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September 17, 2009

Renewed Takeover Speculation Adds Another Leg to Media Stock Rally

Media stocks continue to be market leaders in the latest phase of the stock market rally. The market rally is based on improved sentiment and data toward a global economic recovery. Most revenue drivers for media companies are highly sensitive to economic growth so it is not surprising that media stocks are among the sectors leading the rally. However, I think another is at work. After a multi-year lull, mergers and acquisitions have returned to the forefront of media company strategic planning.

Until this decade, media companies were very acquisitive providing strong support for media stock prices. The AOL-Time Warner merger represented the peak and quickly went wrong putting an end to media M&A except for divestitures. The recession, the collapse of credit markets in 2008, and accelerating secular challenges completely took takeover activity off the table. Now it appears that activity is picking up. In the past, media properties always were sold at a premium to their public market values because they were trophies and often produced good cash flow. Renewed acquisition activity now supports higher valuations for media properties which still trade at a discount to private market value.

The big M&A news, of course, was Disney's recently announced acquisition of Marvel Entertainment. The deal garnered major headlines but to put it in perspective, Disney is paying $4 billion for Marvel against its own market cap of $48 billion. I think this is an important deal for Disney but we are not talking AOL-Time Warner.

Published reports rehashed the deal pretty well so I am not going to dwell on it. However, I think the major takeaway is that branded entertainment may have a leg up on advertiser supported entertainment. Marvel has great brands which Disney can exploit in movie production, theme parks, merchandising, and cable and broadcast TV. No media company has a better array of consumer touch points than Disney but the idea that revenue share for major entertainment conglomerates may shift in favor of branded product at the expense of advertising is legitimate.

Brands can be exploited through any distribution. Advertising is fragmenting and its effectiveness in the digital age is being questioned. All the entertainment companies are already exploiting brands. Time Warner has DC Comics and Harry Potter. Viacom is late to the game but has Transformers, Star Trek, and maybe a revived G.I. Joe. Discovery Communications is rebranding one channel with Hasbro and another with Oprah Winfrey. Whether the brands are being used to attract viewers and advertisers or sell product, the idea is the same: defend market share and attract revenue not just with distribution but with branded entertainment.

The M&A front has also heated up elsewhere. Press reports indicated that bids for Travel Channel were coming in at a better than expected than $800 million. Leading bidders are said to be Scripps Interactive, News Corporation, and private equity in partnership with Discovery Communications. Helping the deal may be a rumor that Cox Communications is willing to guarantee Travel's current debt.

According to SNL Kagan, Travel Channel will have operating cash flow of $69 million in 2009 and $76 million in 2010 with margin of 37-38%. On these estimates the pricing does not appear to be attractive, just 10-11 times EBITDA, or not far off current pubic valuations for Discovery Communications and Scripps Interactive. However, Street analysts have lower estimates with Jessica Reif of Merrill Lynch at around $50 million. A 16 multiple would not be far off pre-financial crisis levels and has positive implications for valuations of publicly held cable networks.

Even if the deal is completed at 16 times, it offers upside to the acquirer. At best it appears that Travel is operating at an upper 30% margin. Many other non-fiction based cable networks operate near a 50% margin. With economies of scale and broader reach enabled by a stable of networks, the new owner of Travel seems to have a good opportunity to quickly raise profitability and slightly accelerate revenue growth.

Somewhat surprisingly, Time Warner and NBC Universal have not been bidding. Travel fits well with either and both have shown a willingness to acquire new assets. The participation of private equity is also a surprise. Apparently, Discovery Communications would partner with private equity by providing management services including advertising sales.

At $800 million, an acquisition of Travel Channel by any of the companies I have mentioned would not be a make or break deal financially. News Corporation probably faces the most skeptical audience of investors given concerns about Rupert's strategic vision but a move to add to the one business segment that offers growth may be well received. Scripps Interactive is the most obvious buyer with the best fit. Normally a smaller company may face financing issues but Scripps is debt free and can easily handle the deal. In fact, easing of financing conditions is one of the reasons that M&A activity is picking up.

M&A speculation also got a boost when a Federal judge threw out the FCC's 30% ownership cap on cable TV system operators. This mainly impacts Comcast and has renewed speculation of a Comcast-Time Warner Cable deal or an acquisition of Cablevision by Comcast or Time Warner Cable post the spin-off of its Madison Square Garden properties. I am a little skeptical that any of these deals happen in the next two years but the renewed speculation adds to valuation support for media stocks and gives investors another reason to focus on the group.

Disclosure: Discovery Communications is widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts.

Posted by Steve Birenberg at September 17, 2009 08:59 AM in Media