Second Quarter of 2018
In the second quarter, the portfolio increased by 13.0% and raised the cumulative return to 73.5% since inception. The fund's current cash position of 34% is significantly higher than in previous periods. This is due to the cash received from the completed acquisition of our M&A arbitrage investment in late June.
In this letter I will discuss this quarter’s largest contributors to performance and opportunities in spinoff divestitures.
Largest Contributors to Performance in Q2
Pandora Media [ticker: P] Pandora's stock is up 63% this year at the price of $7.88/share. Pandora reported Q1 earnings in April and provided very solid subscription and ad revenue results. Most importantly, strategically it looks like management is making all the right moves to grow Pandora in the future. This includes the acquisition of an ad-tech platform company, AdsWizz and announcing partnerships with AT&T and SnapChat.
The stock moved quite favorably in a very short period. I was willing to wait a couple of years for these results, sometimes you get lucky. I believe the surge of investor confidence (who typically vote with their wallets) is directly attributable of who’s running the show now. As discussed in my initial thesis, the Liberty/Sirius playbook is officially in effect. This company has a fantastic opportunity to grow with discipline, develop a strong subscriber franchise, and nurture their ad-supported franchise.
Time Warner [ticker: TWX] This investment paid off handsomely gaining ~12% in 9 months. Mere luck gave us the opportunity to purchase shares of TWX for the second time before it was acquired by AT&T. We got lucky because I sold our original position in Q3’17 when the spread between the current price of TWX closed within ~1% of the acquisition price. Weeks later the DOJ announced the intention to block the merger due to anti-trust concerns. The news drove down shares of TWX by 14%. I started buying shares when I assessed the lawsuit and maintained a strong conviction that the acquisition would be approved.
In conclusion, the court approved the merger between AT&T/Time Warner this June and the DOJ looked quite foolish. The court’s decisive approval may infer interesting implications for future mergers in the media industry.
Discovering Investment Opportunities with Spinoffs
Investment opportunities present themselves in many ways. One such opportunity is a spinoff. A spinoff is when a company takes a business division or segment within its organization and makes it independent. The newly formed independent business will have its own public listing, executive management, and board of directors focusing only on its business. Reasons for spinoffs vary but they all aim to achieve the same thing, unlock shareholder value.
There are instances when spinoffs are mispriced and become very interesting for value investors. Spinoffs can go unnoticed by most investors, receive little or no analyst coverage, and the company’s management may choose not to promote the attractiveness of the business (their stock grants are priced at the IPO). Large institutions typically don’t bother with small issues because they may not fit within their institutional constraints. For all these reasons, the stock price of spinoffs can be depressed and trade significantly below their intrinsic value around inception.
Entercom Communications [ticker: ETM]
Radio… forgotten beachfront property or the equivalent to the horse and buggy? This old mode of communication is not your sexy 21st-century premiere asset like today’s social media platforms. However, the business of radio has endured TV, cassette tapes, CDs, and the internet. Its dollar share of advertising spend has remained stable while older mediums such as newspaper and magazines have lost significantly in the digital age.
My research in Pandora Media (Q4 2017) aided the discovery of our newest investment, Entercom. To understand Pandora’s opportunities and challenges, I examined traditional radio thoroughly. I was impressed by radio’s stable operating profits, cash flow generation, and surprised by the large amounts of negative sentiment that surrounded radio.
It became clear the radio business wasn’t broken, only broken companies creating negative headlines. Excessive debt found new victims in the industry’s two largest companies, iHeart Radio, and Cumulus. Both companies filed for bankruptcy in the past year due to botched acquisitions. I found the typical recipe for disaster, large amounts of debt and aggressive assumptions. Also, it was not surprising these acquisitions occurred right before the financial crisis, circa 2007.
Entercom is not your typical public company. Two CEOs have run the company in its 40+ year history. The two CEOs happen to be a father/son combination and control ~30% of the company. They are excellent operators, highly respected in the industry, and have dedicated their entire lives to the business. In 2017, Joseph and David Field (Chairman & CEO of Entercom, Father & Son) were honorees of the ‘Giants of Broadcasting & Electronic Arts’ by the Library of American Broadcasting Foundation (alongside the Executive Producer of 60 Minutes and President of CNN). This reputation helped them create the second largest radio company with the merger/acquisition of CBS Radio last November.
Terrestrial Radio Is an Industry Entering A New Age
Terrestrial radio consists of AM and FM broadcast stations and websites supporting those stations. Radio’s enduring fundamentals have been cemented by the local connection it provides to the community (news/sports/talk/local DJ talent) and the captive audience in their automobiles. The business model is quite simple, broadcast music/news/sports and sell advertisements.
The industry is approaching its centennial anniversary and the business model remains durable. According to Nielsen, Radio listenership is resilient at 248 million in 2016 versus 234 million in 2008. Local and national advertising revenues are typically split 80/20. In the past 5 years, broadcast radio revenues have declined modestly by .5% but lost market share of total ad-spend at a greater pace of ~ 4%. This decline can be directly attributable to Facebook and Google taking market share and disrupting traditional ad mediums.
The playing field looks to be leveling. For years, venture capitalists have been funneling massive amounts of money in start-ups to build web 2.0 b2b technologies. Ad-technology platforms comparable to Facebook and Google are now coming online. (see Pandora’s acquisition of AdsWizz) Traditional media companies can now compete with equivalent tool sets to assist advertisers in analytics, targeting, and reach.
Traditional radio may also see a revival in home listening. The emergence of smart speaker technology (i.e. Amazon Echo and Google Home) has given listeners easy access to radio with their voice. This should help recapture declining youth listenership and expand listenership outside the car of its core listeners. This growth driver in listenership and ad-share is not being accounted for in current forecasts.
There is also another catalyst reshaping the industry, deregulation. For the first time in decades, the FCC will allow the cross-ownership of local radio, newspaper, and TV stations. This will create new organizational structures that will cut redundant costs on the local level and make the businesses more competitive in the digital world. We are rapid consolidation in local tv stations, content producers, and media networks. The undying strategy is scale with synthesized networks. Radio stations can become very valuable strategic assets when coupled with local TV and newspapers within the same market.
Why do I like this spinoff?
CBS Radio could be a classic example of an underperforming and overlooked business with a set of coveted assets enclosed in a large organization (CBS parent). When spun-off, these assets can be put in the hands of a more incentivized, focused, and enterprising management team. The executive team of Entercom will be running the newly merged company. I believe they can unlock the potential of CBS Radio and increase long-term shareholder value.
We aim to capitalize on the large mispricing created by the merger in this widely unknown, unsexy, and unfollowed company. In my base case, I believe investors are getting Entercom’s legacy business for free. Without any catalyst and zero growth, Entercom’s FCF per share will range between $1.50 to $1.75 per share over the next 3 years. At 7x FCF per share, this will conservatively value Entercom’s stock at $12 per share, providing upside of 60% at current prices.
The bull case involves revenue growing at the pace of GDP (2.0%) and FCF per share growing above $2.00. Some catalysts to stimulate multiple expansion include M&A activity spurred by deregulation and change of sentiment with negative bankruptcy news out of the headlines. These are not aggressive assumptions if Entercom executes and some catalysts materialize, the stock could rise to $16-$18 per share.
A few risks to my thesis include: a poor macro-environment (which we cannot predict), accelerated market share loss of ad-spend, trouble integrating CBS Radio, and/or the possibility that Entercom severely overpaid for CBS Radio. Any of these could damage the carrying value of the radio licenses (intangible assets) and goodwill. After impairments, book value could decline to $6 - $8/share.
Chief Investment Officer