This Stock Could Be an Easy Double

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.

The recapitalization
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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Jim Royal, Ph.D., owns shares of Crown Media. Walt Disney is a Motley Fool Inside Value recommendation. Walt Disney is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (24) | Recommend This Article (85)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 12, 2010, at 10:01 PM, platelet1 wrote:

    If 90 million is nearly fully penetrated, how do you get to the 130 million subscriber number? Thx, interesting article.

  • Report this Comment On October 13, 2010, at 2:14 AM, Estiv wrote:

    Nice work Jim,

    Thanks

  • Report this Comment On October 13, 2010, at 9:41 AM, DNAstock wrote:

    Being on the Motley Fool staff makes it easy to effectively pump stocks that own, doesn't it?

  • Report this Comment On October 13, 2010, at 9:46 AM, TMFRoyal wrote:

    Hi, platelet1,

    The 130 million figure comes from the addition of 90 million from the Hallmark Channel and 40 million (at year-end) from the Movie Channel.

    Fool on!

    Jim

  • Report this Comment On October 13, 2010, at 9:53 AM, TMFBrich wrote:

    @DNAstock --

    Yes, we allow writers to write about stocks they own. We also have strict trading guidelines in place, and "pumping" isn't tolerated. You can read about our disclosure policy here: http://www.fool.com/help/index.htm?display=about02.

    Relevant sections:

    Disclosure

    When a writer writes about a stock that he or she owns or beneficially owns, that fact is disclosed at the end of the article.

    All Fool employees and contractors -- that's anyone with a TMF prefix on their screen names -- are required to publicly disclose their current individual stock holdings on their personal profile pages on the Fool.com website. (We do not disclose the individual stocks that might be in a Fool's mutual funds.)

    An affiliate of The Motley Fool provides investment products that may hold securities mentioned in our publications. Editorial personnel have no nonpublic knowledge of the affiliate's holdings, and the affiliate's personnel have no knowledge of any editorial content before it is published.

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    Must notify our compliance department every time they buy or sell a stock, regardless of whether they have written about it.

    --Brian Richards, Fool.com Executive Editor

  • Report this Comment On October 13, 2010, at 9:54 AM, pstoyanov wrote:

    Waw, up 33% early today. Nice effing call Jim.

  • Report this Comment On October 13, 2010, at 10:15 AM, FoolishMikee wrote:

    34.75% up in almost an hour on open of today's open

  • Report this Comment On October 13, 2010, at 10:36 AM, stevenator65 wrote:

    Jim, you rock! I bought it last night at $2.48 and it's at $3.40. I am now a loyal Jim Royal fan, besides being a loyal Fool reader. Thanks again to Jim and Fool!

  • Report this Comment On October 13, 2010, at 1:14 PM, ferrerim wrote:

    What effect (if any), does the dispute with ATT U-verse have. This seemed to be a big problem in late August, early September. Did they resolve the issue?

  • Report this Comment On October 13, 2010, at 1:33 PM, mikecart1 wrote:

    It's only up because it exceeded average daily volume by like 12x.

  • Report this Comment On October 13, 2010, at 2:03 PM, IdahoAve wrote:

    that is truly amazing, 23 hours after article was written the stock jumps %47 insane. Cheers

  • Report this Comment On October 13, 2010, at 2:47 PM, JohnInvestor99 wrote:

    Wow, this analysis is based off some pretty serious financial inaccuracies. First off, I went to the company's website and read its earnings releases for the past four quarters (Q3'09 through Q2'10). The company reported a combined adjusted EBITDA of $87.0mm over the past four quarters---not even close to the "nearly $220 million" (!!!) reported in this story. I invite all readers to check for themselves on Crown Media's investor relations website. In fact, the company's total REVENUE over the past four quarters is only $274.5mm (!!!), so your numbers suggest a 80% TTM EBITDA margin, which is impossible given the very high content costs, not to mention SG&A. The correct EBITDA puts the company's valuation at roughly 20.9x EV/EBITDA (assuming a current EV of just over $1.8bn). It's pretty dangerous to post a story like this---subsequently getting investors involved in a stock---with inaccurate underlying data.

  • Report this Comment On October 13, 2010, at 3:20 PM, commonsense21 wrote:

    I agree, the above analysis is dangerously innacurate and should be retracted. The cable companies are looking to drop weak 1-channel networks like the Hallmark Channel to reduce their programming expenses. AT&T recently dropped Hallmark Channel and I would expect other distributors to follow suit as their distribution deals come up for renewal. Ratings have been weak and the company has been forced in the past few years to run the business for cash to avoid bankruptcy. At 21x EBITDA, people are going to get burned in this stock. At least get your facts right - EBITDA last year was $81.6 million and is not really growing - hardly $220 million!

  • Report this Comment On October 13, 2010, at 4:49 PM, a3arar wrote:

    Jim,

    Nice article and very well (convincingly) written. Nonetheless, you have to answer the the last 2 comments about ebitda.

    Best wishes

  • Report this Comment On October 14, 2010, at 2:27 PM, TMFRoyal wrote:

    Hi,

    In calculating EBITDA, I’ve used the figures reported in the financial statements and Capital IQ and corroborated them with other publicly available sites to arrive at my $220 million. In contrast, Crown uses its measure of “adjusted EBITDA,” which amounts to about $87 million over the trailing four quarters. Crown showed a substantial gain (21%) over the previous four quarters’ worth of EBITDA ($87 to $71.9 mn).

    Using even the company’s adjusted EBITDA figure of $87 million and applying a valuation multiple that is comparable to recent buyouts (20 to 25 times) yields a price of $3.10 to $4.30. And then add in dilution.

    In any case, this EBITDA calculation was meant to supplement the per-subscriber methodology that I used in the first part of valuation section, in order to “triangulate” a reasonable price on Crown shares. I could have also written about further valuation methodologies that I also used, and with which I arrived at still different (but in the same ballpark) figures. For reasons of space, I did not do so.

    So I stand by my original thesis: Crown shares could be a double because of this special situation event. The recapitalization has removed a significant debt overhang, lessened interest payments, and made the company’s profitability more obvious. HCC looks like it wants to take advantage of that situation, and it makes a lot of economic/operational sense to do so. Based on my analysis, I purchased shares for my own account.

    Fool on!

    Jim

  • Report this Comment On October 14, 2010, at 5:20 PM, commonsense21 wrote:

    Yes, you are a fool for buying based on per subscriber valuation in a buyout. First, why would anyone want to buy a fully distributed cable network with no International rights based on a per subscriber valuation? The reason buyouts happened on per subscriber valuations in the past is because the acquiring company could then expand the acquired property's distribution and thus substantially expand cash flow. Most big media companies have underperforming cable networks that are fully distributed that they can work on improving the programming, so acquiring Crown to do the same thing doesn't make any sense.

    The recap did remove the risk of bankruptcy or reduce it at least. Yet, it also significantly diluted equity holders and as you point out, you have to also add dilution on the upside from the converts. If I assumed almost any company was worth 20 - 25x EBITDA, it would be well over a double. At 22.5x EBITDA, Time Warner would be a triple. That doesn't make it a reasonable valuation. It also highlights how dilutive your pretend deal would be to an acquirer.

    Buyer Beware!

  • Report this Comment On October 14, 2010, at 9:50 PM, pete163 wrote:

    Some of the inside selling is due to time run out contracts, that must be sold or lose out. As you can see the inside selling has stalled at this point! And bigger money managers are starting eyeing up Sirius XM as an up coming runner. Another point the shorts are starting to drop out more everyday. Mel also has a box of ace's up his sleeve to trump the market. Here are just a few that are block buster! 1 he has the Satellite's that were built for the transmission of radio, no one ells has this. 2 he has the rights around the world,if any country wants Satellite radio they must pay Sirius XM to use it Satellite's and the software that runs it. 3 all the receiver boxes. These alone spells money and lots of it for Sirius XM. 4 Is the shock jock going to leave, no the money is to good to leave. Would you walk away from 500+ million! I could go on and on. The stock even with a down grade the stock hit heavy Resistance and held it's ground. In a shorter time then most think Sirius XM will pass Comcast and move on.

  • Report this Comment On October 16, 2010, at 10:33 AM, FlyingRiki wrote:

    They lost almost $22 million last year....yeah sign me up!

  • Report this Comment On October 18, 2010, at 2:18 PM, akbarcaskey678 wrote:

    There are a lot of stocks that can double and have less risk. I will pass on this one.

  • Report this Comment On October 20, 2010, at 10:18 AM, es0p0s wrote:

    Ok jim, maybe you was right, i owe you 20 bucks!!

    crown to sell, shares in there $6.11 region if my math doesn't fail me !!!

    v.soon

  • Report this Comment On November 04, 2010, at 9:02 AM, JohnInvestor99 wrote:

    Crown just reported third quarter earnings. They were absolutely abysmal---sequential and year-over-year declines in revenue and a 41% drop in EBITDA. All other cable networks have reported healthy revenue and EBITDA growth. Yikes!

  • Report this Comment On November 20, 2010, at 4:18 PM, ddkay wrote:

    Most of the world's population lives in cities. Between wireless technologies (wifi/4g) and beyond, how much future does satellite radio really hold. When anyone can choose to stream free or paid radio stations from the internet on a device in their pockets or one integrated into vehicles? I think Sirius market dominance/exclusivity reflects just this, while there should be a competitor in this space, the potential for large profits is quite small.

  • Report this Comment On January 19, 2011, at 4:49 PM, MSSRAL wrote:

    Is this stock going under? It keeps going down, down, down!

  • Report this Comment On January 24, 2011, at 3:22 PM, JohnInvestor99 wrote:

    This is what happens when inaccurate analysis is propagated to the masses---it pushes retail investors into lousy companies trading at very full valuations (causing a short-squeeze in this instance), and they end up losing money. Jim should be ashamed that he did not retract this story after it was revealed that the EBITDA valuation on which he was relying as the basis of his valuation was, in fact, overstating EBITDA by 153%!!! Relying on Capital IQ and failing to read the footnotes to the financial statements is the recipe for a stock-picking mistake, and this mistake cost readers a lot of money. Crown's recent results have been very poor, the company is losing subscribers, and the stock is a complete dog. "Fool" definitely seems to be the operative word with this call.

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