In a fully-valued market, individual stock selection takes on even more importance due to the dearth of attractive opportunities and the risk of paying too rich of a price for a business at the later stages of a strong market cycle. In my experience, market participants tend to underappreciate the importance of strong management teams that also excel in their roles as investors and financiers, as opposed to just being great operators of the underlying business, because methods such as discounted cash flow analysis can't really account for accretive acquisitions or capital allocation strategies. In 2011, Viacom (VIA) made a large commitment to utilize its robust free cash flows to aggressively buy back stock below intrinsic value and combined with the company's extremely strong programming and networks, which cater to some of the most attractive demographics, the business and stock have thrived, and I believe that there is considerable upside to come. Viacom is an excellent example of a great business being offered at a reasonable price and should provide investors with above average returns into the future.
Media and advertising are evolving at rapid rates, and although there is tremendous uncertainty as to which distribution models will be most successful over the long term, there is little uncertainty that great content produced at reasonable costs will still create a wide economic moat. Aside from Disney (DIS) with its ESPN franchise, I believe that there is no other media company with a better long-term competitive position than Viacom. This is a company that has consistently innovated over the last several decades and has built very valuable franchises that have held up incredibly well against the competition. The key franchises such as MTV, VH1, and BET all appeal to valuable demographic for advertisers to reach, setting the stage for higher advertising fees. In a world where a key battle is being waged between content service providers and networks over affiliate fees, Viacom is very well positioned in that for many households, one or several of Viacom's networks are must-haves in any list of programs. This size and breadth is crucial for maintaining strong margins, allowing the company to continue to invest aggressively in widening its moat with creative content.
Programming content has evolved dramatically over the last decade plus, with the shift in consumer tastes towards reality programming, which Viacom has really been a pioneer in. To society's gain or detriment, Viacom has consistently been able to take untalented individuals that are extremely cheap to put on camera, and make them stars, while the company racks up huge profits. This is a very different model than paying big-name actors such as Charlie Sheen or Jerry Seinfeld huge sums of money per episode, and it also allows the company to extend and branch out its brands over many years. For example, MTV's The Real World concept began in 1992 as one of the first reality programs, and is still generating high ratings today. In addition, the company has spun-off a variety of sister shows such as Road Rules and The Challenge, which have extended the shelf-life of the generic, low-cost cast of characters. In my relaxing hometown of Laguna Beach, I saw MTV turn acquaintances and neighbors into real sitcom stars, or millionaire fashion designers, after the company made a show about kids growing up in that city. While the lower start-up capital requirements of launching reality TV shows has also helped smaller networks, Viacom's excellent distribution and valuable franchises will continue to lead to attractive economic returns.
Viacom has two primary reporting segments, Media Networks and Filmed Entertainment. The Media Networks segment generates revenues from advertising sales, affiliate fees and ancillary revenues. The segment accounted for 66%, 61% and 65% of the company's revenues in 2012, 2011 and 2010, respectively. In fiscal year 2012, advertising revenues, affiliate fees and ancillary revenues were approximately 52%, 42% and 6%, respectively, of total revenues for the Media Networks segment.
In the Filmed Entertainment segment, revenues are generated primarily from the theatrical release and/or distribution of motion pictures, sales of home entertainment products such as DVDs and Blu-ray discs, and the licensing of motion pictures and other content to pay and basic cable television, broadcast television, syndicated television and digital media outlets. Revenues from the Filmed Entertainment segment accounted for 35%, 40% and 36% of the company's revenues in 2012, 2011 and 2010, respectively.
Viacom's business is certainly highly exposed to the general economy, and we saw in the Great Recession that advertising sales declines precipitously during that period, pressuring profits. Coming out of the recession, content providers such as Viacom have been very successful raising affiliate fees with content service distributors. At times this has led to disputes over pricing, but it is a tough business decision for a distributor to take Viacom off of its programming offerings over a few dollars a month at the risk of losing a lucrative long-term customer. Future consolidation in the industry and the shift to mobile have the potential to cause temporary disruptions in margins during the adjustment period from one content form of delivery to another, but over the long term, Viacom should remain highly profitable.
The business requires very little capital investment, which means that the majority of free cash flow can be used for a variety of productive uses such as the creation and/or acquisition of new content, debt reduction, dividends and stock buybacks. Over the last several years, Viacom has proactively taken advantage of record-low interest rates to refinance and extend debt maturities, and buy back stock well below current prices. Since 2008, the diluted share count has declined from 625MM to 487MM, which is about a 22% decline in shares outstanding. Viacom has also been raising its dividend, but I believe the company is making the smartest decision by buying back its stock at attractive pricing, and I believe there is a long runway for more repurchases due to the robust free cash flows that the company will be generating over the next several years.
Source: VIA Q2 2013 Investor Presentation
As a result of these buybacks, Viacom has accumulated about $7.673 billion of net debt at a weighted average cost of 4.6%. Considering the company has a forward earnings yield of around 8% and an even higher free cash flow yield, this is a very good utilization of capital that won't be properly identified by analysts or investors that only rely on a discounted cash flow or dividend discount valuation model. At T&T Capital Management, we use a variety of models and methods to ascertain intrinsic value, and finding management teams that understand proper capital allocation and financing can add material upside to a company with the free cash flow productivity of a Viacom. I believe stock buybacks should add 5-7% to earnings per share growth over the next several years, ultimately setting the stage for low double-digit earnings growth over the next 3-5 years.
On May 1st, Viacom released second quarter financial results with revenues declining 6% YoY to $3.14 billion, primarily due to lower Filmed Entertainment revenues. This was partially offset by an increase in Media Networks revenues as advertising revenues increased over the prior year. Operating income declined 9% to $847MM, reflecting lower Filmed Entertainment results and an increase in Media Networks programming investment expense, partially offset by the increase in advertising and affiliate revenues. Adjusted net earnings from continuing operations attributable to Viacom were $481MM, and adjusted earnings per share from continuing operations were $.96 per diluted share. The company repurchased 11.7MM shares for an aggregate purchase price of $700MM.
Based on 487MM diluted shares outstanding and a recent price of $68.13, Viacom has a market capitalization of about $33.18 billion. With net debt of $7.673 billion, the enterprise value is approximately $40.8 billion. In the last 2 fiscal years, Viacom has generated over $8.5 billion of EBITDA, putting the trailing EV/EBITDA ratio at just under 5 times, which is very cheap. Viacom has and should continue to post low double-digit returns on invested capital, 20%+ returns on equity and high single-digit returns on assets. Free cash flow generally exceeds net income, and according to Morningstar, Viacom's mean analysts' earnings estimate for fiscal year 2013 is $4.78. I believe you will see earnings per share growth of 10-15% over the next 3-5 years, which could be higher in the first few years due to the aggressive buyback plan, so assuming earnings growth of just 10% would put 2017 earnings per share at around $7, while 15% per annum would lead to 2017 EPS of $8.36. Viacom is an above average business, deserving of a 15 P/E, so my 2017 target price would be $105-$125. The mean estimate for EPS in 2014 is $5.42 so a 15 multiple on that would put the stock at $81.30, so there is reasonable short-term upside as well, although that isn't my game. While I'm glad that Viacom favors stock buybacks below intrinsic value, I believe that if Viacom paid out 50% of its free cash flow as a dividend instead, the stock would quickly be valued at a much higher multiple due to today's consensus insatiable demand for yield. Moving forward, there are a number of ways to win with Viacom, and I believe that any pullbacks should be bought.