QUALIPORT
Building A Better Franchise

By Maynard Paton (TMFMayn)
October 12, 2004

Commercial radio is a great sector for long-term shareholders. A licensing procedure restricts the impact of industry newcomers, which provides the incumbent players with the makings of a durable competitive advantage. By proposing to merge, the industry's two leading operators, GWR (LSE: GWR) and portfolio watch list member Capital Radio (LSE: CAP), are going to build an even better franchise for their investors.

Licence regime

Here's a quick recap of the licensing process.

OFCOM, the UK communications regulator, uses the following criteria to judge commercial radio licence applications:  

1) Ability to maintain service
2) Catering for tastes and interests
3) Broadening of choice
4) Evidence of demand/support

Obviously the first criterion favours existing radio broadcasters rather than cash-strapped start-ups. What's more, the third criterion favours those applications that won't compete directly with any of the established operators.

At present, there are well over 200 FM and AM radio stations broadcasting in the UK. However, the new licensing regime introduced by OFCOM only grants one 'larger' licence every two to three months, with a 'smaller' licence up for grabs every month. Licenses are granted for specific locations and OFCOM takes a dim view of transmission proposals that interfere with neighbouring areas.

The upshot of the past (and seemingly present) licensing regime is that direct competition is inherently limited within a local broadcaster's patch. And by not being able to start new stations easily from scratch, plenty of industry consolidation has been witnessed over the years.

Those leading the merger and acquisition strategies have been Capital, GWR, Chrysalis (LSE: CHS), Emap (LSE: EMA), Scottish Radio (LSE: SRH), SMG (LSE: SMG), Guardian Media, Local Radio (LSE: TLR) and UKRD, which together effectively control the sector. Read more | more.

GWR

GWR started life in 1985 following the merger of Wiltshire Radio and Radio West of Bristol. A string of mergers and acquisitions followed, including the purchase of Classic FM in 1996. At the last count, local analogue stations totalled 34, listeners totalled 11m and overall market share of the commercial sector totalled 21%.

Not surprisingly, GWR has many financial similarities to Capital. Firstly, GWR was also caught out by the post-2000 advertising downturn. The accounts for 2001, 2002 and 2003 all contained hefty write offs, while those for 2002, 2003 and 2004 have experienced recurring restructure charges. Confusing the recent performance even more has been GWR's relatively large expenditure within its fledgling digital radio business, where losses have been running at £5-6m per annum.

On a positive note, GWR also exhibits high operating margins and low asset requirements. Margins at GWR's analogue radio division were 22% in the twelve months to March 2004. In addition, the company carried tangible assets of around £20m; when compared to annual operating profits of £20m (including digital losses), it would seem GWR's cash flow is not burdened by heavy capital expenditure programmes. Another Capital similarity is a very small net pension deficit; GWR's was £1.5m at March 2004.

GWR's underlying results for the year to March 2004 were encouraging. Sales were up 9% to £126m, pre-tax profits recovered 60% to £17m, the dividend was lifted 9% to 6.3p per share and net debt was reduced by £35m to £65m.

Combined group

According to Capital and GWR, the merged group (whose name has yet to be decided) will have:

* 1 national and 55 local analogue stations;
* 93 digital stations and 28 digital multiplexes;
* 18m listeners, and;
* A 36% share of commercial listening

Management

A negative at Capital Radio has been its management. This 'fat cat' study highlighted Capital's chief executive, David Mansfield, providing shareholders with far less than his pay packet suggested. Thankfully, his opposite number at GWR, Ralph Bernard, has done his investors more favours of late:

Company	Boss	Period	Basic pay	Dividend
Capital Radio	David Mansfield	1998-2003	up 60% to £383k	up 21% to 18.5p
GWR	Ralph Bernard	1999-2004	up 45% to £400k	up 50% to 6.3p

In fact, with Mansfield taking up the role of chief executive of the merged group and Ralph Bernard becoming executive chairman, it will be interesting to see how Mansfield copes being the number two.

Bernard does seem to be the more experienced of the two men. He started his career in commercial radio as a journalist in 1975 and had reached the post of managing director at Wiltshire Radio by 1983. Bernard then took executive control of GWR in 1987, a position he has never relinquished. Mansfield by contrast only took charge of Capital in 1997.

Another positive from GWR's boardroom is that its directors hold far more meaningful stakes than their Capital counterparts. GWR's board presently owns 5% of its firm (a stake worth £17m), while Capital's board owns approximately 0.3% (worth £1m).

Valuation

Based on the latest results available, the combined group could be expected to produce:

* Revenues of £243m
* Analogue operating profits of £51m
* Operating synergies of 'at least £7.5m'
* Net interest payments of £4m

Assuming corporation tax at 30% and 164m shares in issue, post-merger earnings of 24.6p per share look likely. Under the terms of the deal, applying an earnings yield (equivalent in this case to a free cash flow yield) of 7.5% gives a Capital buy price of 329p and a GWR buy price of 198p.

Note that this calculation assumes no growth in the current year and also excludes expenditure on digital radio. Combined digital losses have been running at £11m per annum and it's anyone's guess as to whether setting a net present value of zero for these operations will prove too conservative or too optimistic over time.

Summary

Commercial radio enjoys decent barriers to entry and is a highly visible industry for the ordinary investor, with market shares and operational performances easy to keep track of. But the recent financial performances of Capital and GWR are not spectacular, nor are they easy to evaluate.

Nevertheless, the combined Capital/GWR will remain on the Qualiport's watch list. It will possess the operating characteristics for superior returns in the future, with Capital followers benefiting from a step-up in management quality. Most importantly, the proposed deal creates by some distance the leading force in an inherently attractive sector.

Trading update

Within the next five trading days, the Qualiport will invest its entire cash balance (around £1,270) in London Stock Exchange (LSE: LSE) shares.

Maynard owns shares in London Stock Exchange.

More: Runners In The Race For Radio | Why Radio Is Great For Buy And Hold

Portfolio value

Holding	Number of shares	Closing price 11/10/04 (p)	Value (£)
Associated British Ports	681	456.5	3,108.77
Emap	372	787	2,927.64
Halma	1,920	167	3,206.40
Johnston Press	1,608	564.5	9,077.16
London Stock Exchange	1,669	354.5	5,916.61
Cash			1,270.94
Total			25,507.51