Belden said today it plans to divest its Grass Valley business.

The company has retained JP Morgan to manage the sale process and is actively engaged with several parties.

Accordingly, Belden is now reporting all Grass Valley-related revenues as “discontinued operations.”

Note that ThinkLogical (acquired in 2017) is not part of the intended transaction and will remain part of Belden.

We spoke to Belden management, who told us they expect to consummate a deal relatively quickly, with a private equity (PE) firm being the likely buyer.

Business as Usual

Grass Valley Management told us that they will continue to operate on a business as usual basis while the divestiture process plays out.

Significantly, current Grass Valley management, including company president Tim Shoulders, will remain in their current roles and continue to run the business before, during, and after the proposed transaction.

Further, it’s in Belden’s interest to make the process as frictionless as possible for both Grass Valley and the eventual buyer. Therefore, Belden has committed to continue to provide essential back-office and other corporate services until the transaction has closed.

Culmination of Year-long Portfolio Review

The divestiture of Grass Valley shouldn’t come as a surprise.

Belden has been telegraphing its frustration with the unpredictability of demand in the broadcast sector and its intention to restructure its portfolio for more than a year.

Today, company CEO John Stroup said, “We completed a rigorous strategic review of our portfolio of businesses, and today’s announcement marks an important outcome. We concluded that it is in the best interests of our shareholders, customers, and employees to separate Grass Valley from Belden. This will enable Grass Valley to more effectively execute its strategic plan and pursue growth opportunities. Further, this separation will simplify Belden’s portfolio and improve organic growth and revenue visibility.”

Today’s announcement is the culmination of a year-long process that started around the time of Belden’s Q3 2018 earnings call, when Stroup told analysts:

“Most of [the] revenue miss in the quarter was a result of the miss in Enterprise, and the miss in Enterprise was almost exclusively our Live Media business. So, for the third quarter, I would say, the revenue miss is relatively isolated to the Grass Valley business. On the same call, company management added that the media and broadcast sector “has proven to be very difficult to forecast,” saying Grass Valley went into Q3 2018 confident it would receive a “fairly sizable order,” but the customer decided to push the project into a future quarter.

“We’ve had this happen far too many times,” said a frustrated Stroup. “Quite frankly, what we find in this business [broadcast], particularly North America, is a lot of lumpiness, a very difficult time being able to accurately predict when demand is going to occur. It’s harder to forecast and it’s creating surprises when obviously we don’t want them. I don’t think it is anything more than that, and I think that as our North America customers in particular are struggling to allocate their capital in ways that they feel are prudent, given some of their competitive challenges – this is our reality. And so, we changed expectations for fourth quarter as a result. Quite frankly, if my team does what they say they’re going to do in fourth quarter, then we’ll beat these numbers. But I’m just not in that position to set expectations that way.”

Because of the ongoing challenges in the broadcast business, Stroup said the company is “taking this opportunity to reflect on what expectations should be for the fourth quarter. We’re reflecting on the portfolio in general – I don’t have any updates for you on that, but it’s clearly underperforming the expectations we have, and we need to give it further consideration.”

Accounting for Discontinued Operations

US GAAP doesn’t allow for companies to treat any divestiture (planned or otherwise) as discontinued operations. Rather the divestiture needs to represent a strategic shift set to have a major effect on the owner’s operations or financial results, and the divestiture must meet the criteria for designation of ‘Held for Sale.’ In this instance Management’s commitment to the sale process or the active sale initiative qualify for ‘Held for Sale.’

Grass Valley Performance

Based on Belden’s filings, Grass Valley generated full year 2018 revenue of $426.2 million in 2018. Gross margin for 2018 was 46.7% and EBITDA margin was 19.3%.

Through the first nine months of 2019 Grass Valley’s revenue is $263.4 million, a more than 18% decline versus the same period in 2018. The reduced revenue is reflected in year-to-date 2019 gross margin of 43.3% and EBITDA margin of 12.9%.

The decline is consistent across all quarters in 2019. It is important to remember there is still inherent even / odd year cyclicality in the business, so it isn’t surprising revenues are down year-over-year, though the magnitude of the decline is notable.

If the full year 2019 maintains the same performance as the first nine months, then total revenues in 2019 for Grass Valley will be around $346 million.

Grass Valley Today

The announcement marks the beginning-of-the-end of Belden’s nearly decade-long foray into the media technology sector that saw the company spend more than $700 million acquiring and integrating Telecast Fiber Systems (2009), Miranda (2011), Softel (2012), Grass Valley (2014), and Snell Advanced Media (2018).

Impact of Industry-wide Structural Shift on Grass Valley Revenues

The chart above outlines the transactions that make up Grass Valley today. In aggregate, Belden acquired more than $600 million of revenue via these five transactions, and Grass Valley became one of the largest pure-play suppliers in the media and broadcast sector.

However, according to filings with securities regulators the Grass Valley generates approximately $346 million in annual revenue – roughly 43% less than what Belden actually acquired.

So, where did the revenue go?

While it’s impossible for us to answer this question comprehensively, we have several observations.

In hindsight it’s clear that Belden’s timing of the Miranda and Grass Valley acquisitions was unfortunate. But at the time, the company made these deals with the best of intentions and with an uncheckered optimism.

For example, Belden’s investor presentation on the Miranda transaction stated an expected annual growth of 5 – 6% for Miranda’s market segments within the Broadcast technology market. Even in the relatively halcyon days of mid-2011 those were ambitious figures. At the time, Belden’s CEO John Stroup described the Miranda transaction in highly strategic terms. “This acquisition is another step in the ongoing transformation taking place at Belden. We believe that the combined company would be a leader in one of Belden’s target market segments and would deliver considerable value for Belden customers and shareholders” stated Stroup.

It is difficult to overstate just how poor the timing of the Miranda acquisition was for Belden. Almost immediately after the transaction the growth profile of broader broadcast technology industry changed.

Any attendee of a Devoncroft Executive Summit or IABM briefings in the past six years will have seen seen some variation of the below side from the IABM DC Global Market Valuation Report (GMVR), the industry reference for market sizing and forecasting.

We refer to the step change in market growth rates observed for the period beginning in 2012 as the ‘Structural Shift.’ This stands in stark contrast with the anticipated 5 – 6% annual growth communicated to Belden’s shareholders as part of the Miranda acquisition.

Of course, it is easy to judge business decisions with the clarity of hindsight. The purpose of reviewing the disconnect between expected growth with the Miranda business versus the market reality isn’t to criticize Belden’s management (nobody knows the future), but rather to highlight the perspective of Belden’s shareholders. Shareholders had an expectation of robust growth from this broadcast technology investment; it didn’t happen.

Belden’s intended cure for the challenges faced by Miranda was to add scale, leading to the 2014 acquisition of Grass Valley. Again, the company was very optimistic about the deal, as evidenced by the statements made by John Stroup. “In our opinion, though, that as a standalone business, there isn’t a lot more they [Grass Valley] can do, and I think the owners agree. And by combining these businesses, there’s really an opportunity to create scale that neither of them can do by themselves” said John Stroup at the time of the Grass Valley deal.

Unfortunately, the timing of the Grass Valley deal also looks poor in hindsight. Grass Valley had just benefited from equipment refreshes associated with the latest round of sports rights, most notably the NFL contract.

Indeed, as we highlighted at the 2019 Devoncroft Executive Summit | Las Vegas, the NFL rights refresh led to a build out of new live production capacity, including a series of outside broadcast trucks in North America. This in turn led to a healthy book of business for Grass Valley in late 2013 and early 2014.

However, a refresh of tier 1 sports rights is a near once-a-decade phenomena. This was not a sustainable catalyst for growth.

While Belden clearly got some of the logic wrong – including timing – much of the logic remains sound. Getting bigger had some advantages. Speaking at Belden’s investor day after the Grass Valley transaction, Roel Vestjens, then EVP Broadcast Solutions, stated, “Being the largest player in the industry allows us to ensure that we’re investing in innovation to meet our customers’ needs for years to come. It also provides us with a unique advantage when it comes to serving and supporting our customers globally.”

However, operating at scale can work against a company if market conditions change dramatically.

On Belden’s Q3 2018 earnings call referenced above, Stroup told analysts the Grass Valley’s business in live production “continues to do well and the International continues to do well, but the North America Playout business is struggling.” In other words, demand for the company’s legacy product lines for linear playout (including ITX and ICE) were had softened considerably.

Speaking at a J.P. Morgan technology conference in May 2019, Stroup quantified the scope of the ongoing disruption in Playout, and how it was impacting the performance of the business, saying: “That business [Playout] has gone from a peak of roughly $150 million down to about $30 million today.”

As mentioned above, with the benefit of hindsight it is clear Belden bought Miranda at just about the worst possible time, then three years later bought Grass Valley at an equally disadvantageous time.

The irony of the circumstances is that (in our opinion) now may be the most advantageous time to own the current Grass Valley enterprise. The businesses – including SAM – have been integrated and are generating a healthy level of profitability. Further, the businesses are well-positioned to benefit from what we believe is a milestone year for the adoption of IP-based infrastructure in the media technology sector.

Viewed from the perspective of a potential buyer this is then an opportunity to acquire a reasonably priced, cash generating asset with strong market share in market segments where a refresh cycle is envisioned over the next five years.

However, there is a caveat. Grass Valley today has a business model centered on an expensive direct sales model, deploying capital equipment. The business or a meaningful portion of the business will need to transition to a fundamentally different business model in order to have success deploying technology in virtualized environments. Those business models will be characterized by pricing models based on subscription commitments and pay-per-use. The inescapable impact is a short-term impact to revenue and the need to make significant investments to restructure the business around those new revenue profiles.

Attendees at recent Devoncroft Executive Summits will have existing familiarity with the below slide depicting the short-term revenue impact or ‘J Curve’ of the revenue profile businesses experiencing when moving to this model.

Trying to articulate to already skeptical investors that the declines in revenues being experienced in the short-term is a good thing, is a difficult proposition. Going through the above transformation is made easier outside of the visibility of quarterly reporting and a shareholder base focused on near-term levels of profitability.

As is made clear in Belden’s public statements, Grass Valley is a fundamentally different business than Belden’s other divisions. This is highlighted by the challenges Management has in forecasting revenue performance at Grass Valley.

The catch is Grass Valley – and its precedent businesses – have always been different businesses.

Below is a table shown in Belden’s investor presentation about the Miranda acquisition. It compares several income statement categories between Belden and Miranda. Note the complete contrast in gross profit profile and operating expense burden. On the right you have a solutions business, with heavy emphasis on technology differentiation (reflected in healthy gross margins), sold through an expensive direct sales engagement model, and requiring a substantial annual commitment to research and development. On the left you have a business with modest product differentiation (again reflected in gross margin), exhibiting exception operational efficiency that translates a gross margin of 29% into an operating income percentage of almost 10%.

Those are different businesses. This presents two distinct challenges: (1) management must integrate distinct operating models and (2) management has to explain the new business to existing shareholders. In this circumstance, it would appear the latter proved the much, more challenging exercise.

As noted above, the challenge was only going to get worse. Like many other media technology suppliers, Grass Valley is in the midst of a business model transformation that will ultimately lead to deploying services and technologies in virtualized environments. This should result in a more profitable income statement with a far, higher degree of predictability of revenue – eventually. The short-term impact is a decline in revenue in the aggregate.

Grass Valley Divestiture Process

Belden has hired JP Morgan to run the sale process and is engaged with interested parties to divest Grass Valley. During Belden’s call with analyst, John Stroup indicated the team was moving as quickly as possible and hoped to complete the transaction this quarter.

Since Belden is divesting a profitable business unit, the consequence to Belden’s shareholders is the loss of Grass Valley’s earnings contribution – though balanced in the near-term against cash receipts from the sale. We can estimate the impact of the loss of Grass Valley’s earning contribution by assuming the same trading multiple of 8.9x EBITDA-to-Enterprise Value prevails for Belden’s stock price immediately after the divestiture. Our assumptions suggest the impact to Belden’s stock price is $469 million (TTM EBITDA for Grass Valley is $52.6m) less the cash received in the transaction.

Simultaneous to the Grass Valley announcement Belden is announcing a $40 million expense reduction initiative. A reduction in expenses will help compensate for the loss of Grass Valley’s earnings contribution and mitigate the medium-term impact to Belden’s shareholders. Management has stated the cash flow offset of expense reduction will more than compensate for the loss of Grass Valley’s earnings contribution.

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