Over the past two weeks, most of the major media companies have reported second quarter results. These companies are primarily content producers.
Current entertainment companies held by our clients include CBS Corporation (CBS), Disney (DIS), Liberty Media (LMCA) and Starz (STRZA). Direct competitors including AMC Networks (AMCX), 21st Century Fox (FOX), Time Warner (TWX), Scripps Networks (SNI) and Viacom (VIA) also reported so we have a pretty good idea on the state of the TV advertising market and TV network business heading into the new fall TV season that commences after Labor Day.
Overall, the industry seems to be in good shape. Advertising trends, probably the best measurement of industry and investor sentiment, generally met or exceeded expectations in the second quarter. Management commentary indicated that strength continues in the third quarter, particularly after backing out the impact of 2012’s heavy political advertising and the distorting impact of last year’s Summer Olympics. The TV networks are also in good shape on retransmission and affiliate fees paid by cable, telco and satellite companies. This revenue stream has been front and center recently, as CBS and Time Warner Cable (TWC), two industry heavyweights, are currently in nasty negotiations with Time Warner Cable customers blacked out from CBS TV programming. This revenue stream is growing mid-single digits to low double digits at most TV networks with no signs of letting up. Retransmission and affiliate fees are extremely high margin and the primary driver of healthy industry fundamentals on a financial basis.
There are a couple of thorns in the outlook for TV networks and their parents. First, ratings for the broadcasters (NBC, CBS, ABC and FOX) were quite weak as a group last TV season. Cable networks saw ratings growth but across the universe there was mixed performance. Short-term broadcasters are losing market share to cable networks while cable networks face fragmentation of audience. Long-term, all networks face a challenge from online video, both access to their own programming and competition from the likes of Netflix (NFLX), Amazon (AMZN) and YouTube.
Second, programming costs are rising as networks compete more aggressively and produce better quality TV shows to improve ratings and justify the rising retransmission and affiliate fees with better programming. Although not alone, huge success by AMC Networks with Mad Men, Breaking Bad and Walking Dead has had a significant impact on the industry. Other networks see the unique programming and step up their games. That means more original productions and often more expensive original productions, together driving programming cost inflation in the high single digits. This cost growth well in excess of industry ad growth pressures an otherwise positive margin outlook.
Within Northlake’s current holdings, CBS and Starz had positive earnings surprises and saw their stock price rise. Disney beat its earnings forecast but mostly on timing differences and shares have fallen since the report. Liberty Media is an asset play but is in the primary content business. it has 53% ownership of Sirius XM Satellite Radio, which continues to perform very well adding new subscribers and producing free cash flow.
CBS reported very modest growth against tough comparisons but once again exceeded Wall Street expectations. Overall, the company should grow revenue and operating cash flow by high single digits to low double digits in 2013, an excellent result in a generally sluggish environment for large corporations. EPS should grow faster as the company continues to aggressively repurchase shares including another big bump in the authorization last month. Ad trends should pick up over the second half of the year as the company recoups ad time devoted last year to Presidential debates and political conventions and does not face Summer Olympics on NBC. Another catalyst is coming next year with the divestiture of the Outdoor business and another increase in the share buyback. The primary risk is a poor ratings performance at CBS in the upcoming TV season. I think the shares can reach the low $60s, another 20% upside, based on a P-E of 17 times 2014 earnings of $3.60.
Disney results were in line with estimates on revenue and ahead on operating profits and earnings per share but the stock has sold off on lower guidance for the September quarter related mostly to timing issues and a write-off on The Lone Ranger. Disney will grow revenues and earnings mid to high single digits this year. I anticipate acceleration over the next few years as the company exits a period of heavy investment in programming, acquisitions, theme parks and cruise ships. The story really accelerates in 2015 when Star Wars films come back to theaters. Free cash flow is set to grow rapidly and eventually DIS will accelerate its already meaningful share buyback program. It may take a little patience but DIS has the most potential of its peers looking out several years.
Starz easily beat Wall Street expectations but most of the upside came from its home video division and accounting catch up related to its recent renewal with Time Warner Cable. The core business of Starz and Encore pay TV channels was mostly on target with modest subscriber growth. Share buybacks are ahead of schedule and remain a major part of the story as the company remains under its debt leverage target. Starz is doing a good job of finding low cost replacements for its 2016 loss of Disney films, having recently signed agreements for catalog titles from 20th Century Fox and MGM. The pay-TV business needs some big new program hits to really juice the story but share buybacks and the possibility the company is sold or merged provides upside to the stock.
Liberty Media has seen the underlying value of its assets soar as 53% owned Sirius XM and 27% owned Charter Communications perform well. LMCA still trades at 10-15% below asset value and has numerous avenues for creating additional value by restructuring its ownership of Sirius or driving cable industry consolidation through Charter. Although a much smaller investment for LMCA, the company’s almost 30% stake in Live Nation Ticketmaster is paying off big time as LYV shares have almost double this year. I also was pleased to see the company execute a forward purchase contract for $380 million of its own shares. This represents an acceleration of the company’s recent pace of share repurchase and provides a nice boost to net asset value for continuing shareholders. Continued growth in its portfolio companies, restructuring actions, share buybacks and the discount to net asset value create plenty of additional upside in LMCA shares.CBS, Disney, Liberty Media and Starz are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. CBS, Disney, Liberty Media, and Starz are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.