TEGNA: An Arbitrager’s Nightmare Is A Fundamental Investor’s Opportunity (NYSE:TGNA)

Situation Overview

On Friday after the market closed, the FCC issued a Hearing Designation Order related to the proposed acquisition of Tegna (NYSE:TGNA) by Standard General. The FCC’s decision is based on the two main issues of retransmission rate increase and local news job cuts, despite Standard General’s assurances to the contrary. While the FCC has not completely blocked the deal, the Hearing Designation Order requires the parties to present their case in front of an Administrative Law Judge, although a date has not been specified. This approach is often used by the FCC to effectively halt a deal, as the uncertainty surrounding the timeline can be a deterrent for both parties, particularly in light of the accruing daily ticking fee. Tegna and Standard General may choose to extend the outside date of the deal, though this has not been confirmed.

In my view, the most likely outcome is that Tegna and Standard General will decide to terminate the proposed transaction. Since the FCC issued a Hearing Designation Order, Tegna has the right to terminate the deal and collect a $136 million termination fee, which is what I anticipate will happen. For Standard General, it is in their best interest to walk away from the deal, given that each passing month results in additional ticking fees of $0.125 per share, or $1.5 per share for 12 months.

As a side note, I previously suggested a long bond and short stock trade in light of this situation, and I believe investors who followed this recommendation should have weathered the situation relatively unscathed. This underscores the significance of hedging in scenarios with binary outcomes.

Technicals

Let’s start by examining the technical aspects of the situation. Tegna’s stock has dropped from Friday’s close of $21.84 to $16.30, and it’s uncertain where the optimal deal break price should be. From early 2019 to early 2020 (pre-COVID), the stock was trading in the range of $15-17 per share, although this might not be the unaffected price due to rumors of Apollo’s interest in buying Tegna in February 2019. There may be additional selling pressure from Standard General as they liquidate their holdings in Tegna, although they could potentially buy more as well. It’s also unclear what proportion of the float is held by the risk arbitrage community, given the high degree of regulatory risk in the current situation (I personally think it’s low because the regulatory risk is too high). As a result, there may be a rotation of Tegna’s shareholder base in the near future, until the price falls sufficiently to attract more fundamental-based investors.

Fundamentals

Looking at Tegna from a fundamental investor’s perspective, I’m very comfortable with Tegna’s situation. Like other publicly-traded TV broadcasting companies, Tegna generates most of its revenue through advertising and retransmission, with a roughly equal split between the two. Retransmission revenue is the fee that cable operators pay to carry a local broadcasting station’s signal, and is based on a $/subscriber/month basis. Broadcasting stations can negotiate rate increases over time, and there are still many viewers who prefer to watch local news on TV. Cord-cutting has been a challenge for broadcasting stations, but the impact has been less severe than expected due to a growing subscriber base of virtual MVPDs, such as YouTube TV. Retransmission revenue is recurring, sticky, and growing from rate increases, which offsets the more cyclical advertising revenue.

Advertising revenue is self-explanatory, with Tegna selling TV advertising slots between and during shows. The company receives signals from broadcasting networks and supplements them with local news produced by Tegna, resulting in advertising slots shared between the network and Tegna. Broadcasting networks sell national advertising, while local broadcasting stations sell local advertising. Although advertising revenue is cyclical, Tegna benefits from political advertising every two years, which provides a windfall. Local TV remains one of the most effective ways for politicians to reach a broad audience, and this is a pure margin for Tegna as there are few additional costs associated with political advertising revenue.

Tegna’s costs include payments to broadcasting stations for the signal, known as reverse compensation or reverse retransmission revenue, which is a mix of fixed fees and $/sub/month depending on the network. Other operating expenses are mostly fixed in nature, providing Tegna with a significant operating leverage, especially during election years.

Finally, Tegna has one of the best balance sheets in its comp group, with net leverage of approximately 2.6x. The company has a good balance of predictable retransmission revenue, cyclical advertising revenue, and periodic windfall from political revenue. It generates substantial free cash flow and maintains a conservative balance sheet.

Valuation

My valuation of Tegna is based on the FY2024 EBITDA, which I adjusted using a lower EV/EBITDA multiple because the company will “over-earn” in 2024, a presidential election year. I have estimated the FY2024 retransmission revenue at $1.65 billion, political revenue at $475 million, and advertising revenue at $1.3 billion. With an EBITDA margin of 36%, I arrive at an estimated FY2024 EBITDA of approximately $1.224 billion. Using a cyclical trough multiple of 6.0x against net debt of roughly $2.8 billion, my target price for Tegna is $20.60 per share.

For context, I anticipate Tegna’s retransmission revenue to be around $1.5 billion for FY2022, with subsequent negotiations driving the rate increase by more than 5% annually to reach $1.65 billion by FY2024. The company generated $445.5 million in political revenue during the last presidential election year. I have also assumed an 8% decline in advertising revenue. While the FY2020 EBITDA margin was approximately 35.5%. Given the higher political revenue, I have factored in a 0.5% margin expansion.

As a side note, although I don’t have the benefit of detailed due diligence that Standard General conducted, I can understand how they could underwrite this investment at $24 per share (with my fair value close to $21, plus some control premium) – while $24 may be a full price for Tegna on a controlled basis, the company’s cash flow generation ability and the windfall from political advertising revenue every two years will enable Tegna to pay down debt relatively quickly, given that it generates $400-700 million in free cash flow annually.

Conclusion

It’s unfortunate that despite Standard General’s best efforts, the FCC still blocked the well-negotiated transaction between the two parties. While the deal is technically still on the table, I anticipate that both parties will ultimately walk away from it. Perhaps another buyer will emerge in the near future, given that multiple parties have shown interest in Tegna over the past few years. In the meantime, I believe that the asset value has not deteriorated and that Tegna is worth at least $20 per share based on fundamentals, and $24 per share in a take-private transaction. Although there may be volatility ahead, I would argue that $16.30 is not a terrible entry price for value-oriented, long-term-focused investors.