By The Valuentum Team
Image Source: Comcast 2015 10-K
Comcast (NASDAQ:CMCSA) is a global media giant with two key business lines - Comcast Cable and NBCUniversal. The company boasts a very strong free-cash-flow generating profile, even if it is saddled with a rather high debt load. Operating cash flow generation in 2015, for example, totaled ~$19 billion, increasing 30%+ since the mark in 2011, a simply fantastic pace of expansion. The measure continued to advance in the first quarter of 2016, too, with a 6.9% rise on a year-over-year basis. Free cash flow may have dropped from the year-ago period in the quarter, but Comcast still generated $2.8 billion in free cash flow during the period. It's just hard not to like this free-cash-flow rich enterprise.
Many analysts continue to believe that the age of cord cutting will weigh on Comcast's performance, but the company's video subscriber base grew 53,000 during the first quarter of 2016 (versus a loss of 8,000 in the year-ago quarter), and the period was even the best first quarter net-add result in nine years. The major drawback to an investment thesis in Comcast, in our view, is its massive net debt position of $50.7 billion, which could limit financial flexibility, and by extension, hinder potential dividend growth in the future (its pace of dividend growth has been on the decline since 2009). Debt-averse investors should take note, but we note that on a full-year basis, free cash flow has averaged ~$9.1 billion (several times that of its ~$2.5 billion annual cash dividend obligations). We'll also be monitoring the impact of the AT&T (NYSE:T) deal with DirecTV--AT&T is Comcast's largest phone company competitor.
Comcast's strong free cash flow generating abilities allow it to continue to invest in the growth of its operations. In 2016, the firm spent $3.8 billion on the acquisition of DreamWorks Animation (NASDAQ:DWA) as it targets an improving presence in the family and animation area. Comcast also recently purchased 51% of Universal Studios Japan for $1.5 billion expanding Comcast's global footprint. Though we are vigilant of integration risks associated with acquisitions, Comcast does have a solid track record as it relates to integrating new business it purchases.
Comcast's Investment Considerations
• Comcast is a global media company that presents its operations in the following five business segments: Cable Communications, Cable Networks, Broadcast Television, Filmed Entertainment, and Theme Park. Comcast's 'Cable Communications' business generates most of its EBITDA (more than 80%). It was founded in 1963 and is headquartered in Philadelphia, Pennsylvania.
• The company's cable offering, Comcast Cable, is the US' largest provider of video, high-speed Internet and voice services to residential customers under the XFINITY brand. We like the scale and cash-rich nature of its cable operations.
• Comcast recently acquired DreamWorks Animation for $3.8 billion, and it will become a unit of Comcast's Universal Filmed Entertainment Group. The acquisition is targeted at improving the firm's presence in the family and animation arena. The deal is expected to close by the end of 2016, and adds franchises such as Shrek and Kung Fu Panda to Comcast's portfolio.
• Xfinity Voice has more than 11 million customers, good for a 20% penetration rate. Xfinity High-Speed Internet has ~22 million customers, and it has added at least 1 million customers for 9 consecutive years. The High-Speed Internet segment has increased Internet speeds 15 times in the last 13 years.
• Though cord cutting remains a major concern for all cable providers, Comcast has put up solid results in recent quarters. Its Cable Communications segment's revenue and operating cash flow have grown at a mid-to-high single-digit rate as of late. You can't talk about Emerson without mentioning its fantastic dividend growth profile. The firm's dividend yield and Dividend Cushion ratio offer an excellent combination. It is a former holding in the Dividend Growth portfolio.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Comcast's 3-year historical return on invested capital (without goodwill) is 11.7%, which is above the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation rating of GOOD.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. Its future economic returns warrant an attractive Economic Castle rating.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Comcast's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.0 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Comcast's free cash flow margin has averaged about 13.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Comcast, cash flow from operations increased about 33% from levels registered two years ago, while capital expenditures expanded about 29% over the same time period.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Comcast is worth $61 per share with a fair value range of $49-$73. Shares are currently trading at ~$62, just above our fair value estimate. This indicates that we feel there is slightly more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our forecasts for 2016 and 2017 are similar to that of consensus estimates for both Comcast's top and bottom lines. We're expecting revenue growth in the mid-single digits as the firm benefits from subscriber growth in the first quarter of 2016 and the acquisition of Dreamworks Animation. We're anticipating earnings expansion to outpace revenue growth in coming years. Downside to our expectations exists in the potential for integration risk as well as growing competition from the likes of AT&T and the pressure from the cord cutting generation.
Our model reflects a compound annual revenue growth rate of 3.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6%. Our model reflects a 5-year projected average operating margin of 23.3%, which is above Comcast's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.8% for the next 15 years and 3% in perpetuity. For Comcast, we use a 9.1% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $61 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Comcast. We think the firm is attractive below $49 per share (the green line), but quite expensive above $73 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Comcast's fair value at this point in time to be about $61 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Comcast's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $79 per share in Year 3 represents our existing fair value per share of $61 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.