling value of their RSN acquisition and write it down to market value. Actually, I’m still not convinced it quite has been written down all the way to true market value, but that’s a topic for another day.
For now, it is at least a good deal closer to it, as Sinclair took a massive $4.3 billion write-down on their $9.6 billion acquisition*. This reflects the complete elimination of all the goodwill in the transaction as well as approximately one-third of the “definite-lived intangible assets” included in the purchase. Those are basically the sports contracts themselves with the various franchises.
*The RSNs themselves were actually valued at $11 billion at the time of acquisition, but $1 billion belonged to minority shareholders whose losses Sinclair doesn’t share, and another $400 million was saved when Sinclair received a rebate for the carriage dispute with DISH that had already started when the sale closed.
Drilling Down On Sinclair
So, that’s the Diamond side of things. Now, let’s bring in the broadcast half of the business as well, and look at Sinclair’s overall numbers.
In 2020, Sinclair reported a net loss of over $2.4 billion, but that owes to the massive write-down it took in the third quarter. Excluding that write-down, its net income was actually reported at an all-time high, of $1.85 billion, for 2020.
As might be expected for such a massive explosion in operating income in a single year, that number is almost entirely illusory. Let’s turn it into a real estimate of Sinclair’s earnings potential going forward. In order to do that, we have to strip out all the 2020 distortions.
The first thing that has to be done is to apply some of the changes we’ve already calculated. Going forward, sports will not be shut down - baseball season starts tomorrow for my home team - and the $277 million in losses that were saved will come back into the company finances.
“Net income, other” is another red herring. It was reported at $325 million last year. In no other year going back to 2016 has it gotten over single digits. Management indicated it is largely composed of write-down-related gains. We’ll write it down to $2 million to keep our numbers round and lower the net income to $1.25 billion.
Another thing we have to do is deduct the massive income tax benefit the write-down itself produced, which obviously will disappear when the write-downs do. Sinclair reported a $720 million income tax benefit in 2020. If we instead applied a 20% tax rate to the write-down-free number, we’d get $250 million in tax owed, rather than a tax benefit. That takes net income down to $280 million - thus, already, 85% of that massive profit number is gone.
The Four-Year Cycle
Lastly, we need to normalize the political spending. One of the things that people often throw at me when I’m discussing the challenges facing broadcast companies is that political spending is incredibly cyclical, more than any other category, and it runs like clockwork - very low spending levels in years one and three, very high spending in year two, and monstrously high spending in year four of every cycle, the high spending years corresponding of course to election years. When it's not an election year, broadcast bulls love to yell at me that next year will be better because it’ll be an election year. When it is an election year, though, a lot of them seem to forget that next year won’t be an election year, and the numbers will be worse.
The way to handle this even-handedly, of course, is to amortize the political spending over the life of the cycle to get a true, baseline figure. Sinclair’s imputed $280 million profit run rate is based on a year when, by the CEO’s own admission, political spending was 40% higher than any other year on record. And that previous record, I’d bet, was probably also a presidential election year, which only happens once every four years.
Political last year came to $373 million. With two off years, we should cut that in half, but since mid-terms aren’t worth as much as presidential years we should deduct even more. Let’s call it $200 million less, on average, than 2020.
Don't Count On Diamond For Help
Nor will Diamond’s all but inevitable bankruptcy changes these numbers all that much. Yes, Diamond’s bankruptcy will remove over $8 billion in debt from Sinclair’s consolidated balance sheet, along with roughly $350-$400 million in annual interest payments. If we take the high end of that estimate and deduct the $80 million tax hit that increased EBIT would produce, net income at the company would seem to quintuple, to $400 million.
Except, from that number would need to be deducted the sports segment’s own operating income, and yes, it does have operating income. Saying that Diamond is underwater doesn’t mean that it has no operating income, it merely means that its operating income is insufficient to cover interest expenses and return any profit to shareholders.
In 2020, Sinclair reported its sports segment generated $663 million in operating income, excluding the other income line and the massive goodwill/intangibles write-down. As we’ve covered, the number going forward will be $277 million lower, leaving $385 million in operating income that will no longer be generated as Diamond’s bankruptcy voids its sports contracts and leaves it with no content. That means that Diamond’s bankruptcy will take Sinclair’s annual profit stream up a grand total of just under 4%, from $80 million per year to $83 million.
Investment Summary
That’s my best guess. Sinclair’s core broadcast platform is probably looking at around $80 million or so in sustainable run rate profit per year over a full, four-year cycle. Even at a 25 P/E, that comes to 11% below its current market cap… and I have my doubts that a 25 P/E is appropriate any longer as inflation fears start to take hold and the Fed begins to look seriously at tightening in the months ahead. If the P/E drops to 20 or even 15, Sinclair could have a real downside even at these levels.
My prior bullish stance was based on $150 million per year in net income outside of Diamond Sports Group, but that was an extrapolation from half-year numbers. The full-year doesn’t look as good, and the political side of things may have slanted my previous estimates more than I accounted for at the time.
Whatever the reason, when I run the math now I just don’t get to $150 million anymore. Barely half that. And that has me more cautious than I was six months ago when the stock could be bought $10 cheaper to boot.
Conclusion
I had a nice run with Sinclair on the way down from $66 to $12, and then again from $19 back up to $38. Based on these new numbers, rather than go for the charmed third time, I’m going to sit on the sidelines for a while.
