Media General - This Pig Might Fly

As a deep value investor, you often spend time looking at pretty awful businesses. My fund does invest in some pretty solid businesses at cheap valuations but some of the best winners from my experience have been buying some pretty crappy businesses when valuation was at historical lows, near term prospects were relatively stronger than what the market was impounding, and credit risk was also lower than market expectations. One of the bigger challenges is acknowledging that the business sucks for the long-term so in some cases, particularly during heavy periods of market volatility, you can see the value of these positions fluctuate considerably whereby you want to chastise yourself for owning an obvious turd. Nonetheless, if the analysis is correct and you can avoid being your own enemy, and weight the position appropriately within your portfolio, the risk/reward of a busted but deeply undervalued holding can make a significant positive contribution to your portfolio.

Whenever I consider a potential investment, the first thing I do is weigh the bear case (or bull case for shorting). I want to familiarize myself with what the key risks of a potential investment are and what the skeptics see and then try to put some holes in the bear case when developing the bull case for the company. After that, I try to reconcile the bad and good of the potential investment to its current valuation and if it looks like there's a chance to make meaningful gains (100+%) from current levels, I'll build a position slowly.

That brings me to Media General ("MEG"), which I think may offer one of the best risk/reward opportunities for the next year. MEG is a newspaper and broadcast television company, offering 3 metropolitan newspapers, 20 community paper, and 18 broadcast television stations, operating primarily in Virginia, Tennessee, Florida, North Carolina, Ohio, and Rhode Island. Aside from the newspaper and television segments, MEG owns Dealtaker, a web-based coupon site, as well as roughly 200 specialty publications in specific smaller communities. Those wanting further detail on MEG's operations and financials can review the company's SEC filings. Upon reviewing those filings, the following points will likely resonate as the key points for MEG bears:

1) Levered Pig: MEG has a horrific balance sheet. Based on MEG's Q2 2011 balance sheet, the company carries about $650MM in net debt excluding its $163MM pension liability. On a net debt/LTM EBITDA basis, MEG is levered at about 6.5x LTM EBITDA. However, 2010 benefited from ad spending related to the nationwide political races, resulting in much higher operating results than in off-election years such as 2011. As a result, MEG's net debt/EBITDA ratio could be much higher as the year progresses, indicating less breathing room for the company.

MEG also has little in the way of undervalued assets on its balance sheet. MEG management squandered cash in prior years, overpaying for acquisitions leading to $355MM of goodwill. MEG has about $388MM in PPE and does in fact own a considerable amount of land. In fact most of MEG's television stations are located on land owned by MEG. MEG also owns a number of its buildings and all of its newspaper production equipment and facilities. Nonetheless, all of these assets have been pledged as collateral. While the value of MEG's FCC licenses may have some value beyond the $211MM recognized on the balance sheet, overall MEG's assets providing little breathing room in the event of a company credit crunch.

For example, refineries in recent years traded for cheap valuations due to high debt to cash flow metrics but the liquidation value of their key assets - the refineries - were in a number cases much higher than the depreciated book value. This provided some margin of safety in the event of a credit issue. MEG does not have that asset backstop.

2) Horrific management and governance: MEG's management team is awful. CEO Marshall Morton has led MEG's overpaying acquisition spree in digital media, acquiring Blackdot and DealTaker in recent years. DealTaker recently suffered a big set back in February 2011 when Google altered its search algorithm. Since then, MEG is blowing money on consultants to help fix this issue but as of Q2 2011 has nothing to show for it except continuing declining sales and negative cash flow for this segment.

In addition, management owns few overall shares with CEO Morton owning shares solely through exercisable options and stock awards. Despite the poor historical business performance of MEG under Morton and his team's leadership, MEG investors pay MEG's management team over $6MM per its latest proxy. This total compensation represents over 10% of MEG's current equity value. What is particularly unfortunate is that in 2011, MEG has instituted aggressive firmwide layoffs yet there appears to be little to no indication that MEG management is willing to take one for the team and scale back its pay. This can be problematic as those responsible for the content generation are let go and what's left is an overpaid, incompetent, uninspiring management team.

MEG shares are also split in the typical Class A and Class B structures, whereby most investors have little control. The majority of control - via Class B shares - is held by MEG's Chairman, J. Stewart Bryan III, a direct descendant of MEG's founder. Despite MEG management destroying the company, the Chairman has shown little interest in replacing this management team. The Board is also feckless, content to pocket in aggregate $1.2MM in fees in 2010...who knows for what other than to loot shareholders.

3) Florida is a major headwind: MEG breaks down its operations based on regions and it's Florida ("FL") region continues to be a major drag on its operations this year due to the greater acuity of economic challenges in states with large exposure to the housing implosion. The Tampa Tribune and NBC affiliate in Tampa represent about 23% of MEG's total revenues and 10% of operating profit. The main problem is that FL represented 14% of operating profit in 2010 while accounting for the same amount of revenue, representing the current difficulties in that market. While all of MEG's markets have struggled relative to 2010, FL in particular has caused the most amount of negative contribution.

4) Core Business Eroding Daily: The newspaper industry is migrating online which is very likely to result in the overall death of the industry. While some companies have been able to successfully establish paywalls, the track record of MEG's management suggests that they will not be able to pull

this off. MEG's newspaper segment represents just under half of its total revenues and each quarter, year over year declines have come in just under 10%.

With all of these problems it's not surprising that MEG's share price is around $2, representing a market capitalization of $50MM or so. MEG's is valued at about 6.7x EV/LTM EBITDA but this is based on two quarters of 2010 results which benefits from 2010 political spending. It also trades for 1.1x EV/LTM Sales, not insanely cheap and then 0.4x book value although when accounting for goodwill, MEG has no book equity. So overall, MEG looks like a real piece of crap company and it's therefore no surprise the stock is where it is and that short interest can range from 30-55% on the stock. Nonetheless, despite all of what I've discussed above, I actually think it may currently offer one of the best risk/reward propositions in the coming twelve months.

A lot of the bear case discussed above can be addressed by a number of events in 2012 - the US Presidential elections, the Summer Olympics, and Super Bowl 46. Let's work backwards to touch on each event. The Super Bowl alternates each year between FOX and NBC. In 2011, Super Bowl 45 was broadcast on FOX and in 2012 Super Bowl 46, representing the 2011-2012 season, will be broadcast on NBC. This matters because the majority of MEG's television stations are NBC affiliates and the Super Bowl has historically brought in about $2-3MM for MEG based on comments in MEG conference calls.

The Summer Olympics will also greatly benefit MEG due to its NBC affiliates. The 2010 Winter Olympics generated roughly $7MM in sales for MEG. However, in 2008, in the midst of a nasty economic period, the 2008 Summer Olympics generated $13MM in revenue for MEG.

Most importantly, 2012 will culminate in the US Presidential elections which could result in the highest amount of political spending in history. Due to the Citizens United v FCC ruling, political ad spending is virtually limitless and a number of 501(c)(4) organizations have raised tremendous amounts of capital to be deployed in 2012. That capital will be deployed in advertising across all media including broadcast television and even newspapers. In fact, 2010, a non Presidential election year, brought in more political ad spending than in 2008 so there's good reason to be optimistic as far as 2012 having a very positive impact on MEG. Another benefit for MEG is that it operates in key battleground states such as Florida, Virginia, Ohio, and North Carolina which could receive a larger portion of total political ad spending relative to other states.

So how does this translate into addressing the main bear points? The reality is that 2012 won't change the long-term expected demise of the newspaper industry. However, nearly 50% of MEG's revenues are derived from its broadcast television stations and more importantly 60% of the company's cash flow comes from its television stations compared to about 33% for its newspaper segment and the balance from its online segment. This cash flow distribution is based on 2011 - an off-year for political ad spending. In on-years for political ad spending the cash flow contribution from the broadcast television division increases. This is because ad sales for the television segment are largely generated by a cheaper, commission based sales force and there are no additional costs to running ads on television at higher pay rates. This provides considerable operating leverage when the ad cycle is strong as it should be in 2012.

Florida should also perform better in 2012. In 2009 MEG's FL segment generated $12MM of EBITDA on sales of $158MM. In 2010, FL segment revenue was $157MM with EBITDA of $7MM. In 2011, the FL segment is on track to generate $147MM in revenue but most likely recognize EBITDA of -$5MM. Without much in the way of broadcast television ad dollars in 2011, there is little operating leverage meaning FL's Tampa Tribune segment imparts a greater operational drag on the segment. Given MEG's FL television segment is an NBA affiliate in Tampa, the FL television segment should experience relatively strong performance in 2012.

MEG has a lot of debt but the main question is if it's serviceable. The first thing I like to look for is if there are any near term potential threats via impending refinancing needs. The closest maturity for MEG's various debt components is its $364MM term loan which matures in March 2013. While MEG is working to address this financing issue, the company has some breathing room.

Another concern by bears is that MEG could breach its covenants. After Q2 2011, MEG's LTM EBITDA was within its covenant levels but the poor performance in Q2 2011 led investors to wonder if tough Q3 results would lead to MEG violating its covenants. However, after Q2 MEG management indicated it would reduce H2 2011 costs by 3% relative to H2 2010. In 2010, MEG's operating costs excluding D&A was $553MM with H2 2010 costs at $280MM. Through H1 2011 those costs were $275MM. With that announcement, MEG's H2 2011 should have about $272MM in total costs resulting in total operating costs of $547MM.

I expect MEG to generate about $641MM in revenue for 2011 compared to $678MM in 2010 which would lead to EBITDA of $94MM against net debt of $645MM leading to a net debt/EBITDA ratio of 6.9x. However, investors should note that MEG's lenders included step-ups in the covenants in Q3 as the net debt/EBITDA covenant is set at 8.0x while year-end Debt/EBITDA drops to 7.75x. In the case of MEG's covenants, it appears that there is more breathing room than bears think.

The biggest challenge for MEG is Q3 because Q4 historically is the company's strongest quarter. If MEG gets by Q3, the next several quarters will be much better than what's experienced in 2011. MEG's historical quarterly figures since 2009 along with my Q3 2011 and Q4 2011 estimates are in Chart I. As can be seen, Q4 in both 2009 and 2010 was pretty strong and there's no reason to think that Q4 2011 will not follow the prior Q4 quarters. In addition, a potential positive wild card for MEG could be increased political ad spending in Q4 2011 ahead of 2012.

CHART I: MEG QUARTERLY OPERATING RESULTS

Once an investor can become comfortable with the understanding the bear case and potential weaknesses in that case, the question becomes what upside potential does MEG offer in 2012. Chart II are my own rough estimates for MEG which are rather conservative.

CHART II: MEG 2012 ESTIMATES

I assume MEG's newspaper segment continues to lose revenue, declining by 9% compared to similar declines in 2010 and 2011. If the consultants MEG has hired do their job, the digital segment should not fluctuate too significantly. The real wild card is the broadcast segment. The television segment is unlikely to decline much in 2012 given the potential positive contributions from the items previously mentioned. In the revenue build up in Chart II I estimate $2MM from Super Bowl 46, $14MM from the Summer Olympics, and just $50MM in political ad spending. Keep in mind that MEG recognized similar political spending in 2010 despite it being a non Presidential election year. Assuming MEG bounces back to 2010 expense levels, 2012 will result in EBITDA of $125MM which matches its 2010 levels.

What investors should note, however, is that in 2010, MEG's average share price was close to $9, hitting the low teens for the few months before the election. The climb to these levels started in H2 2009, in part driven by a successful refinancing of MEG's debt in 2009. The overall constant is that MEG appears to be fairly anchored to an EV/EBITDA valuation of about 6.8x. So if MEG can increase that EBITDA figure, either through larger than expected television revenue which largely flow to the bottom line, there is considerable upside for MEG investors.

In 2009, MEG's EBITDA was $108MM. At 6.8x its enterprise value was $734MM but in 2009, MEG carried $679MM in net debt resulting in an equity valuation of $55MM or about $2.33 per share. If one looks at a chart of MEG in 2009, it's apparent that the median share price was probably in the low single digit range. In 2011, it appears that MEG is traversing in that same range albeit with nothing close to the debt refinancing issues faced in 2009.

However, using that same multiple on $125MM expected EBITDA in 2012, MEG could legitimately be valued at close to $9/share. It's important to note that MEG's revenue could be a bit higher than what Chart II suggests. The television segment provides the biggest EBITDA bang for sales buck, so a lot of the incremental revenue from political ad spending will drive EBITDA. If MEG generates $135MM in EBITDA, the potential share price using a 6.8x EV/EBITDA multiple is $12. Because of MEG's high debt load, an 8% increase in EBITDA can correspond to a 25% increase in share price. The inverse can be a concern but when one is investing at these current levels, the risk/reward clearly favors a long position. In addition, there are market dynamics that can favor longs at this share price. MEG shares are relatively illiquid with nearly 40% of shares held by various entities controlled by Mario Gabelli. Short interest ranges from 30-50% and positive catalysts are around the corner which could result in a rather quick move upwards. In addition, this is company that one holds for a year or so and disposes of ahead of the actual election in 2012 (sell on the news phenomenon). Overall, MEG is a bad company in a bad long-term industry but currently has investment dynamics similar to cyclical companies such as airlines and refineries. Airlines are not great investments but they are worth evaluating when the industry is struggling and some positive catalysts can be identified. The same approach is used with MEG which I think is one of the best risk/rewards for 2012. When one considers a conservative 50 basis point allocation in MEG, if the stock goes up just 100%, that's already 0.5% of performance contribution. If MEG does what it appears capable of doing fundamentally in 2012, then the stock could increase well more than 100% from these levels leading to an additional 2-3% of performance versus worst case a loss of 0.25%-0.5% in the portfolio. That type of risk/reward proposition could warrant a small position in even the most conservative portfolios.

DISCLOSURE: AUTHOR MANAGES A HEDGE FUND AND MANAGED ACCOUNTS LONG MEG.