We recommend Scripps Networks Interactive (NYSE:SNI) as an Accumulate with a Fair Value Price of $70.99 per share. Our rating is based on SNI's strong revenue and profit growth from lifestyle media content business and ample free cash flows. We expect to see the company generate earnings per share of $3.70 in 2013 and to increase EPS by 12-15% annually over the following three years.
We are reiterating our Accumulate rating on Scripps Networks Interactive Class A Common Shares and increasing our fair intrinsic value target share price 70.99, which is ~10% above current levels. We expect to see the company generate earnings per share of $3.70 in 2013 and to increase EPS by 12-15% annually over the following three years.
Scripps Networks Interactive is an industry leading developer of high-profile, lifestyle-oriented content for many media platforms including television, digital, mobile and publishing. SNI was previously headquartered in Cincinnati before relocating to Knoxville, TN in 2011. SNI also has offices in New York, Los Angeles, Chicago, Cincinnati, Detroit, Atlanta, Nashville, San Francisco and Chevy Chase, MD. SNI has 1800 employees; only about 5.6% work in corporate overhead. On July 1, 2008, Scripps Networks Interactive, Inc. became a publicly traded company as the result of the separation of The E. W. Scripps Company into two independent, publicly-traded companies through the spin-off of Scripps Networks Interactive, Inc. to the E. W. Scripps shareholders.
The company's media portfolio includes these popular lifestyle brands:
Management: The current Chairman, President and CEO, Kenneth W Lowe, has been Chairman, President or CEO since 1994 and has been with the company and its predecessors since 1980. He built the company into one of the nation's fastest growing and most successful creators of unique brands for cable television and the Internet. He founded and launched HGTV in 1994; oversaw the acquisition and transformation of the Food Network into an American pop culture icon; presided over the launches of the DIY Network and the Cooking Channel as well as the acquisitions of the Travel Channel in 2009 and Great American Country (GAC) television network in 2004. We also like the level of experience found in the rest of the management and board of directors.
Ownership: More than 42% of the outstanding stock was controlled by The Edward W. Scripps Trust. The trust owned 26.8% of the outstanding Class A Shares and 93.5% of the Common Voting Shares. The trust owned about $3.8B worth of stock on behalf of the Scripps family descendants. The trust had three trustees serving on the Board of Directors of Scripps Networks and its former parent The E.W. Scripps Company: John Burlingame, Mary McCabe Peirce and Nackey Scagliotti. The rest of the executives and board members own about 660,000 shares directly, plus another 1,950,000 shares through options which provide a satisfactory level of alignment between the interests of stockholders, management and other stakeholders.
We would prefer that the company end the dual-share class ownership structure as holders of Class A Common Shares are entitled to elect the greater of three or one-third of the directors of the Company but are not entitled to vote on any other matters except as required by Ohio law. Holders of Common Voting Shares are entitled to elect all remaining directors and to vote on all other matters requiring a vote of shareholders. Each Class A Common Share and Common Voting Share is entitled to one vote upon matters on which such class of shares is entitled to vote. Now that the last member of Edward W. Scripps's descendants has died in October, the E.W. Scripps Trust had been terminated and the trust's assets will be distributed to certain descendants of E.W. Scripps. There has been takeover speculation concerning SNI now that the trust has dissolved even though the company is only 10% off its all-time high of $66.33 set on October 19th.
Notable Mutual Fund owners include Harris Associates (Manager of the Oakmark Funds) with 4.4% of outstanding Class A stock, Longleaf Partners Small-Cap Fund (1.5%), Paulson & Company, Gabelli Funds LLC and Gardner Russo & Gardner.
SUMMARY OF OBSERVATIONS
We like the fact that the firm has been able to increase its high consolidated corporate operating margins from 35% in 2003 to 42.78% in 2011 (before dipping to 39.3% in 2012) and we feel that the company can maintain or steadily expand firm operating margins, due to its increasing scale and balanced growth from acquisitions and organic growth of the core business.
SNI has increased its revenue from $535 Million in 2003 to $2.31 Billion in 2012 (17.6% CAGR) and its adjusted profits from $81.96 Million to $500 Million (22.25% CAGR) during the same time period. SNI achieved this through organic volume growth as well as selective acquisitions during the period. In 2010, the company grew its revenues by 37.7%, helped by its acquisition of the Travel Channel. On a pro forma basis that assumed the Travel Channel acquisition was completed in the beginning on 2009, the company was able to grow its 2010 revenues from 2009 by 18.8%, which is still very impressive. We are especially impressed to see that the company had increased revenues each year since 2003. It even increased revenues by almost 4% during the 2009 economic trough.
We are attracted to SNI because the networks have a strong following amongst its viewers. This loyal viewer base lends itself to natural product placement and sponsorship opportunities as HGTV and Food Network rank highly in upscale households. The company works hard to build relationships with advertisers and evidence of this can be seen through the exhaustive upfront ad sales process. Most cable networks have one upfront presence location in New York but Scripps has an upfront presence in eight major cities with 1,200 customized presentations. Scripps' content is relatively cheap to generate. For example, Food Network relies on chef personalities for several of its higher-rated programs, but these individual stars don't define the network and only have so much negotiating power. SNI's networks benefit from barriers to entry, making it extremely difficult for a startup network to simply replicate the content and compete. For example, a new network may be rejected by some distributors, and even willing partners require initial incentive payments for several years.
Sources: Facebook and Scripps s 2012 Q4 Earnings Release
VALUATIONS AND PROJECTIONS
Our $70.99 per ADR FV is based on applying an 18.75 times price to earnings multiple to estimated 2016 earnings per ADR share of $5.41 and discounting the terminal value back to April 2013 at a cost of capital of 11%. We believe that SNI is undervalued by 10% relative to the current market price. Although SNI's forward Price to Book and Price to Tangible Book ratios are higher than the average broadcast firm, we believe it is justified due to SNI's superior franchise and focus on lifestyle media niches, which explains why SNI's forward PE is lower than the average broadcast media company. SNI also has a lower beta than its peers, even though it offers higher potential return prospects in our opinion. We also believe that the multiple used is justified considering that the firm has grown faster than its industry and the strength of its superior growth and ability to meet or beat EPS estimates from sell-side analysts.
We believe that the company will continue to grow its core lifestyle media businesses. We see continued increases in revenue from advertising and network affiliate revenue. We're also pleased with the steady growth of the digital business, recording double digit revenue growth in 2010 and 2011. We are glad that the company was able to record an 11.3% revenue increase in 2012 despite the global economic turmoil headwinds that media companies faced.
RECENT QUARTER (Q4 2012)
The company enjoyed solid revenue performance during the quarter and year over year sales increased by 9.2% despite a challenging economic environment. The company enjoyed 8.7% growth in its advertising fees and 14.7% growth for its network affiliate fee revenues. However, we were displeased that the company's operating leverage resumed its negative trend that we had seen in H1 2012. We were aware that the company has decided to accelerate promotional and marketing investments this year and it negatively impacted H1 operating margins. Based on this quarter's performance as well as management guidance for FY 2013, we see this trend continuing into the next year. Earnings from affiliates increased by 60% due to the UKTV acquisition and this offset a 37% increase in Interest Expense. Operating income increased by 13.4% year over year and income from continuing operations before minority interests increased by 15%. We also took note of the strong cash flow generated, as Free Cash Flow from operations was over $551 Million and this enabled SNI to buy back ~$478.6 Million in stock YTD net of proceeds from employee stock option issuance. All of SNI's operating brands showed solid year-over-year revenue growth in Q3 2012 though we were surprised that its Digital Business only grew by 9%.
The company provided the following outlook for 2013.
- SNI's Total revenue is expected to increase 7-9%.
- SNI's Cost of services are expected to increase 12%-14%.
- Selling, general and administrative expenses are expected to increase 7%-9%.
- Depreciation and amortization, $115 million to $125 million.
- Interest expense, $50 million to $55 million.
- Effective tax rate, 28 percent to 30 percent.
- Noncontrolling share of net income, $175 million to $185 million.
- Capital expenditures, $65 million to $70 million.
KEYS TO INVESTMENT THESIS
We like that Debt Net of Cash only accounts for 26.6% of assets. Although the company has total debt that represents 33.4% of total assets, the company could easily pay it down by devoting 3 years of net income from continuing operations to pay it down. SNI has $439M in cash and $237M in strategic investments in international affiliates. We like to net out the cash from the outstanding debt and we see that this reduces net debt to less than 27% of assets.
Considering that the interest rates in the capital markets are at ridiculously low levels and not due until 2015, SNI should be looking at ways to lock in its cheap cost of debt financing beyond 2015 and 2016. We can see why even though SNI's debt has coupons of 2.7% and 3.55%, it is collectively trading at a nearly 5.25% premium to par value, up from over 3% at the beginning of the year.
SNI's prudent cash management on behalf of shareholders. SNI repurchased $485M in stock last year net of share issuance for employee stock options. In 2012 SNI repurchased another $410M and increased its dividend by over 26% to $.12/quarter, resulting in a .78% dividend yield.
Source: S&P Capital IQ
We like the low capital expense requirements of the business. We can tolerate acquisition activity by SNI due to its low capital expense requirements. We feel that acquisitions of small but established media content properties serve as a great avenue for the company to engage in growing its business.
Source: S&P Capital IQ
SNI's disposition of its interactive online comparison shopping segment. In 2007 and 2008, SNI took a $655M write-down of goodwill and intangible assets relating to its acquisition of its interactive online shopping businesses, which included Shopzilla, BizRate, uSwitch and UpMyStreet. The interactive online business did contribute to the overall profitability of SNI; however the segment did not provide the revenue and profit growth that SNI expected in relation to its acquisition cost. SNI sold uSwitch in 2009 and sold off Shopzilla and the remaining online shopping businesses in 2011. We think management has learned from its mistake and focused on its media-related content.
SNI properties enjoy strong demand. Food Network is a Top 10 rated cable network and it is seeking to become a Top 5 network. Food Network's In the Kitchen has been downloaded more than 450,000 times, making it the #1 paid culinary app in the iTunes Store. Food Network has more than 1000 licensed products available through Kohl's Department Stores and its premium wine collection Entwine ranked 34th in the premium wine category out of almost 400 labels.
HGTV is the #1 network for upscale women. With HGTV, SNI forged a strong bond between the love media consumers have for their homes and the entertaining and informative quality of HGTV's programming. Being consistently faithful to that core concept is why nearly 1 million U.S. households tune in to HGTV during prime time every night. HGTV finished 2011 on a very high note, with the highest-rated December ever in total day for adults 25 to 54. We are impressed with HGTV's 2.4M fans following its Facebook Page.
Risks to Achieving Fair Value Target Price
- Failure of investment community to recognize SNI's competitive advantages, resulting in a stagnant or declining price/earnings ratio.
- Carriage disputes between SNI and cable vendors resulting in lower fee growth to SNI or even seeing its channels temporarily or permanently dropped.
- New content developed or acquired fails to work out (Shopzilla).
- Changes in public and consumer tastes and preferences could reduce demand for its content, reducing business segment profitability.
- Consumer behavior changes resulting from new technologies and distribution platforms. We think that SNI will be able to handle it better than other competitors due to the fact that SNI's business segments had utilized the web in order to increase brand awareness of its content.
- Economic changes in the US, Canada and Europe reducing demand for SNI's content.
- Issues relating to intellectual property rights and protections.
- Changes in FCC rules and regulations, particularly with regards to spectrum allocation.
- Issues relating to entertainment personalities on SNI programs (Paula Deen).
- Loss of key entertainment or business personnel.
MEDIA AND TELEVISION INDUSTRY OUTLOOK
Scripps Networks Interactive faces direct and potential competition from other cable and broadcast television networks, online and mobile outlets, radio programs, billboards and print media. With capital markets showing measured gains, we believe that there is potential for consolidation. Examples include Cumulus Media's acquisition of Citadel Broadcasting, Sinclair Broadcasting's acquisition of eight TV stations owned by Freedom Communications in a move for Freedom to eliminate its debt, E.W. Scripps Company's acquisition of McGraw-Hill's 10 TV stations and SNI's acquisition announcement of Travel Channel International.
The broadcast, cable and satellite industry will see a one-year spike in advertising revenues due to expected increases in political advertisement spending for the elections. Excluding political spending, we expect to see measured increases in advertisement spending, as the United States economic recovery is tempered by continued weakness in Europe as well as slowing growth in Asia and Latin America. Also, we have seen several TV station groups and networks begin to reap a new revenue stream of retransmission payments from cable operators and satellite TV providers. As more of such affiliate contracts come up for renewal over the next several years, this nascent revenue base should ramp up significantly, likely providing TV broadcasters an important buffer for traditional advertising revenues.
Overall, we feel the industry is fairly valued, however we would use declines in the market to add to positions in high quality firms like Scripps Networks and gains in the market to sell weaker firms. We are especially pleased that Scripps does not appear to have many direct competitors in the segments that SNI operates in due to the company's focus on specialty niches. The only competition SNI has is primarily competition from other interests and consumer tastes, i.e. sports media, movies, business, outdoor and nature themed programming, news, popular music, religious themed content and ethnic-oriented shows, for example.
Disclosure: I am long SNI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.