21st Century Fox (FOXA) reported earnings after the bell that disappointed analysts and confirmed the two major challenges the company faces going forward. The company missed expectations on earnings with EPS of $0.33 versus hopes of $0.35, though revenue of $7.06 billion bested expectations of $6.8 billion. However, with ramped up spending on content, this revenue was unable to boost earnings as hoped, and EPS fell from $0.95 last year as operating expenses grew by $900 million. Time will tell if increased spending is worth it.
For investors unaware, 21st Century Fox was spun-off from News Corp (NWSA) earlier this year as Rupert Murdoch separated the growing media business from legacy newspapers with television channels, its BSKYB stake, and film studio, the major driver of FOXA's revenue. This quarter reflected continued weakness in the film studio and aggressive spending on cable programming, which dragged down results.
First looking at the film studio, results were clearly disappointing with operating income before depreciation and amortization dropping by a quarter to $328 million from $433 million. Fox's film studio has been in a serious rut. Among the "big six" distributors (Fox, Warner Bros., Paramount, Sony, Disney, and Universal), Fox has gone the longest since releasing a $200 million blockbuster at the domestic box office, last doing so in Christmas of 2009 when Avatar and Alvin and the Chipmunks were released. 2013 has been a disappointing year with Fox standing in 5th place, $700 million behind leader Warner Bros., and with no tentpoles to be released by the end of the year, there is an outside chance it finishes behind smaller studio Lionsgate/Summit (LGF).
Fox hopes to end this long drought in 2014 with expensive sequels to its X-Men, Night at the Museum and Planet of the Apes franchises while adding several major original films, though some like Noah have received a very weak early reception. In response to this four-year drought, there has been significant turnover in Fox's production and marketing team, and 2014 will be a key test of this new management. Fox currently lacks the powerful franchises of Warner Bros, Paramount and behemoth Disney with Marvel and LucasFilm. Its X-Men series has disappointed three times in a row, making next year's film critical to boost the franchise. While its distribution deal with Dreamworks (DWA) should help, it is a lower margin business that alone cannot turn around the fortunes of the studio. Right now, Fox and Sony are losing share to the other Big Six studios, and if Fox cannot turn it around, shares will be held back.
Next, the driver of Fox's growth has been in its cable networks, in particular FX, National Geographic and ratings behemoth Fox News Channel. Fox News Channel consistently draws more viewers than MSNBC and CNN combined, and its revamped primetime lineup has boosted ratings in the key 25-54 demo with Megyn Kelly delivering stronger 9 PM numbers. In fact last week, FNC was the second most watched network in all of cable while CNN and MSNBC were both outside of the top 20. With ratings turning around from a relatively weak first quarter (for FNC's elevated standards) and a new lineup, I expect FNC to continue to deliver strong numbers. However, 12% growth in cable networks revenue was more than offset by increased spending on content, which led to a decline in OIBDA from $1.02 to $991 million.
Fox has noticed that the only network able to out-rate FNC has been ESPN, which consistently tops the cable world. As such, Fox has launched Fox Sports 1, which has required massive capital outlays as it buys sports programming, far outpacing advertising revenue, which is to be expected of a start-up channel. Just about every media company seems to be launching a sports network to take on ESPN. I believe it will be an especially long and expensive struggle to topple ESPN, which has long term programming deals for Monday Night Football, Sunday Night Baseball, some college sports, and other agreements with professional sports leagues. While Fox Sports 1 has added Big East Basketball to its programming, it lacks NFL and MLB games, which are what really drive viewership. At the end of the day, consumers are loyal to their team, not the channel, so unless Fox spends billions to beef up content, it will be unable to compete with ESPN. Even then, this investment may prove not to be profitable. I expect added content costs for another two years before we see any serious return from Fox Sports 1.
Therefore, Fox has serious problems with its movie studio and lacks the franchise fare of its competitors that can gross $200 million with ease domestically especially as an Avatar sequel is unlikely until 2016 (if ever). Moreover, ramped up spending at its cable networks more than outweigh continued rating strength and will pressure profitability for at least another 12 months. Despite these challenges, FOXA has a forward multiple of 22x while Disney (DIS) trades at 17.5x and Time Warner (TWX) at 15.98x. With their superior studios, strong franchises and more measured investments, I prefer DIS and TWX to FOXA. FOXA's valuation does not reflect the challenges it faces, and I would not consider buying unless it fell below $30.