As a value investor, I am on the lookout for strong companies that are currently under-priced in the market, but at the same time exhibit good long-term business prospects and minimum downside risk.
In this article, I will outline why I feel that Viacom (VIAB) is a strong media company that is trading at a discount to its intrinsic value.
For those who don't know the company, Viacom is a media and entertainment company. The company's Media Networks division consists of several popular TV networks, including: MTV, VH1, Nickelodeon, BET, Comedy Central, and others. The Filmed Entertainment division consists mainly of Paramount pictures, one of the premium makers of Hollywood movies. It should also be noted that Viacom has several prominent competitors in this space, including The Walt Disney Company (DIS), Time Warner (TWX), and News Corp. (NWS).
All figures that I will reference in the article have been sourced from the company's latest 10-K, unless otherwise noted.
To make my thesis, I will focus on several criteria which I feel are important in evaluating any potential investment. It's never enough to just look at one aspect - you need to look at different aspects to come to an overall conclusion on the risk vs. reward ratio for the company in question. For detailed information on my philosophy, you can view my user profile or go to my website.
Magic Formula Screen
The first criteria I have looked at for Viacom is the Magic Formula screen. For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt. The methodology was first described in Greenblatt's The Little Book that Beats the Market. Details about his methodology including the screens can be found at his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the Return on Invested Capital (ROIC) that they produce. So you are screening for "good" companies at "bargain" prices. If you check out the website above, you can sign up for free and view the current screens.
I frequently use this methodology as a starting point to look for good companies which might be temporarily out of favor.
Viacom is currently on the top 50 over $1 billion screen. This tells me that the company has good internal return rates based on results of the previous year, and also that the market price is very cheap relative to the earnings the company generates.
This is good news to start. Next, I'll examine some of the future business prospects in order to verify how likely it is that the company can continue performing well.
A lot of the larger media companies have been out of favor because of some perceptions that they will have trouble to make the full transition to digital media. There are concerns that they will not be able to keep monetizing their content with the same margins that they have been accustomed to. I believe these fears are largely overblown, and also the traditional media markets (including TV and movies) are certainly not going away anytime soon. Viacom recognizes the growth of digital media and the importance that it has in the coming years to the business. The company has adopted a strategy to aggressively pursue partnerships to ensure they fully participate in this trend. Some highlights of the execution of this strategy:
- In April 2012, Viacom's Paramount Pictures reached a pact with YouTube to allow rentals of almost 500 titles through the site.
- In February 2012, Viacom announced a licensing deal that will add TV shows from its networks to Amazon's video service.
- In February 2011, VIAB announced a content partnership with online video site Hulu.
A recent article described the 2012 London Olympics as the first true "Digital Olympics." By 2014, 21.5% of the ad market was expected to be on the internet, with continued rapid growth in the years to come. The key is that media companies like Viacom need to have successful strategies to monetize the new consumer demand channels. I believe they are well on their way to doing this with the above mentioned partnerships already secured.
The key to their business prospects therefore is really to be producing high quality content that consumers want to view - this will keep the revenues and earnings growing even with the further transition to digital media. As long as Viacom continues to produce the content that consumers really want to watch, the company will be able to profit fully from the digital revolution. I will discuss further in the Moat section below that Viacom is well positioned for this with strong brands and entertainment franchises.
Viacom is Shareholder Friendly
I believe it is important to assess how well a company's management has shareholder interests in mind, as this always can have a large impact on the return you will receive for your investment over time. Viacom pays a dividend yielding 2.0%, with a payout ratio of only 30%. Another positive sign is that the company has significantly lowered the outstanding share count in the past year. In November 2011, the board increased the share repurchase funds to $10 billion (with $2.8 billion already spent in 2011). This is a significant amount for a company with a market cap of $29 billion. At time of writing, there were 514.59 million outstanding shares. Ten years ago it was 786 million shares and almost every year it keeps dropping. This tends to mean that management is being prudent with stock options, which is another friendly sign towards shareholders.
Strong Competitive Moat
Viacom owns some of the most well known brands in television and entertainment. In 2011, MTV reached 98 million households in the US, and 600 million households in more than 150 countries worldwide. MTV has a very strong moat in music entertainment television and the brand is widely known around the world. Nickelodeon, a popular network for kids, also reached more 300 million households in 110 countries.
In Filmed Entertainment, Paramount Pictures has been around for 100 years. It was a pioneer in Hollywood entertainment and continues to be one of the premier movie makers, producing 14-16 films per year. They also own some of the biggest franchises in movies (e.g. Indiana Jones).
Overall the strength of the brands that Viacom has is unquestioned, and clearly the company has competitive advantages and attractive pricing powers that come with it. Another positive sign is that gross margin is 10% higher than the industry average.
I typically look at whether there are any risks to the financial health of a company before investing. Viacom does have a fair amount of debt. The company has a debt/equity ratio of 1.07. This is generally higher than I like, and is probably one of the weaker aspects of the company. The good news however is that interest coverage is 9.4, so the debt payments would seem to be well covered. Even if earnings were to drop 50% one year due to recession, they could still pay the interest without issue.
With this criterion I look at how predictable and dependable a company's earnings have been in the past. Generally, I do not like to invest in wildly cyclical businesses where in my opinion it is notoriously difficult to time when a good entry point might be.
In the case of Viacom, earnings have been growing steadily over the past 10 years, with some dips, particularly in 2009-2010. Earnings have grown from 1.26/share in 2002 to 3.61/share in 2011. This is an 11% average increase yearly. The stock is very well covered by Wall Street, with 27 analysts predicting 15% annual growth in the coming 5 years. To be more conservative, I will assume 10% in my DCF model below. Consistent growth however gives us more confidence in the predictability of future earnings.
How about the Valuation?
To calculate whether the current price constitutes a sufficient margin of safety against what I feel is the intrinsic value of the company, I have performed a simple DCF, using one my favorite DCF calculators. The inputs to the model are below:
- Current Earnings: $3.61/share
- 10 year average growth of Earnings: 10%
- Growth after 10 years: 0%
- Discount rate: 6%
- How confident are we in our earnings estimate? 75% confident
These inputs give me an intrinsic value of $98.74/share.
With a current market price of only $56.22/share, there would appear to be a sufficient margin of safety in the shares. This is more than a 40% safety margin with an upside potential of 75%. I believe that 10% is quite reasonable growth, looking at the past few years.
Looking at the chart of the past few months, you may notice that the share price has increased over 20% since July. I do however believe there is still plenty of value left in the shares. This is also validated by the fact that the forward P/E is only 11, and the PEG ratio at 0.88.
Overall, I believe Viacom is a strong established player in the media industry. The company has well known media networks that have developed moats around their brand names and programming. Although some people doubt the traditional media companies can succeed long term with the increased usage of the internet and other non traditional media outlets, I believe these concerns are overblown. TV and Hollywood entertainment continue to be very strong businesses globally, and Viacom will continue to stay relevant by having lucrative content sharing partnerships with online media companies.
Viacom should be a welcomed addition to any value investor's portfolio.
Disclosure: I am long VIAB.