- Comcast shares dropped about ~8%, or ~$16bn in market cap value, post its counter-offer for Sky at a rather generous ~$41bn EV.
- Given the headwinds in the pay-TV industry, I would definitely view the price as excessive and deserving of a negative market response.
- However, the share price decline was overdone and Comcast shares now offer compelling value, with further upside should the deal not go ahead.
- If the deal does go ahead, it should be earnings-neutral as well as assist with geographic diversification of the company – which is not a bad outcome, either.
Comcast (NASDAQ:CMCSA) is causing headaches for Disney (DIS) and Fox (FOX), having initially tried to counter the Disney offer for key entertainment assets held by Fox [inclusive of Sky (SKY)] and now making a play for Sky alone. Whilst there is certainly strong rationale for this given the importance of owning high-quality content, the seemingly inflated offer price has drawn the ire of the market and resulted in a sell-off in Comcast shares. This, in my opinion, has presented an opportunity for contrarian investors looking for a bargain asset.
Whilst, I think Sky is a solid asset with good content and market share in developed market economies, it is not an asset with highly attractive growth prospects. The effective ~12.2x EV/EBITDA multiple offered for the business is in my view at least 2 turns too high. Having said that, the transaction has not been accepted, and we may yet see a counter-offer from Fox, which should (hopefully) put an end to Comcast's interest.
Even if the offer is accepted, the Sky acquisition will likely be earnings neutral for Comcast, as they would have the gearing capacity to fully debt fund the deal, meaning the acquisition of Sky "should pay for itself" (calculations to be demonstrated later).
The existing Comcast business is trading attractively largely due to negative sentiment and concerns regarding the company's exposure to pay-tv in the US given chord-cutting trends. However, it remains a highly cash generative business with strong margins and should see robust growth from the high-speed internet, filmed entertainment and theme park segments to offset the decline in video.
Factoring in the Tax Cuts and Jobs Act, the adjusted 2017 EPS of $2.06 would be in the range of ~$2.35 and therefore means that Comcast is now trading at about ~15.5x on a trailing P/E basis, with a forward P/E ratio of about ~14.6x based on consensus FY18 EPS. Analysts in the market also agree that Comcast is a strong value play, with 15 out of 18 analysts rating it as a buy, of which 14 rate it as a strong buy, with no sell recommendations
The obvious risks for Comcast relate to the growing trend towards video streaming businesses [most notably Netflix (NFLX) and Amazon (AMZN)], but with Disney also expected to enter the fray aggressively in 2019). Further competitive threats include Google (GOOG) (GOOGL) via YouTube TV and even Facebook (FB) recently made a push into video streaming options with exclusive content via the Watch tab.
What this implies is that there has been a moderate trend towards cord-cutting, which is likely to accelerate going forward. However, I believe Comcast actually has a number of mitigants against this risk, which I list below, in order of least to most beneficial:
- Comcast has a 30% stake in Hulu, which provides a partial hedge against this structural trend. Hulu is however way behind the curve relative to Netflix.
- Sport and news services are still largely unavailable on video streaming services, so many customers tend to continue with their cable services and add a video streaming service on top due to the low price point. Comcast has also looked to evolve with the market with innovative value options like Xfinity Instant TV bundled with its broadband offering to retain customers.
- Coupled with the above, Comcast's packaged deals with high-speed internet, mobile/voice options and home security means they have a compelling ecosystem, which reduces customer churn.
- Mostly importantly, Comcast is likely to see continued growth in customer relationships and ARPU from high-speed internet/broadband services (which is also a much higher margin product). This market is likely to keep growing as customers demand better and faster internet packages to support video streaming and gaming growth.
The other major risk is the Sky transaction, which was the reason for the sell-off in Comcast shares last week.
As alluded to earlier, I believe Comcast's offer price for Sky is too high, at an effective EV/EBITDA multiple of ~12.2x. The market has rightfully penalized the business for the proposed acquisition, although the extent of that penalty appears to be excessive for reasons I will mention shortly. I would personally assign a back-of-the-matchbox valuation closer to 8x-9x EV/EBITDA (which is in line with Comcast's own EV/EBITDA valuation).
This would value Sky at around $25-$28bn. I therefore do not think it is a coincidence that the difference between Comcast's offer price ($41bn) and the aforementioned valuation range is roughly equal to the decline in the market cap of Comcast following the announcement of the offer (i.e. ~$16bn). However, I believe two major points mean I am less bearish about the prospect of the deal.
I strongly believe the offer on the table is as high as Comcast will go, and has been carefully designed to maximize its offer value without being earnings dilutive in year 1. I regard the probability of Comcast entering into a bidding war as unlikely, with Sky either ending up in Comcast's hands at the current offer price or Fox counter-offering at a higher level resulting in Comcast stepping aside.
Given that the probability of either outcomes is unknown, all we can conclude is that Comcast should either recover the ~$16bn market value lost (if Fox wins the bid) or stay flat should they be successful at the current bid. The poorer outcome (in my opinion) is Comcast winning the bid, so I will deal with that next.
Sky Pays For Itself
It does not take a mathematical genius to figure out that Sky is likely to "pay for itself." Sky's FY18 profit after tax is likely to be ~$1.48bn at the current exchange rate, which factors in the ~$10bn debt on Sky's balance sheet.
Source: Sky Investor Relations (Sky Corporate)
Source: Author calculations
As per the above, the equity value could therefore be funded with $31bn of new debt on Comcast's balance sheet, which would need to price at an interest rate of about 6.05% (pre-tax) or 4.78% (post-tax) to be earnings neutral for Comcast in terms of EPS (based on the current exchange rate). A cursory glance of Comcast's annual financial statements demonstrates that new debt for the company is likely to price at slightly below this level (around 5.5% pre-tax) to increase its gearing from ~2.2x to ~3.0x Net Debt/EBITDA.
For a business such as Comcast, ~3.0x ND/EBITDA is far below the level that I would regard as "risky' or over-geared, and given the lower relative dividend yield of the business, Comcast could easily reallocate cash from share repurchases (expected to be $7bn in FY18) towards de-gearing the balance sheet in need.
Source: Comcast Financial Statements
There is also strategic rationale to the deal, which is well articulated and reasoned in the slide pack on the transaction published on Seeking Alpha. Comcast currently generates ~91% of its revenue from the USA. The Sky transaction would provide diversification in the form of UK and European exposure, increasing the non-US revenue to ~25%. Sky is also a complementary business with high-quality content most notably the rights to English Premier League Football (or soccer, as Americans would call it) till 2022. The below slide demonstrates the fit of Sky as an acquisition.
Source: Comcast slide pack
Is Comcast Well-Priced?
We still need to answer the question as to whether Comcast (the existing business excluding Sky) is a good asset and worthy of investment at ~$36.50 per share. I have therefore performed a conservative base case model, which factors in the decline in certain segments (i.e. video and advertising) over time as well as the growth of others (such high-speed interest and theme parks). The results are shown below in detail:
Source: Author Modeling
The summarized key metrics are as follows:
- Revenue to grow at a CAGR of ~3.5% from ~$85bn to ~$119bn by 2027, with much of this inflation-linked price increases rather than market share growth.
- This reflects customer relationships in video declining from ~22.4m to ~19.0m, with high-speed internet customer relationships increasing from ~25.9m to ~32.4m, over the next 10 years.
- Strong growth in theme parks and filmed entertainment revenue offsetting gradual declines in advertising revenue and stagnant voice/mobile revenue.
- Moderate growth in broadcast television and cable networks of ~2.5% and ~4.4% CAGR respectively.
- Group consolidated EBITDA margin enhancement from ~33% to ~34% over time due to the shift to high-speed internet offset by NBC Universal becoming a larger share of the overall business. This assumption is highly conservative and could result in outperformance relative to the base case.
- EBITDA therefore growing by a CAGR of ~3.7% from ~$28bn to ~$40bn by 2017.
- Tax is also assumed to be 25% (the mid-point of 24-26% guidance) under the next tax law.
- The above assumptions would result in an EPS of $4.98 with a dividend per share of $2.02 based on growth of about $0.14 per year from now till 2027.
Based on the above assumptions, Comcast should be valued at around $80 per share in 2027, which would represent a P/E ratio of ~16.1x or an EV/EBITDA multiple of ~8.4x, which in my opinion would be fair, if not undervalued.
The effective IRR for an investor in Comcast today would be around ~10.7% (a bit higher, given that the dividends would be received quarterly rather than annually), and is shown below including dividends and the exit share price of about $80 (which would at the time would be equivalent of a ~6.7% earnings yield with limited financial risk at a Net Debt/EBITDA of ~1.7x):
Source: Author Assumptions
I believe Comcast offers attractive risk-adjusted value with a conservative base case model showing an IRR approaching ~11% over the next 10 years following the decline in the share price in the wake of the Sky offer. I believe there is a strong margin of safety on these assumptions given my conservative forecast company revenue CAGR of ~3.5% and limited margin enhancement from the shift in the mix of revenue to the profitable broadband segment.
Due to the strong free cash flow generation and hence share repurchasing ability, EPS growth should greatly outpace revenue and EBITDA growth. Alternatively, Comcast could pay significantly more dividends and become a compelling purchase for dividend growth investors. Either way, I do feel that Comcast represents an interesting value play in an otherwise overheated market.
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Analyst’s Disclosure: I am/we are long CMCSA. 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.
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