The prospect of a buyout is thrilling, and that's what I expect will happen to the stock I'm about to describe below. The stock could reasonably double from today's price, and I'm confident enough that I've put my own money to work in the idea. But even without a buyout, the company's improving operations should be reflected in a higher stock price, so there's a couple ways to win here.
This is more than mere speculation. The company has executed several moves that suggest it's looking to capitalize on a buyout, as I'll explain below. The company -- Crown Media (Nasdaq: CRWN ) -- has just executed a recapitalization, a special situation that makes its profitability more apparent to investors.
Special situations investing
The field of special situations can be a happy hunting ground. As Joel Greenblatt details in his You Can Be a Stock Market Genius, special-situation investing led him to 50% annualized returns for a decade. That type of return transforms a $1 investment into $52 in just 10 years. Such special situations are created by transactions that transform the business -- spinoffs, reorganizations, and recapitalizations, to name a few. But the value created by such transactions often isn't reflected in financial statements, and so agile investors can get a jump, and a good price, on these stocks before they appreciate to full value. Also, these situations can be complicated, but it's this transactional complexity that creates value.
You may know Crown Media for its Hallmark Channel or its Hallmark Movie Channel. The former has around 90 million subscribers, making it nearly fully penetrated among American homes, while the latter has 36 million subscribers and is expected to have 40 million by the end of the year. As of this fall, the Hallmark Channel now features Martha Stewart, whose lifestyle programming allowed the company to ramp ad rates up 117% compared to last year. The company pumps out great cash flow and requires very little reinvestment. So Crown is a valuable, if small, media property.
In the case of Crown Media, the company recently undertook a recapitalization at the behest of its majority owner, Hallmark Cards (HCC). But for the last decade, HCC had owned the vast majority of Crown's stock. Equally as important, it held substantially all of Crown's debt. Over the past decade, HCC was content to let Crown roll over its interest payments into more debt, which added still further interest burden onto Crown. In effect, Crown's interest payments obscured otherwise very profitable operations, as you can see below.
The difference between the blue line (operating margin) and red line (net margin) was fully consumed by interest payments. As HCC exacted ever higher interest year after year, it made the vampire squids at Goldman Sachs look like amateurs.
Not surprisingly, Crown's stock price languished as debt piled up, even though its operations were improving and Crown turned free cash flow positive, as the following graphic shows.
That's when we get to the special situation. (I'll spare you some of the gory financial details.)
After a decade of exacting interest from Crown, HCC recently decided that it would exchange about 62% of its debt for an equity stake in the company. In early February, HCC announced it would convert about $600 million of debt into stock at $2.60 -- roughly 85% higher than the stock was trading when the announcement was made. Why would a company that effectively owned more than 80% of Crown stock before the recap now want to up its equity stake at a price higher than the market was willing to pay? (Wait for it ...)
The remainder of HCC's debt stake was converted into new debt and convertible preferred stock. The net effect of this transaction is as follows:
- HCC now owns more than 90% of the outstanding equity of Crown.
- Shares outstanding more than tripled.
- Crown's interest payments have been cut drastically.
- Crown should now look profitable on a GAAP basis, as of the next quarterly filing.
Of course, with this much dilution, the holdings of a few other minority shareholders have been watered down. DIRECTV (Nasdaq: DTV ) now owns less than 2% of Crown. DIRECTV is also part-owned by billionaire John Malone, chairman of the Liberty Global empire, who himself made substantial dough by investing in special situations, as detailed by Greenblatt. Malone has made a habit of buying up media properties and then extracting significant value from them. Malone did as much through Liberty Capital, when it acquired an interest in Sirius XM (Nasdaq: SIRI ) last year.
So, again, why would HCC suddenly want a greater equity stake in Crown?
Maybe they want to sell it
Crown is about the last stand-alone cable channel remaining. Other channels, such as Sundance, Court TV, and the Weather Channel, have been bought up in the last decade and combined into larger media empires. It makes little sense to have a stand-alone channel, since overhead eats up a huge share of the profit. In contrast, it can be very profitable for a media conglomerate to come in, slash costs, and realize huge profit, much more than Crown or HCC could ever realize itself. Those synergies -- and boy, do I hate that word -- mean that Crown is worth a lot more to a media company than it is to HCC or us.
Why else would HCC want to sell? If HCC had sold out when Crown was highly leveraged, it would have received a 1:1 payback on its debt and some good upside on its (much, much smaller) equity stake. By converting Crown to a larger equity stake, HCC gets more of that buyout bounce if and when it sells Crown.
But who might buy?
- Discovery Communications: Crown could join Discovery's portfolio of media channels, some of which are focused on the lifestyle categories that Crown itself focuses on. It also doesn't hurt that media maven John Malone sits on the board of Discovery.
- Disney (NYSE: DIS ) : The similarity of Disney's and Crown's programming -- wholesome family fare -- is undeniable. Disney is undoubtedly looking for opportunities to grow, and while Crown would be a bolt-on acquisition for a behemoth like Disney, it could still be an attractive acquisition, especially as Martha Stewart is now appearing on Crown's channels.
- Comcast (Nasdaq: CMCSA ) : The cable operator is increasingly moving into the area of content with its purchase of General Electric's (NYSE: GE ) majority stake in NBC Universal, and in fact already tried to buy Disney.
- Time Warner (NYSE: TWX ) : Crown's channels could fit nicely into the lifestyle content at Time Warner, joining the Networks division at this entertainment giant.
- One of the various Malone-influenced Liberty businesses.
How much could the deal fetch?
Let's take Cablevision's purchase of the Sundance channel in 2008 as one data point. One analyst estimated that Cablevision paid $19 per Sundance subscriber, a figure that's around the median buyout price over the last decade. Multiply that by Crown's expected 130 million subscribers by year end, and we'd have a total value of $2.47 billion. Back out Crown's net debt of $628 million, and you get a stock price of $5.11 -- more than double today's price.
Let's do another sanity check. Buyouts in the last decade, including purchases of Sundance, Fox Family Channel, and Weather Channel, have gone for more than 20 times cash flow. That's pricy by usual standards, but such cable channels have very low capital reinvestment, as does Crown. Using EBITDA as cash flow, Crown generated nearly $220 million in the last four quarters (please see the comments section for further discussion of EBITDA). Multiply that by 20, and back out the net debt, and the per-share price comes to $10.50, a figure that looks much too high. Instead, use a very reasonable figure of 12-15 times cash flow, and you're still looking at more than a double.
However, as part of the recap, HCC restructured $185 million of debt into convertible preferred stock, which converts at $2.60 per share of Crown stock. That means that at any price over $2.60, we need to calculate in the dilution provided by such shares, which is 20% all told. That puts the target range from $4.27 to $6.19 per share. Still a very good upside, and with limited downside, as the recapitalization makes Crown's profitability obvious.
Foolish bottom line
This deal isn't without risks, of course. First, recently declining viewer ratings could hurt, although Crown's deal with Martha Stewart has already resulted in a doubling of ad rates for her time slots. Second, HCC owns more than 90% of Crown shares, so it can do pretty much what it will. But HCC has pledged to refrain from several dilutive actions for the next few years, among other protective actions. Third, minority shareholders whose stakes have been diluted by the recapitalization are suing HCC for that action.
Still, might not these minority shareholders' insistence indicate how much value remains in Crown's shares? I certainly think so, and I've put my money where my mouth is.
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