Hallmark’s Billion-Dollar Debt Bet

5/17/2009 3:00 PM Eastern

When Bill Abbott takes the helm of Hallmark Channel parent Crown Media Holdings next month, he’ll have his hands full maintaining the momentum the family-oriented network has built over the past several years.

New Hallmark Channel topper Bill AbbottBut the far bigger pressure may come from the mountain of debt the network is carrying: $1.1 billion.

Crown’s debt has been an issue at least since 2003, when its largest shareholder — Hallmark Entertainment Holdings, with 67% of the equity — also became its largest debtholder, securing a $400 million note that helped Crown undo a messy preferred-stock deal. That note has since grown to about $700 million, mainly through accrued interest, and brings the total tally of monies owed Hallmark and its subsidiaries to about $1.1 billion.

“It’s a great company,” said one executive familiar with Crown’s finances. “But in this interest-rate environment, running debt at 10% [annual interest] or more and to keep accruing it, makes it almost impossible for the company to generate enough cash flow to ever cover the interest on that debt.”

Crown has been lucky to have a benevolent debtholder in Hallmark — as the largest equity holder, it has no incentive to force a default and for years has opted instead to extend maturities. But the company has said its goal is to remove Hallmark as its banker. To do that — Crown has said that could happen as early as next year — would require a significant and consistent operational boost. Although Crown has shown strong growth over the past five years, it has never generated enough cash from operations to even cover the interest on its debt. And chances are that a third-party debt holder won’t be as forgiving as Hallmark.

Comparisons are difficult, since no two cable programmers operate under the same financial architecture. Some smaller publicly traded companies like The Outdoor Channel and World Wrestling Entertainment have very little debt — Outdoor had no outstanding debt in 2008 and WWE had about $3.9 million in long-term debt during the same period.

Hallmark ChannelEven compared to much larger companies, Crown’s leverage is high from an enterprise value to earnings before interest, taxes, depreciation and amortization standpoint, one of the most widely used valuation ratios. Crown’s enterprise value/EBITDA ratio is about 21 times compared to Viacom and News Corp., much larger companies with EV/EBITDA ratios of 5.8 times and 4.8 times, respectively. To get to that neighborhood, say 6.5 times, Crown would either have to reduce debt to around $100 million or increase cash flow to $214 million.

Crown wouldn’t have to drop its ratios that low, but even with robust cash-flow growth, getting to just half that level would seem difficult, even with a strong advertising environment.

In the meantime, the bill on its debt keeps rising. According to Crown’s 10-K annual reports, interest expense on the debt has grown from $66.9 million in 2004 to $100.2 million in 2008. Last year, 2008, was the first time in its history that Crown generated positive adjusted EBITDA, a measure of cash flow. But at $66.2 million, it still fell well short of covering interest expense for that year.

Analysts have dogged the company in the past to restructure the debt — one, Natexis Bleichroeder’s Alan Gould, dropped coverage of the stock in part because of its debt structure.

“While ratings and distribution are strong, we believe the capital structure remains the biggest issue facing Crown,” Gould wrote in his January note announcing that he was dropping coverage.

Despite the outside pressure, Crown has held fast in its strategy to focus on operations growth. On a conference call with analysts to discuss first-quarter results on May 7, Crown chief financial officer Brian Stewart said the intention is to grow cash flow to the point where the debt can be refinanced. However, given the current state of the credit markets, that is likely a 2010 event.

Crown investor relations spokeswoman Mindy Tucker said the refinancing would involve a third party, removing Hallmark as a creditor all together.

Tucker wouldn’t say how much cash flow has to grow in order to make that happen.

Salvatore Muoio, principal and chief investment officer of S. Muoio & Co., one of the larger individual shareholders in Crown with about 5.2%, or 3.9 million shares, said he is confident the company can rectify the debt situation.

“I look at it as at least benign debt,” Muoio said. “It’s not the kind of debt that is going to put them in a bind; it’s the kind of debt that they have to outgrow.”

Crown Media has consistently grown its operations in the past five years —
$ in Millions

  2004 2005 2006 2007 2008
SOURCE: Company reports
Long-term debt $886.3 $971.6 $975 $1,004 $1,100
Adjusted EBITDA -$0.056 -$1.4 -$12.6 -$11.3 $66.2
Interest expense $66.9 $73.9 $98.7 108.1 $100.2
Revenue $138.2 $197.4 $201.2 $234.4 $281.8