Tribune Shareholders Vote Yes On The Zell Deal But The Stock Price Indicates The Smart Money Is Not So Sure The Deal Will Go Through On Current Terms

Philip Stone August 23, 2007

Some 97% of Tribune shareholders approved the Sam Zell takeover which puts the company into junk debt to the tune of some $13 billion, but with the share price around $6 less than the agreed purchase price there still seems a fair amount of doubt that Tribune is doing well enough financially these days to support the repayment schedule.

Tribune is being pressured by lenders who are getting particularly worried at the company’s poor performance thus far this year, and it will be very close whether the company will be able to satisfy earnings requirements for repayments. The severe downturn in the newspaper business this year has caught everyone by surprise and there is nothing to indicate it won’t get any worse in the second half of the year, especially since several groups reporting July performance showed no improvement.

Tribune needs to earn, before taxes, interest, depreciation and the like around $1 billion a year to satisfy the debt repayments. Current forecasts, taking into account that the first half saw print and online advertising revenue down some 9% over the year before, puts such earnings at around $1.1 billion for this year, but last week Lehman Brothers analyst Craig Huber scared the markets with a projection of around $990 million next year. Certainly not a lot of breathing room, and it must mean that the cost cutting, brutal as it has already been, is only going to get worse, and perhaps more asset sales might be necessary.

As part of its plan to free up cash Tribune is selling the Chicago Cubs baseball franchise and indications are it could get in excess of $1 billion whereas it had been counting originally on somewhere around $700 million, but if earnings for the rest of the year get even tighter, then the company might  be forced to sell more.

Since  there are few buyers for metropolitan newspapers at decent prices these days then the attention will be on selling its one-third interest in the cable Food Network which could bring in around $1 billion, or some of its TV properties. It really doesn’t want to sell television if it can help it because 2008 should be a banner advertising year with the Beijing Olympic Games and the Presidential, Congressional, and State elections.  But when it comes right down to it, it will have to do what it has to do to make the deal work.

A prime example of how much doubt there is in the market is that Standard & Poors chose the day before the shareholder vote to further downgrade the company’s debt, saying that operational performance and cash flow is far worse today than when the deal was announced five months ago. The debt already has junk status and S&P lowered it one more rung on that scale, to BB-, and said it would reduce it even more when the Zell deal completed in December. And then there is Huber again warning, “The likelihood of the Tribune privatization deal happening in the upcoming months is no better than 50-50." So, all in all,  certainly not a vote of confidence!

But there are hedge funds out there taking the gamble that the Zell deal at $34 a share will go through.  According to Securities and Exchange documents filed by June 30 three hedge funds have bought from 1.4 million shares to 7.3 million shares each. If they bought at around current prices and the deal goes through they’ll make around $5-$7 a share profit. On the other hand, if for some reason the deal does not complete then Huber has told his clients he thinks the shares could tank to $4 to $5 each. Before Tribune started the privatization process the shares were languishing in the mid $20s. One needs a strong stomach to be in that risk arbitrage business!

If the deal does go forward the current shareholders will get their $34 a share and then it’s an employee owned (but not managed) company with Sam Zell holding about 40% of the company, named chairman for his $315 million investment (and you wonder how billionaires become billionaires – by investing as little of their own money as they can for possibly very big rewards) – and the employees will own 60% but they don’t even have a promise of getting a seat on the board of directors!

The risks for the employees are great. The deal is being structured under what is called an ESOP (Employee Stock Ownership Plan). There are great tax advantages to an ESOP, but the prime disadvantage is that if things go bad, if the debt cannot be repaid, then it is the employees and their pensions who are left holding the bag.

That’s why the Teamsters Union, which represents some 2000 Tribune employees, warned investors, employees and creditors at the shareholder meeting Tuesday about the financial risks but, frankly, all the shareholders really care about is getting their $34 a share.

An ESOP offers several tax advantages but puts employee pensions at risk. Instead of Tribune contributing to the 401k type of pension plan at most US companies that allows employees a free choice of how that money is invested for their retirement, an ESOP requires the employer to put that retirement money into it, and the ESOP in turn invests in the shares of the now privately held company, with stock dispersed at retirement age to the employees.

The ESOP contributions are treated as paying off principal, so both principal and interest can be deducted from Tribune’s taxes, rather than just interest. Very clever, but if Tribune drowns under all of that debt then where are the employee pensions? Answer: They’re not! If Tribune does really well under private ownership then the value of those shares will increase and it will truly be one big happy family. No wonder the Teamsters and other unions are not wild about this buyout!

For all of this, the company is insistent that its financing for $11 billion in loans is complete and secure. “ Our going private transaction is on track and the financing is fully committed (the final $4.2 billion from four banks) ,” according to spokesman Gary Weitman. “We anticipate closing the transaction in the fourth quarter, following FCC approval and expect to be in full compliance with our credit agreements.”

That Federal Communications Commission approval on waivers for owning newspapers and television stations in each of five markets including the big three -- New York, Los Angeles, and Chicago  -- is crucial. The FCC has given no hint on how it will vote on continuing and transferring the current waivers, but the smart thinking says it will grant approval, especially since FCC Chairman Kevin Martin has signaled he favors eliminating cross ownership rules, or at least not having them so draconian.

Lenders have already squeezed Tribune more than the company had wanted to pay in interest. For instance, Tribune had wanted seven years to pay back $8 billion; instead the bond holders increased the interest rate on the loan by half a percentage point, said that applied to $6.5 billion that could be paid in seven years but the other $1.5 billion, at a slightly lower interest rate, had to be paid back within two years.

Going forward through December, tracking Tribune’s share price, and how much it differs from the $34 buy price will give a good feel for how the market believes the deal is going. In most deals there is usually about a 10% spread between purchase price and current share price. Shares last week sank to around $25, a 26%% spread, but since then the spread has narrowed to 17.7 % with its shares jumping 5% on Monday, and closing Tuesday after the deal approval at $27.98 , a 3.55% increase.

The odds are the transaction will complete in December. The company has repeatedly said the financing is in place, so the only real question – and it’s a biggie -- is what Tribune will have to do if newspaper revenue continues to tank in order to ensure it brings in that $1 billion plus in annual earnings necessary to service the debt.