With change accelerating in the media/telecom world seeming to accelerate in the past few years, I finally got around to reading Walt Hawyer’s history of Capital Cities (I read the paperback edition and through this post I will reference the page numbers in case you have the book and want to follow along). I was already a little bit familiar with the company as a result of reading the Berkshire annual reports and knowing that Buffett has always said great things about Tom Murphy and Dan Burke (the two main leaders at Cap Cities following the death of its founder Frank Smith). I then learned a little more about the extent of the phenomenal returns Cap Cities produced for shareholders when I read William Thorndike’s book The Outsiders.
Cap Cities got started when its founder Frank Smith and a group of investors purchased a bankrupt radio station in Albany, New York in 1954. Starting with one radio station, Cap Cities grew and acquired other radio stations, then TV stations, then publications and newspapers, a CATV company, and then the ABC network in 1985.
Hawyer gives the reader an extremely detailed account of (1) the many different people that were key to the success of the company and (2) many of the great challenges and opportunities Capital Cities encountered in its corporate history. It’s a book focused mostly on the people and the individual radio/TV and publishing assets Cap Cities acquired. And there are a lot of people in the book. Towards the end it was getting tedious enough that I was frequently scanning and skipping pages.
The few times he did, it was always very interesting when Hawyer gave details on some of the financials of Cap Cities’ various acquisitions and dispositions—the growth rates and returns for some of their radio and TV station deals were astonishing in some cases.
Given the paltry financial details, I hungered for more and took a two-pronged approach to learning more in this area. First, I would pick one deal in the book that had sufficient financial details that would allow me to do some guesstimation and come up with rough/approximate IRR figure. This one deal was the acquisition of KTRK-TV in 1967. Second, I would do some googling for any historical financials or annual reports for Capital Cities. Given that I have no access to any databases for historical financials, I wasn’t expecting to find much or anything at all, so I started with the thought experiment.
Guesstimating the KTRK Deal IRR
Below are the key details I used to guesstimate historical pre-tax income for the station and thus a rough IRR:
- TV station based in Houston, Texas and 3rd place in ratings (pg. 93)
- Station's investors only making "some money" by 1966 (pg. 94)
- KTRK ownership was highly splintered: 11 of the original investors were dead and their stock was in their estates and the two main figures that were still alive could not agree on business matters (pg. 94)
- Acquired in 1967 for $22.5 million: $4 million came from cash and the other $18.5 million from trading away their WPRO-TV station (pg. 92)
- Started to pay off dramatically by the early 1970s when pre-tax profits exceeded $22.5 million each year until 1985 when Texas economy crashed (pg. 93)
- In 1984, pre-tax profit was more than 2x what Murphy paid for the station (pg. 93)
- Produced several hundred million in pre-tax profits for Cap Cities (pg. 96)
- Worth over $300 million in 1994 (pg. 96)
So Cap Cities purchased KTRK for $22.5 million. At the time, Houston had a population of about 700,000 and KTRK was third place in terms of ratings. Cap Cities quickly cut expenses, improved sales and profitability, and kept the ball rolling until the station was valued at over $300 million in 1994 according to the author. Not accounting for leverage, my best guess for the after-tax IRR of this purchase was in the low 30% range. Again, the table below is based purely on my best estimates for this particular station given the clues from the book, they are not real numbers.
KTRK-TV Guesstimated Pre-Tax Income and IRR
It's also important to consider the other options Cap Cities had with its money at the time. Towards the end of 1967 when Cap Cities purchased KTRK, the U.S. ten year note was at about 5.7% after increasing steadily from WWII lows and the S&P earnings yield was about 5.5%–5.6%. So let's say Cap Cities had a goal of getting low to mid-teens returns on their capital at that time, or roughly 2.5x the yield on a ten-year note. Assuming KTRK had $2.0 million of pre-tax income and $1.2 million of net income, Cap Cities purchased the station at a 18.75x net income multiple or a 5.3% yield. Without knowing anymore details beyond that, you'd think Cap Cities may have been kinda dumb: why buy something risky that yielded less than a T-note? Or, since we can only guess at the details, maybe the station was earning a little more money than my guesstimate and Cap Cities paid a lower multiple simply because the original investors wanted out?
Anyways, whatever the actual numbers were, there is no doubt the KTRK purchase was super cheap given the enormous growth prospects! Cap Cities could have paid $60 million for KTRK at a 66.7x earnings multiple or a paltry 1.5% earnings yield and they still would have gotten a high-teens IRR based on my guesstimates in the chart above! And just think if they had used even a little bit of leverage. This illustration just goes to show how important growth can be when it comes to returns and valuation.
This was probably a time where even an average operator could succeed. Purchasing a station in a market that had a high likelihood of above average growth at even an above-average multiple seems like it would have produced good returns for an investor. Getting into a city like Houston when population growth goes gangbusters will obviously do wonders for returns. If you own a radio or TV station in a city growing 30%–60% decade over decade versus the national average of 10%–20%, you're gonna do just fine.
But picking the right growth markets doesn't fully explain Cap Cities success. The Cap Cities crew really kicked their returns into overdrive by just being flat-out the best operators and managers.
One of the big reasons Cap Cities was so successful was they had a management culture that could easily cut unnecessary expense while simultaneously investing new equipment or sales reps when they were necessary. You could say this culture really was branded on them by their original circumstances in purchasing a bankrupt station housed in a former convent for nuns. The original, barebones staff was hired purely based on what Smith and his investors could afford (which was not much). Employees had multiple jobs and responsibilities and had to make do without financial resources. In the 14 months after Smith purchased his first radio station, they were over $700,000 in the red. However, with good programming and a focus on keeping expenses low and investing in sales growth, the station came to be profitable and Smith started looking to acquire a second station. And the rest is history as they say.
Throughout Cap Cities’ history, Smith and Murphy frequently acquired assets that were underperforming in some fashion and then worked on turning them around. A radio station may have had too many employees, its ad rates may have been too low, or it hadn’t invested enough into hiring good salesmen. One of the lessons Murphy learned from Smith was “to look for properties that previous management had failed to develop to their fullest potential” (pg. 95).
Does this sound at all like other people and companies in 2015? Valeant, 3G, Transdigm, Danaher? Cap Cities may have been one of the earlier companies that could have been described as “lean” or taking a zero-based budgeting approach. This is even even more impressive given they were in the media business, which typically has not been known for great cost controls.
Corrupting With Autonomy and Authority
This gets to the second big reason why Cap Cities did so well. Cap Cities executives hired good managers and took a hands-off approach with them. As long as managers were growing sales and cutting costs, Tom Murphy and Dan Burke did not have to give marching orders or micro-manage: “Once Capital Cities taught them how to run a business, they let them run it with virtually no interference.”
Dan Burke recalled some comments Smith once made on the subject of autonomy:
Smitty said to me, "Some of you fellows may think I tie you to Capital Cities by corrupting you with compensation and stock options. … But I've decided the reason you're scared to leave is because the system we have corrupts you with autonomy and authority. And I suspect that after you live that way, you're very fearful that someplace else wouldn't be the same" (pg. 89).
Furthermore, Hawyer wrote:
“Over the next two decades leading up to the ABC merger in 1986, Murphy would borrow religiously from the Smith formula: An unpretentious, decentralized management style that gave his executives authority and responsibility to run their operations without heavy-handed interference from the top” (pg. 91).
This combination of bare-bones SG&A expenditures—concurrent with investing/spending money only when it was necessary—and a hands-off management style are what produced 70% pre-tax margins for Cap Cities TV stations versus the industry average of 34% according to this Fortune article!
Here are two charts from Robert Hagstrom's first edition of The Warren Buffett Way showing Cap Cities margins and returns on equity:
Cap Cities Pre-Tax Margins
Cap Cities Returns on Equity
Again, what a company!
A More Complete Picture
Moving from a case study of a single transaction, let's look at Cap Cities as a whole. Throughout its history, Smith and Murphy continually bought and sold assets. Given the FCC rules and restrictions regarding ownership of media assets, there was really no other way to grow at the pace they wanted to grow. They rolled up assets, selling them in order to trade up for a different asset with a bigger opportunity, frequently using a generous amount of debt. Had there not been FCC restrictions, Cap Cities probably would have been even more aggressive earlier on, but this is hard to tell as other media owners/investors might also have been more aggressive and thus media assets might have been bid up to sky-high valuations, thus eliminating Cap Cities' opportunities. But this is just pure speculation…
Anyways, with its acquisitions, Cap Cities could afford to pay what some considered a generous premium because Cap Cities knew how to vastly enhance the sales growth and reduce the operating expenses of the acquired asset. Cap Cities knew how to cut all the costs that weren’t needed while at the same time they were not afraid to spend money on capital upgrades or hiring more salespeople to boost revenues.
The two charts below are from financial data I painstakingly assembled from searching through many issues of Broadcasting Magazine, which has an online archive available to the public. I did my best with this data and make no guarantees as to accuracy. I think these charts nicely sum up Cap Cities' amazing run from 1958 to 1985, the year it announced it would acquire ABC for $3.5 billion:
Given these figures, the returns for shareholders were amazing. At the end of 1957, Smith offered his first group of employees the chance to purchase Capital Cities shares for a price of $0.71875 per share (pg. 31). The share price would close 1985 at $224.50 per share. Over those 28 years, that’s an annualized return of nearly 23% and this is excluding dividends! (NB, I adjusted these per share figures for the three 2-for-1 splits that would occur between 1957 and 1985, but did not adjust for the 10-for-1 split that would happen in 1994).
I know this post strayed from being a true review of Hawyer's book and veered mostly into the realm of finance, but I had fun doing this. Even though Hawyer's book was more about the people than about the deals and financials, it was still extremely illuminating and enlightening. I mean, without all the great people, Cap Cities would not have been nearly as successful! So perhaps I will delve more into the people side in a second post about Cap Cities?
In the end, my takeaway is Cap Cities was indeed one of the most successful roll-ups in corporate history. Thorndike was absolutely correct in his analysis of the company and I bet there is a reason he led off his Outsiders with Cap Cities and Tom Murphy. Cap Cities' cost-cutting, hands-off management style and willingness to divest/acquire many assets (and their use of debt in the process) is precisely what led to such amazing returns for their shareholders. If you're able to find a management team of Cap Cities' caliber in an industry that that can be rolled up, it seems inevitable you will do great, whether its pharma, food, life sciences, or industrials. This is how minnows can eventually swallow whales.
- Griffin, Tren. "A Dozen Things I've Learned from Tom Murphy About Capital Allocation and Management." 25iq. <https://25iq.com/2015/01/11/a-dozen-things-ive-learned-from-tom-murphy-about-capital-allocation-and-management/>
- American Radio History online archive of Broadcasting Magazine issues, <https://www.americanradiohistory.com/Broadcasting_Individual_Issues_Guide.htm>
- Thorndike, William. The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Boston, MA: Harvard Business Review, 2012. Print.
- Hagstrom, Robert G. The Warren Buffett Way: Investment Strategies of the World's Greatest Investor. New York: J. Wiley, 1997. Print.
- Capital Cities/ABC Inc. 1993 10-K <https://www.sec.gov/Archives/edgar/data/17109/0000950130-94-000530.txt>
- Nisen, Max. "The Man Who Taught Warren Buffett How to Manage a Company." Quartz. Quartz, 23 Oct. 2014. Web. 08 July 2015. <https://qz.com/273797/tom-murphy-taught-warren-buffett-how-to-manage-a-company/>.
- Houston population:
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