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Gray Television: Our High-Conviction Value Stock

Summary

Gray Television fulfills our five parameters as a value stock.

Importantly, we don't see a value trap in which Gray does not operate in a dying industry.

Compelling catalyst is in the form of: 1) Gray stepping up M&A activities (which it's now doing); or 2) its being a buyout candidate speculation.

Our EV/IC valuation framework suggests 38% upside potential (base case) against 9% downside potential (pessimistic case).

Gray presents an asymmetric risk/reward ratio.

Having sifted through local broadcasting/television companies, we arrive at a conclusion that Gray Television (NYSE:GTN) is our high-conviction value stock. As of June 2015, Gray owns and operates 76 television stations in 45 markets, with US household reach of 8.3%. Relative to its listed peers, the company's household reach of 8.3% is fairly small, with Sinclair (NASDAQ:SBGI) being the largest (38%), followed by Media General (NYSE:MEG) (23%), E.W. Scripps (NYSE:SSP) (18%) and Nexstar (NASDAQ:NXST) (17%). However, we do believe Gray would offer the biggest upside potential given its deeper value.

What are our value stock parameters?

In our opinion, to be of great value, a company/stock has to offer the following characteristics: 1) it looks boring/sleepy; 2) it generates strong free cash flow, not only accounting earnings; 3) it has underappreciated business model; 4) it's got little research coverage or is less followed by the Street; and 5) importantly, there is no value trap (especially, the company does not operate in a dying industry). In short, we believe Gray fulfills all these five parameters. Let's deep-dive into each of these parameters.

Parameter #1: It looks boring/sleepy

One of the investing truth we have learned is that a value stock does not look flashy at all (you would hardly jump up and down by just reading the business line/industry, unlike reading biotech, internet/e-commerce, electric automobile, and the like). Gray fits the bill perfectly. As mentioned, it is a small listed local television company with only 8.3% household reach. Moreover, the company operates in Designated Market Areas ranked between 61 and 209 (there are only 210 DMAs). Hence, none of its television stations are located in the top DMA quartile, let alone in the top 20 markets. Meanwhile, other competitors have at least 2 stations in the top 20 markets. Furthermore, 67% of Scripps's stations are in the top DMA quartile, followed by Media General (44%), Sinclair (37%), and Nexstar (13%).

Furthermore, what makes Gray look more boring relative to peers is that it's come late to the M&A party. The local broadcasting industry has seen a big wave of industry consolidation since 2012 as the industry evolves in the face of such threats as cord cutting and a structural shift into mobile/digital advertising. In particular, its stations' household reach goes up by a mere 2.1 ppt to 8.3% as of June 2015 from 6.2% as of December 2012. As a comparison, over the same period, Sinclair's jumps by 11 ppt from 27% to 38%; Media General's 15 ppt from 8% to 23%, Nexstar's 6 ppt from 11% to 17%, and Scripps's 4 ppt from 14% to 18%.

(Source: Company data)

Notably, Gray has not been involved in any high-profile M&A deal (yet) amid big industry consolidation. For example, on 28th September, Nexstar proposed a bid to acquire Media General in a $4.1 billion deal (including US$2.2 billion net debt). Prior to this, Media General had acquired previously listed Lin Media for a transaction enterprise value of $2.6 billion, with the deal closing in December 2014. Also, there is no publishing asset spin-off as Scripps had done earlier this year. Scripps's share price rose by a nice 36% over a 8-month period from the spin-off announcement on 31st July, 2014 to the completion on 1st April, 2015. As a matter of fact, with regard to spin-off play, Gray has no angle at all, as it has been a pure-play broadcaster for quite some time.

Moreover, during the company's latest earnings call, management is the only one among peers to say it is unlikely to participate in the FCC's spectrum auction coming in 1Q'16. As a comparison, Sinclair has gone out on a limb by saying it could monetize up to $2 billion worth of its spectrum holdings at a cost of less than 3% of its EBITDA (as it has to lease spectrum back afterwards). After tax, we calculate this amounts to $1.2 billion in proceeds, or $12.5/share - a hefty 40% of Sinclair's current share price. Our point in bringing up such a comparison is that this is another example why Gray Television and its management is seen by the market as fairly boring.

Parameter #2: It generates strong FCF, not only accounting earnings

Based on our experience of covering small cap stocks in particular, unfortunately, income statement manipulation is rampant. So many companies try the "earnings game", thanks to the Street's myopic on quarterly earnings, just to boost their stock prices. At the end of the day, if you are interested in discovering substantially undervalued stocks, we believe that the focus is on cash earnings or FCF.

Hence, our broadcasting FCF analysis (based on our average 2015-16 forecasts) shows that Gray would generate a stellar 13% yield. This translates into a 7.6x P/FCF, which, to us, is much more compelling than seeing a less-than-10x P/E company, given our belief. Arguably, the peers trade at double-digit FCF yield as well. However, we hold that this does not diminish Gray's...


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