What follows is a list of media businesses that illustrate how multiples can often be misleading. While the rule of thumb in value investing is to look for companies that have PE ratios below 14, there are a plethora of exceptions. In the instances of Sirius XM (SIRI) and Netflix (NFLX), the stocks are overly discounted due to the market's failure to properly factor in growth and operating changes against appropriate risk. Yahoo (YHOO), on the other hand, appears to be a comparatively cheaper investment on a multiples basis. Fundamentally, however, its discount to intrinsic value is less than that of Sirius and Netflix.
Sirius trades at a respective 33.2x and 21.1x past and forward earnings with no dividend yield. Consensus estimates for Sirius' EPS forecast that it will hold steady at $0.07 in 2012 and then explode 57.1% and 36.4% in the following two years.
These multiples, again, would make an amateur value investor uneasy. However, a discounted cash flow approach evidences Sirius' attractiveness. Let's begin with a few assumptions: (1) per annum revenue growth of 19.8% over the next few years; (2) SG&A, R&D, and capex as 30%, 1.6%, and 8% of revenue, respectively; (3) taxes being sheltered by net operating loss carryforwards. Subtracting out net increases in working capital while taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 15% yields a fair value figure of $4.60. This carries a great margin of safety that nicely complements the takeover premium.
Netflix trades at a respective 25.6x and 43.4x past and forward earnings. Consensus estimates for Netflix's EPS forecast that it will be -$0.24 in 2012 and then turn profitable in the later years, hitting $4.57 in 2014.
In our DCF model, we assume a few key points, namely that Netflix will (1) grow 17.4% annually over the next few years, (2) taxes are normalized, and that (3) cost of goods sold eats 64% of revenue versus 17% for SG&A, 7.5% for R&D, and 9% - 8.5% for capex. Subtracting out net increases in working capital while taking a perpetual growth rate of 2% and discounting backwards by a WACC of 10% yields a fair value figure of $130.51. This perpetual growth rate is overly conservative for a media business and helps to offset the risk inherent in the growth modeled in the explicitly forecast period. In short, Netflix is definitely not as fundamentally weak as some bears would have you believe.
Yahoo trades at a respective 18.4x and 16.2x past and forward earnings. Consensus estimates for Yahoo's EPS forecast that it will grow by 1.2% to $0.82 in 2012 and then by 12% and 9.7% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $0.90, the stock would be worth right around where it is today.
While my forward multiples for Sirius and Netflix are higher than what I give to Yahoo, this is simply based on an objective DCF standpoint. If Yahoo grows 11.5% over the next half decade, taxes stay around 39% of adjusted EBIT (ie. excluding non-cash depreciation charges), and operating metrics stay around the same, the stock is just 17.6% undervalued at a WACC of 10% and a perpetual growth rate of 2.5%. For a company that has kept the same logo for years, failed to address competitive pressures from Google (GOOG), and is replete with corporate governance issues (although the recent shakeup helped address some issues), I am not optimistic about the inputs going into this model. My models for Sirius and Netflix fundamentally factored in the risk and still found both more undervalued than Yahoo. Higher risk-adjusted returns will be just an added bonus.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.