Monday, May 02, 2005

1+1=3? Hmmm…let’s rethink this

On Friday, after reporting generally disappointing first quarter earnings, Clear Channel Communications (CCU), the country’s leading radio station chain, announced several strategic initiatives. Beset with languishing equity performance (CCU stock off over 30% since the beginning of 2004), management set forth a plan to both align business segment interests and maximize shareholders returns. As part of the prescribed shift in strategy, the company plans to IPO 10% of its Outdoor Business and spin-off 100% of its Live Entertainment Business. Additionally, CCU increased their annual dividend 50% from $.50/share to $.75/share and announced a one-time special dividend of $3.00. Clear Channel CEO Mark Mays commented that CCU is attempting to “unlock the [firm’s] considerable value” and “create a strong foundation for future growth, by improving the strategic, operational and financial flexibility in each of [the firm’s] leading business units.” This change is strategy comes two months after media-giant Viacom announced similar plans to divide its business into separate publicly traded companies.

Investor’s reaction to the news was initially quite positive as CCU’s stock was up over 7% in early trading. However, it failed to maintain these early gains and closed the day slightly in the red. The positive reaction from equity analysts on Wall Street was fairly unanimous. Lehman Brothers equity analyst William Myers believes the return of capital to investors via the increase in annual dividends and the payment of a special dividend is encouraging. However, Myers asserts that the restructuring and strategic initiatives are unlikely to improve the operating fundamentals. Equity analyst at JP Morgan, Spencer Wang, is slightly more constructive on the restructuring, believing the spin-off of the lower-growth, lower-margin Live Entertainment business could improve CCU’s overall growth and return profile. As expected, the reaction from fixed income analysts and the ratings agencies was arguably less sanguine. Before the announced restructuring, all three ratings agencies (S&P, Moodys and Fitch) rated the company’s debt at low BBB (one notch away from junk). Moodys and Fitch put the company on review for downgrade, while S&P put the company on negative outlook. The rating agencies clearly view the higher leverage that will result once the aforementioned strategic initiatives are executed as negative…and may push Clear Channel off the cliff from investment grade to junk status.

Clear Channel’s strategic shift is representative of a changing landscape in corporate America. Ending what was one of the longest and largest equity booms in U.S. history, accounting scandals and concerns over corporate governance were at the heart of a broad market correction in the early part of this century. In a post-Enron/ post-Worldcom world, corporate America refocused their efforts on “balance sheet maintenance,” highlighting the role of financial responsibility and stability. However, with balance sheets considered to be quite strong today, and corporations flush with large amounts of cash, management is often left with the most obvious of questions: How can we increase returns? Given greater financial flexibility, can we reposition ourselves to make our shareholders happy?

This heightened equity-friendly environment came to the fore in 2004 with a wave of mergers and acquisitions, increased dividend payouts, and an uptick in leverage buyouts. Media companies like Viacom and Clear Channel have presented the market with a different spin on how to make shareholders happy: split oneself into multiple pieces! Management clearly believes that the old adage “the whole is greater than the sum of its parts” does not apply here. In essence, management believes that the market is not valuing the company correctly, but is putting a “conglomerate discount” on the firm. Why however do we think that separating the company will “unlock” any additional value? Are efficient markets that naïve that they cannot correctly value a firm with multiple parts? Perhaps not everyone is buying into this rationale. Lehman Brothers analyst Meyers appropriately entitled his research piece…”Value Distribution, Not Creation.”

While it isn’t necessarily obvious that Clear Channel’s strategy will unlock any additional value, CCU’s move away from a conglomerate approach should be applauded. Arguably, economies of scope should present themselves under Clear Channel’s current structure. With over 1200 radio stations, approximately 35 TV stations, over 700,000 advertising displays and a live entertainment company, one would think that synergies should present themselves from the ability to cross-sell events and products through various mediums. This was one of the main drivers for the firm’s entry into the concert arena five years ago. Management believed that the company’s existing billboard and radio businesses would be complemented by live entertainment. However, these synergies never materialized to any significant extent. Yet another example of the “elusiveness of synergies.” Absent any meaningful economies of scope, why should a conglomerate approach be used? Aren’t capital markets efficient enough to allow investors to diversify in a less costly manner than companies can do themselves? Perhaps, CCU has come to that realization. In any event, investor’s should welcome a less diversified approach.

Ultimately, Clear Channel’s “slicing and dicing” of the company hasn’t really changed the environment they compete in. Perhaps this was what Myers was eluding to when he mentioned that “strategic initiatives are unlikely to materially improve the operating fundamentals.” The changing industry trends do not favor Clear Channel’s approach. Consider the growth in the internet. In ten years, the number of internet users has escalated from an estimated 16 million to 888 million users. At just under 14% of the world population, this medium clearly has not reached saturation. And with such growth, comes a growth in advertising via new methods. The likes of Yahoo and Google provide a real competitive force for Clear Channel’s outdoor and radio segments. Combined these segments represent nearly 90% of CCU’s operating income. Satellite radio has experienced considerable growth over the past 2 years and firms such as Sirius and XM Satellite create yet an additional competitive force for CCU. And what about those customers who don’t even listen to the radio anymore? One need only take a brief walk along Lake Michigan on a warm day to observe how quickly MP3 players have saturated our society. Slowly you can begin to put the pieces together and form the mosaic of a competitive landscape in which CCU has some issues to address.

Who knows, maybe this refocused strategy will work for Clear Channel. But is it “creating” any real value right now? Probably not. At the end of the day, 1+1 still only equals 2!

Michael Miranda and Brad Pitzele


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