Friday, April 27, 2007

Tribune offers big payday or mayday - 40% returns possible for employee owners; debt concerns loom

Tribune offers big payday or mayday - 40% returns possible for employee owners; debt concerns loom
By Michael Oneal
Copyright © 2007, Chicago Tribune
Published April 27, 2007

The significant risks and potential rewards facing Tribune Co. as a highly leveraged concern became clear this week when the company launched the first step in an audacious $8.2 billion gambit to take itself private.

Documents filed with a tender offer for roughly half its outstanding shares disclosed for the first time the financial assumptions Tribune and its advisers used in assessing the company's various options during its six-month auction process.

The documents also contain "pro forma" data showing what could happen to Tribune's financial picture when the company increases its debt to more than $13 billion after transferring ownership to an employee stock ownership plan and Chicago billionaire Sam Zell.

The welter of charts, text and tables paints a vivid picture of the rich upside and chilling downside presented by the leveraged ESOP structure. For employees, who will end up owning 60 percent of the new Tribune, the potential returns could be staggering -- better than those of either Zell, who will control 40 percent, or management, which will receive phantom stock equivalent to 8 percent of the company.

But if Tribune falters, as it did in the first quarter, those returns could evaporate quickly. And even if the company does just a little worse over the next five years, it could easily find itself rubbing up against debt covenants that could trigger a default, the documents show.

"That's not an unrealistic outcome given where we are today," said one source close to the company. "But we think we can do better than that."

The management projections used to analyze the deals assume Tribune's revenues will grow an average 0.7 percent each year between 2006 and 2011, to about $5.6 billion. This lack of growth helps explain why only 4 of the 31 groups that examined Tribune's books eventually made offers.

The projections assume that revenues from the company's newspapers, which include the Chicago Tribune and the Los Angeles Times, remain flat. The broadcast group, which includes Chicago's WGN-Ch. 9, would have to grow a little less than 2 percent annually under this scenario.

Operating cash flow, meanwhile, would grow about 2.7 percent, powered mostly by 20 percent growth in equity investments like Tribune's 42.5 percent stake in CareerBuilder and its one-third share of Food Network TV. Without those investments, overall cash flow would grow just 1.2 percent annually and publishing cash flow would essentially stay flat.

Despite these anemic projections, the Zell deal has the potential to pay off big for the company's new employee owners, the documents show.

Employees stand to reap returns of about 40 percent annually over the next 10 years, assuming that the company's shares are valued at about 8 times cash flow by the end of that period.

What does that mean for the typical employee? Say the employee makes $60,000 a year. In the first year of the deal, that employee's distribution from the ESOP would likely be 5 percent of his or her salary, or $3,000. Even if that $3,000 was all the employee ever got from the ESOP, it would grow to $86,766, compounded at 40 percent annually.

But if the employee got $3,000 distributions every year, that return would jump to almost $380,000.

Those kinds of returns are made possible by the leverage. Because the new company will have more than $13 billion in debt and a tiny sliver of equity initially, the company's stock will be worth very little in the beginning. But if the debt gets paid down and the company's balance sheet improves, its cash flow will grow quickly and the equity value will explode.

It's the same principle as taking out a mortgage. Equity grows as you pay down the loan, and if the market for houses increases, the return is all yours.

Zell's potential rate of return -- somewhere between 25 percent and 30 percent annually -- is significantly less than the ESOP's for two reasons. First, he is investing more upfront and second, he is buying his shares for $34 apiece while the ESOP purchased its stake for $28 a share.

These terms were negotiated by the ESOP trustee charged with guarding the employees' interest.

The documents show that in a version of the deal contemplated in late February, Zell's 10-year annualized return would have been in the mid-20 percent range while the employees' return was less than 20 percent.

Over the next month, the trustee pushed Zell to contribute more equity, and on the final weekend of negotiations the trustee squeezed out terms that allowed the ESOP to buy its stake at a $6-per-share discount, meaning the employees' return would always outpace Zell's.

The leverage that drives those returns was made possible because Zell's team figured out how to structure the deal so that the company will not have to pay taxes. The interest expense incurred as a result of the debt will slash Tribune's cash flow, but if all goes as planned, the elimination of taxes will make the debt affordable.

According to projections prepared by Merrill Lynch, the new Tribune would generate free cash flow available to pay down debt of close to $300 million in 2008. If the management plan holds up, that number would grow to more than $580 million by 2012, even accounting for capital spending of about $300 million.

The question posed by the company's dismal first-quarter results, however, is what happens if management's plan doesn't hold up?

Plagued by falling advertising and circulation revenue, Tribune's revenue fell 6 percent in the first quarter, which was 2 percentage points below management's assumptions in February, the documents show. And many in the industry are bracing themselves for declines in cash flow stretching into 2008 as readers and advertisers defect to the Internet and newspaper companies struggle to adjust.

Under a "sensitivity plan" included in the Merrill Lynch analysis, management tries to imagine a less rosy future. It assumes a 2 percent annual decline in publishing revenues, a drop in operating cash flow and flat revenues in broadcasting.

In that case, free cash flow to pay down debt would start close to $200 million in 2008 and drop to about $196 million in 2012. The amount of debt eliminated over that period would be just 17 percent, versus 48 percent under the better-case plan.

Consequently, those massive employee investment returns would shrink from 40 percent to somewhere between zero and 8 percent, depending on certain assumptions. If the results get any worse, which could happen given the industry's troubles, the returns could evaporate entirely and problems could escalate.

The documents show that if the company pays down its debt on a regular schedule, as envisioned in the management plan, it will easily fly below debt-to-cash-flow limits imposed by its bank agreements.

But under the sensitivity plan, one document shows, debt-to-cash flow could approach these limits as early as 2011. That might force management and Zell to sell assets or look for other ways to throw off ballast. And that assumes a 2 percent decline in publishing revenue. If the revenue dropped more, the threat of technical default could arrive even sooner.

The effect of all of this is that it puts enormous pressure on the company to turn around its advertising and circulation declines while squeezing more revenue out of TV stations that are depending on the unproven new CW Network to provide them programming.

Zell has handed Tribune employees the chance to make a bundle. But unless they find ways to solve problems that have confounded the industry for years they could easily be left holding the bag.


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