Fitch Places Gray Television on Negative Watch Following Quincy Media Acquisition Announcement
(The following statement was released by the rating agency)Fitch Ratings-San Francisco-04 February 2021:
Fitch Ratings has placed Gray Television Inc.'s 'BB- 'Long-Term Issuer Default Rating (IDR) and all issue level ratings on Rating Watch Negative, following the company's announced agreement to acquire Quincy Media for $925 million in cash. In addition, Gray has secured $925 million in committed incremental senior secured term loan capacity to finance all or part of the transaction.
While Fitch recognizes the strategic rationale of the acquisition, the Negative Watch reflects the potential for a near-term weakening in credit protection metrics following the transaction, lack of clarity on the final capital structure, as well as the potential impact on Fitch's recovery expectations.
Fitch expects to resolve the Negative Watch at close of the Quincy transaction, and will assess the impacts of the acquisition, financing strategy and planned divestitures on Gray's credit profile and leverage trajectory. At that time, Fitch will resolve the Negative Watch with either a downgrade or an affirmation of the existing ratings.
Key Rating Drivers
Quincy Media Transaction: Fitch expects Gray's acquisition of Quincy Media will have a neutral-to-slightly negative impact on Gray's credit profile in the near term, but will depend on the ultimate funding sources for the transaction. Fitch believes the strategic rationale for the transaction is sound, due to the businesses' complementary station portfolios and the potential for modest synergy realization.
Quincy Media is a small scale, family-owned, TV broadcaster based out of Quincy, Illinois, and owns 16 stations primarily located throughout the Midwest, although the company has additional station assets in the Northeast and Southwest. Quincy has nine stations that are ranked #1 or #2 in their respective markets. To comply with FCC regulations, Gray will divest stations in six markets, including stations in Wisconsin, Arizona, Iowa and Illinois. Quincy also owns a small newspaper business, which is not part of the acquisition.
Fitch believes the company has flexibility to determine the final funding strategy of the acquisition. Fitch notes that final pro forma leverage could increase or decrease based on the amount of debt ultimately used to fund the acquisition. Currently, Gray has a large readily available cash balance it can use to reduce the amount of debt-funded consideration. In addition, Fitch expects the net proceeds from the six Quincy station divestitures will be applied to debt reduction, which would improve leverage metrics. Fitch also notes that Gray could opt to raise additional unsecured debt instead of borrowing on the committed incremental term loan facility. The ultimate mix of secured and unsecured debt used to finance the acquisition could alter Fitch's expectations for issue-level recoveries. The transaction is expected to increase pro forma two-year average leverage slightly from 5.6x to 5.7x, including the $23 million of identified synergies.
Coronavirus Impact on Advertising: The advertising environment has faced significant pressure since the onset of the coronavirus pandemic, owing to widespread government-mandated restrictions on commerce and movement. Fitch expects both local and national advertising revenue to decline by double-digit rates in 2020. However, the pace of the ad market recovery has exceeded Fitch's initial expectations, and Fitch remains cautiously optimistic about the continued ad market recovery in 2021. Positively, declines in Gray's ad revenue were more than offset by record political advertising revenue in 2020, driven by contentious presidential and congressional political races in a number of markets where Gray owns top-ranked stations.
Fitch believes Gray is well positioned to manage through weaker operating performance, as contracted retransmission revenues now account for a larger percentage of the revenue base (37.5% in fiscal 2019). Additionally, a weak advertising environment did not appear to materially impact the level of political ad spending in 2020.
Highly Levered: Fitch-calculated two-year average gross leverage (total debt with equity credit/Operating EBITDA) is expected to be roughly 5.6x at YE December 2020, excluding the impact of the Quincy acquisition. The leverage impact of the Quincy acquisition will not be clear until the funding structure has been finalized; however, Fitch expects the transaction to be slightly leveraging. Fitch expects Gray will remain outside of Fitch's negative rating sensitivity of 5.5x through 2021, but notes that Gray's deleveraging could be accelerated by optional debt reduction with excess cash flow or lesser debt-funding for the Quincy acquisition.
Strong Television Portfolio: Pro forma for the Quincy transaction, Gray will reach 25% of U.S. television households. The company has a strong portfolio of station assets, with #1 ranked stations in 77 of its 102 markets (~75%) and #2 ranked stations in 16 markets. Gray network affiliations are weighted towards NBC and CBS.
Gray's legacy television stations were present primarily in smaller designated market areas (DMAs), ranked between 61 and 209, that were generally less competitive and overlap in university towns and state capitals. The Raycom acquisition added a complimentary portfolio of highly ranked television stations located in some larger markets, predominantly in the Southeast. The Quincy acquisition will further add a small, but complementary station portfolio, with top ranked stations in markets primarily across the Midwest
Growing Net Retransmission Revenues: Fitch expects that retransmission revenues will grow at a high-single-digit pace over the near to medium term. Fitch expects these fees to continue to increase given the significant gap between a broadcast station's audience share and its share of multichannel video programming distributors' (MVPDs) programming fees. However, Fitch notes affiliates share an increasing proportion of these fees with the networks, which will increase from roughly 51% in 2018 to 55% by YE 2023, per SNL Kagan. Fitch expects net retransmission fees will grow more modestly in the low single-digit range.
Improving FCF: TV broadcasters typically generate significant amounts of FCF due to high operating leverage and minimal capex requirements. Gray generated $236 million in Fitch-calculated FCF in fiscal 2019, and generated $459 million in Fitch-calculated FCF in the LTM period ended Sept. 30, 2020. Gray continued to generate significant FCF despite a pullback in advertisers' marketing budget, due to stronger than expected political advertising and stable retrains revenue. Gray and other local broadcasters benefit from having a more material cushion from retransmission and political advertising revenues than in prior economic downturns.
Sufficient Liquidity: Liquidity is supported by $467 million in balance sheet cash and full availability under the $200 million revolver as of Sept. 30, 2020. Gray guided to ending 2020 with upwards of $725 million in cash due to strong political advertising in 4Q20. Gray does not have any required debt amortization under its existing term loans. Gray does not have any significant maturities until 2024. Gray also intends to upsize its revolver by $100 million at close of the Quincy acquisition.
Advertising Revenue Exposure: Fitch estimates that advertising revenues accounted for roughly 53% of Gray's average two-year total revenues (excluding political). Advertising revenues, especially those associated with TV, are becoming increasingly hyper cyclical and represent a significant risk to all TV broadcasters. Gray works to offset this risk with its focus on increasing its share of more stable local advertising revenues. Local advertising revenues accounted for approximately 80% of Gray's advertising revenues (excluding political) in fiscal 2019.
Viewer Fragmentation: Gray continues to face the secular headwinds present in the TV broadcasting sector including declining audiences amid increasing programming choices, with further pressures from over-the-top (OTT) internet-based television services. However, Fitch expects that local broadcasters, particularly those with higher-rated stations, will remain relevant and capture audiences that local, regional and national spot advertisers seek. In addition, Fitch views the increasing inclusion of local broadcast content in OTT offerings as a positive. Growth in OTT subscribers could provide incremental revenues and offset declines of traditional MVPD subscribers. However, Fitch does not believe penetration will be material for Gray over the near term, particularly give the company's predominance in smaller and medium-sized markets.
Gray's 'BB-' Long-Term IDR reflects its smaller scale and higher leverage relative to the larger and more diversified media peers, like ViacomCBS, Inc. (BBB/Stable) and Discovery Communications (BBB-/Stable). Gray's ratings incorporate the company's high leverage, which is offset by the company's enhanced scale and competitive position following the Raycom acquisition. Gray is the fifth-largest independent station group by U.S. TV household reach, but maintains the highest broadcast revenue per television household owing to its strong portfolio of highly ranked television stations.
Pro forma for the Quincy acquisition, Gray will have #1 ranked television stations in 77 of its 102 markets and #2 ranked television stations in 16 markets. Fitch notes that high ranked stations garner a larger share of the local and political advertising revenues in their markets. Gray also has a favorable mix of affiliated stations weighted towards NBC and CBS. Gray's pro forma average two-year total leverage of 5.7x is favorable to E.W. Scripps's pro forma total leverage of 6.2x (B/Stable). Gray also benefits from its stronger and high performing station portfolio and significant exposure in political battleground geographies, which further supports the rating differential. Gray's EBITDA margins, in the high 30% range (two-year average), lead the peer group. Comparatively, Fitch expects Scripps' EBITDA margins will remain in the high teens range (even-odd year average).
--Core advertising declines in mid-double digits in 2020, rebounding in 2021 though not returning to 2019 levels. Core advertising returns to flat to low single digit declines thereafter.
--Political advertising revenues of roughly $400 million in 2020 with strong presidential election cycle.
--Gross retransmission revenue growth will decelerate over the ratings horizon, from low-double-digits in 2020 to high-single-digits in 2021 and outer years.
--EBITDA margins fluctuate reflecting even year cyclical revenues. Margins compress slightly over time due to expected low single digit ad declines, a growing percentage of retransmission revenues are paid to the networks in reverse retransmission compensation, and fixed costs growing at low-single digit rates.
--Capex in a range of 4% of revenues annually.
--Gray pays scheduled debt amortization ($14 million annually).
--Fitch assumes Gray completes the Quincy acquisition early in 3Q21. Identified run-rate synergies are fully realized by 2022.
--Fitch assumes Gray uses a meaningful portion of excess cash flow to focus on near-term debt reduction and beyond that time frame balances acquisitions and shareholder returns
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Fitch expects to resolve the Negative Watch by affirming the ratings if Gray funds the Quincy transaction in a manner that prioritizes deleveraging to below 5.5x (Total Debt with Equity Credit/Last eight quarters annualized [L8QA] EBITDA) in the near term.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Fitch expects to resolve the Negative Watch with a downgrade if the funding structure for the Quincy acquisition is expected to materially delay deleveraging to below 5.5x materially, particularly if station divestiture net proceeds and excess cash are not allocated toward nominal debt reduction.
Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity and Debt Structure
Comfortable Liquidity: Liquidity was supported by $467 million in balance sheet cash and full availability under the $200 million revolver as of Sept. 30, 2020. Gray expected to close 2020 with more than $725 million in cash, and intends to upsize its revolver by $100 million as part of the Quincy transaction. Gray does not have any required debt amortization under its existing term loan B. Gray's next sizeable maturity is not until 2024, when the $595 million term loan becomes due.
In addition, Fitch expects liquidity will be supported by stable free cash flow generation over the rating horizon. Gray continued to generate strong free cash flow in 2020, despite a severely weakened advertising environment. Fitch expects both growing retransmission revenue and strong political ad spending in even years to provide a cash flow generation buffer against potential future advertising downturns. Fitch also expects meaningful net proceeds from the divestiture of six Quincy-owned station assets, which will further boost liquidity.
Gray's first-lien credit facilities have modest covenant protections. The revolver has one financial maintenance covenant, a first-lien net leverage ratio of 4.50x, which steps down to 4.25x two years after closing and is only tested when the revolver is drawn. The first-lien credit facilities also require a 50% excess cash flow sweep when first-lien net leverage is greater than 4.50x, stepping down to 25% when leverage is greater than 3.75x and 0% otherwise.
Sources of Information
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REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria.
Gray Television Inc.; Long Term Issuer Default Rating; Rating Watch On; BB-; Rating Watch Negative
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