RETRANS KEY TO GRAY'S DIGITAL DUOP STRATEGY

During the last round of retransmission negotiations with cable operators three year ago, Gray Television COO Bob Prather trod a different path than his peers at Nexstar and Sinclair.

Instead of waging a no-holds-barred battle for retrans dollars, Prather opted for carriage of second digital channels, mostly affiliates of UPN, that Gray had created in many of its markets.

With the virtual duopolies, Prather figured, Gray would capture more of the markets’ advertising dollars and preempt the competition.

“I thought while the real estate was available we ought to get it while it was cheap,” Prather says.

“We had 11 UPNs on digital channels that were doing real well,” he says. “And basically we made a deal to get channel placement on the analog tier, real good channel selection.”

The strategy looked like a solid hit until the networks threw Gray a curveball in early 2006: UPN and WB, which had been delivering solid audience numbers with their youth-oriented programming, were dissolving, leaving in their wake CW.

"One of the things that happened to us was the cable guys took that opportunity, claiming that because UPN was no longer in existence, our [retrans] contract was null and void and the only way they would give us those analog tiers was if we would sign up for additional years of no retrans payments and we refused to do that," Prather says.

"We wound up getting pushed up to the digital tier in a number of markets because we refused to give an extra three years to the cable people on retrans," Prather says.

"We had an excellent station, very profitable on UPN and now we've got a My Network on digital that doesn't reach but half the audience because half the audience doesn't have digital boxes."

Post-UPN-WB meltdown, Gray was forced to lower short-term financial expectations for the digital dividend. Nonetheless, Prather has continued to pursue aggressively the digital strategy and says the channels should achieve positive numbers by the end of this year.

Gray now has 40 digital second channels. Of those, 30 are affiliated with networks—MNT (16), CW (8), Fox (5) and ABC (1).

In addition, it operates eight digital local news-and-weather channels and two digital independents.

Supplementing the network programming on the affiliates is paid programming and barter syndicated programming.

Gray’s primary stations—36 in 30 markets—are often ranked tops for news and it doesn't take an advanced degree in economics to see how it’s possible to create synergies, and thus hold down costs, through virtual duopolies—even if the second half of the duopoly doesn’t rank in the top four or five in its market.

Prather talks about how the digital second channels offer programming unavailable on the network affiliates—college and high-school sports programming, in-depth local weather and news, for instance.

According to Prather, the group has spent roughly $15 million so far developing 40 channels—an average of $375,000 each.

But what interests security analysts that cover the publicly traded company is the opportunity costs of the digital strategy. How much retrans revenue did Gray forgo by opting for digital carriage deals rather than simply payments?

The answer to that question is purely speculative.

The financial community's response to Sinclair's and Nexstar's battling it out for retrans dollars has been overwhelmingly positive.

As analysts like to point out, retrans dollars fall directly to the bottom line—no filtering, no overhead, no additional costs, unless you count the time and brain damage incurred by negotiations or the possible loss of ad revenues from stations sometimes temporarily bounced from cable systems.

Sinclair, a substantially bigger group than Gray, projects $60 million in retrans money this year, on the middle to low end of estimates by Bear Stearns' Victor Miller.

And Miller projects that Nexstar, closer to Gray in size and market profile, is looking at somewhere between $18 million and $60 million this year.

Under Miller's early model, Gray would have brought in around $24 million at the mid range. He’s now projecting Gray will collect about $15 million in retrans fees “eventually.”

When we were last doing retrans, I decided to go with digital channels with UPN,” he recalls.

At this point, Prather is making no apologies for his strategy.

“There were no retrans fees to be had when we did these deals,” Prather says. “If we thought we could have gotten paid retrans, we would have asked for retrans. At the time, I don't think anybody was getting paid.”

And Prather has his believers—on Wall Street and elsewhere.

“What he's saying is that if I can put a CW on a second channel and put some news on it, I eventually can nurture it into a real competitive force and I'll do that via cable,” says Larry Patrick of Patrick Communications. "He's gambling on whether that will work. I'm sure some analysts will say always go for the cash. But investing in your franchise is a good idea."

Roughly two-thirds of Gray's properties come up for retrans talks next year, the remainder in 2009. Prather sees a strong digital presence as a potentially powerful bargaining tool and a chance for carriage and cash.

He says he will definitely be looking to get retrans fees and analog tier placement for the digital second channels.

“I haven’t ranked them,” he says, “But I think they're both important.”

Analog carriage alone will help, he says.

“I think [cable and satellite] will have a hard time not giving us cable placement for these channels,” he says.

“They're in the business of getting viewers and I think they'll have a hard time explaining to people why these channels are not on the air. We could end up getting full digital must carry for all our spectrum.”

Like other broadcasters, Gray will have a powerful new card to play in the next round of retrans talks—broadcast network programming in HD.

“I am a Mark Cuban cubist—he's the most articulate evangelist for HD,” says Wachovia’s Bishop Cheen. “All this retrans stuff isn't about [syndicated] programming, it’s about hi def [network programming].

“I think digital TV operators are going to want to carry the full 6 megahertz of spectrum in hi-def mode,” Cheen says. “Therefore, if you want my hi-def signal, there's nothing else you can do for me than give me cash."

Affiliates of the major networks, Gray’s main channels all offer HD and, Prather says, the digital channels will all eventually upgrade to HD, too.

“I would hope that would be strength in the negotiations.”