Shares of media companies have fallen substantially in recent weeks. The response of shareholders to a disappointing quarter from Walt Disney (NYSE:DIS) has been nothing compared to the huge decline with investors in Viacom (NASDAQ:VIAB) have seen. It all started when Walt Disney's popular ESPN sport channel reported that it has seen a "modest" decline in subscriber numbers.
The emerging decline in sales as well as high leverage position is a potentially dangerous mix for Viacom. If management would aggressively tackle the issues and try to orchestrate a business model change, the future would look a lot brighter.
As management has announced its intentions to start buying back even more stock in the near future, it becomes obvious that reduction of leverage is not a key priority. This leaves the business saddled with a lot of debt and fewer resources to successfully pull off a business model transition.
The continued usage of leverage makes shares very risky. Not only the external environment, but also management's focus on returning cash to investors, creates unnecessary risks. This means that I am not a buyer of this large pullback.
Looking Back At 2005
Back in 2005 Viacom's future still looked very bright. The company reported 18% growth in its revenues which rose to $9.6 billion that year. Operating margins came in at a healthy 25% while the balance sheet was in relatively good shape. After taking into account $360 million in cash, the company operated with a net debt load of $5.3 billion.
A lot has changed since. Viacom is on track to grow its sales to roughly $12.5 billion in this fiscal year. While sales are up versus 2005, revenues have been trending lower compared to last year as third quarter revenues came in 11% below last year's levels. Despite the disappointing recent revenue trends, Viacom has managed to improve operating margins to 35% in the past quarter.
While revenues have only grown modestly over the past decade, and are actually falling at the moment, margins have been very strong. As topline sales might come under further pressure, one has to consider the fact that this long term trend of margin gains might actually reverse at some point.
Following years of large share repurchases, the company's net debt position has risen to $12.6 billion, which is much higher compared to 2005. It goes without saying that both absolute and relative leverage has risen a lot over this time period. While this is not a problem if the business posts solid results, investors are scared as sales come under pressure. The rapid changing in the external environment make it very realistic that Viacom's business model and earnings potential might come under a lot of pressure in the coming years.
Looking At The Buybacks
Back in 2005, Viacom had 752 million shares outstanding, as the company's consistent buybacks have reduced the outstanding share base to 401 million shares. From 2011-2015, Viacom bought back 246.6 million shares, according to a recent investor presentation.
This came at a cost of $15 billion, indicating that the company bought back its shares at an average of $61 per share. Notably the most recent repurchases have been painful. Year to date, Viacom has been buying back shares at an average price of $71. This means that the company and its investors lost 40% on these most recent "investments" as shares are trading around $44 per share.
It actually gets worse. Viacom has been borrowing heavily to finance these buybacks. This means that the company has been incurring high interest expenses in recent years, while the company's balance sheet is saddled with debt.
Opportunity Or Trouble's Ahead?
Viacom' shares have fallen nearly 50% on the back of worries about the sustainability of its business model, dismal revenue trends, an elevated debt load, and the fact that capital allocation decisions have been poor.
Third quarter revenues fell by 10.6% to $3.06 billion. Filmed entertainment revenues plunged by 44% to $479 million amidst a lack of theatrical debuts. While the performance of this volatile segment cannot be extrapolated, network revenues were up by just 0.2% to $2.60 billion. This came after these revenues still grew at a pace of 3.9% in the first half of the year.
In Viacom's defense, the strong dollar hurt network revenues by 2%. The real worry for this business has been a 9% drop in domestic advertising revenues, driven by poor ratings. With Jon Stewart retiring from his popular show, the short term outlook remains challenged in any scenario.
Other than that, the results were not even that bad with operating profits being flat. The real worry has been seen in advertising revenues as those declines appear to be driven by longer term trends. This has everything to do with advertisers shifting online and consumers opting for other entertainment services such as Netflix (NASDAQ:NFLX). This is especially occurring at young age cohorts which means that these trends have the potential to worsen and be prolonged.
As a result, the results will undoubtedly come under further pressure as parts of its business model will see steep declines. While margins are still very solid, profitability could come under pressure alongside revenues which could result in a "double whammy" on reported profits. This is kind of problematic as Viacom operates with a leverage ratio of over 3 times EBITDA at a time when its profits appear to be peaking.
With a business model coming under pressure, and restructuring efforts taking away much needed resources, Viacom would be best advised to contain leverage. The challenge to transition the business model might potentially involve expensive deals, higher capital spending and restructuring costs.
Given the restructuring costs incurred, Viacom has suspended share repurchases exactly at a time when the stock is trading at much lower levels compared to prices when management very recently was happy to buy back shares. This situation tells investors that management might be far to optimistic or potentially shortsighted with as changes are taking place at a rapid pace.
Viacom's equity looks very cheap at current levels if you look at the recent results. Third quarter profits came in at nearly $1.50 per share. If annualized, this translates into an earnings multiple of just 7-8 times.
There are two main problems with this observation. For starters is the fact that topline sales fell by 11%, as secular trends are unlikely to introduce a big revival in sales momentum. This is even the case if I assume that theatrical revenues will recover to "normalized" levels.
The other big items is the $13 billion debt load which is very high and poses real challenges. Further pressure on sales, and undoubtedly margins, will impact the ability to make sure that this amount of leverage remains manageable.
Even if the company can successfully transform its business model, Viacom will need to engage in large capital spending or make large deals at premium valuations, both requiring large cash outflows. With leverage prohibiting the potential to incur more debt, Viacom has to resort to other forms of financing. Unfortunately equity financing is not really a credible source of financing as the shares have come under a lot of pressure. Management would furthermore be very hesitant to issue stock as it only recently bought back a lot of stock at much higher levels.
This fact alone will haunt management and limit the options for Viacom to deal with the situation. As a matter of fact, CEO Philippe Dauman stressed in the third quarter earnings report that the company remains committed to resume the buyback program in October.
That says it all in my opinion and raises big red flags. While a potential rebound could be lucrative for investors buying into the stock at current, I have seen too many cases in which management is ignoring reality. Instead some management teams have a tendency to be in denial and focuses on creating "shareholder value" by buying back shares.
For this fact, I am happy to avoid the shares at current times. While Viacom's assets are great and a business model change could revive the company, the large focus on cash returns to investors raises the risks to very high levels.
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.