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Downgrading My Outlook: Stars Aren't Aligning For Starz

|Includes: FOX, Starz (STRZA), TWX

I am changing my rating to neutral from buy on Starz with a $30.50 price target on growing concerns over a weaker cash position, increased long-term debt, and lack of original content which has ultimately failed to excite viewers including myself. With today's news announcement that Twenty-First Century Fox (NASDAQ:FOX) has bid for Time Warner (NYSE:TWX) lifting the entire media content sector, investors shouldn't get too excited over Starz, as the company is likely to remain on the sideline despite continued speculation of a buyout. While Starz maintains stable cash flow from operations, revenue and earnings haven't kept up with Wall Street expectations and subscriber growth has been lackluster at best. With a current market value of $3.1 billion, any potential bidder will have to take on the assumption of $1.4 billion in long-term debt. Stripping out $55 million in cash holdings, an acquirer is looking at a company with an enterprise value of $4.45 billion. At a current price of $29 a share, any potential bidder would be paying 3.55 times EBITDA, or 17.5 2013 earnings for Starz. In comparison, Fox's bid for Time Warner comes in at a slight premium compared to Starz current EV metrics (This is after a nearly 18% rise in TWX share after the announcement was made). Starz shouldn't command anywhere near the same value as Time Warner as TWX controls significant channel breadth and depth in content and can use its leverage for further synergies and network negotiations (This includes sports viewing deals with MLB and NCAA Basketball and HBO). In comparison, Starz original content continues to bleed the company's cash position and ultimately could lead the company to either scale back on content creation or raise additional debt to fund productions.

My analysis suggests that given current trends in operating costs and interest expenses, the company will likely earn between $210-$225 million for 2014, down from $247.3 and $254.48 in 2013 and 2012 respectively. Furthermore, in the absence of a hit original series the company will face continued headwinds when they loose the rights to Sony films movie library in a couple of years. I remain skeptical over management's ability and foresight and though the stock may look cheap on a fundamental basis, there is a clear reason for why that is.

My original analysis was written in Q2 2013 when the stock was trading at $21.50. At the time I had a $32 dollar twelve month price target on the name.

Starz (NASDAQ:STRZA): Content is King

Does STARZ Have Staying Power?

Starz, formerly a unit of Liberty Media Corporation, is an integrated global media and entertainment company providing subscription video programming with domestic United States pay television channels (Starz Channels), global content distribution (Starz Distribution) and animated television and movie production (Starz Animation). As of January 14, 2013, its network included Starz, Encore, and Movieplex, Retroplex and Indieplex. Its businesses included Anchor Bay Entertainment, Starz Worldwide Distribution, and Starz Digital Media. Starz Animation produces animated television (NYSE:TV) and movie content for studios and networks. Starz Distribution develops, produces and acquires entertainment content, distributing it to consumers globally on digital versatile disk (NYSE:DVD). On January 11, 2013, Liberty Media Corporation announced the complete spinoff of Starz into an independent company.

Content is King
There has been a shift in the way subscription based media companies operate. Inspired by rival HBO's "Game of Thrones," Starz has produced hit shows like "Spartacus," "Da Vinci's Demons," "The White Queen," "Magic City," and "Black Sails," (The last is a pirate based film produced by Michael Bay scheduled for release in 2014). Production for original content can be expensive, but it can also attract a significant amount of new subscribers and deliver a major boost to overall growth targets. Last quarter management also announced a joint partnership with British BSkyB to produce a series called "Fortitude." An important venture that could help Starz garner an overseas presence. Many analysts haven't yet caught on and investors may want to take note before they do so.

Spartacus was Starz first major hit, attracting 2.5 million viewers per episode. Good but not great. While the finale of Spartacus attracted a larger following, new programs will have to deliver going forward. Da Vinci's Demons may be one of the answers. The show has been so popular that Starz greenlit a second season only three episodes into season one. My original content hopes rest with "Black Sails". Produced by Michael Bay, who was responsible for the Transformer movie series, this production has tremendous potential.

Starz recently lost a lucrative programing content deal with Disney. However in place they were able to secure a new long-term one with Sony Pictures for exclusive distribution rights to new and existing films. This programing deal will last until 2017 and though programing right expenses increased nearly $26 million from last quarter, this deal with Sony is likely to pay off for the firm in terms of net subscriber retention and future growth.

Historically many of these premium channels where available only through cable and satellite operators, squeezing margins in favor of companies like Comcast and Verizon. However with the addition of new media platforms, such as personal devices, premium channels have now found a new medium to reach their subscribers. Furthermore, they are able to provide more in depth content in order to keep viewers more involved and entertained. Last month Starz announced that it will offer its programs on Kindle and Google devices. A great deal given the fact that the mobile and personal device market continues to outgrow the aging cable and television market.

Fundamental Outlook
Based on fundamental indicators Starz is a very compelling investment. With a recent P/E of 11, Starz trades at a much lower premium to rivals. Though the spinoff of Starz burdened the company with nearly a $1 billion in debt, Starz remains a cash machine. Subscriptions increased 7% at Starz and 4% at Encore, and last stood at 21.6 and 35.1 million respectively. Earnings per share came in at .47 cents for the latest quarter, or $105 million. This represented a 13% decrease in operating income from the previous quarter. Though revenue also came in a little light at $399 million, I don't expect any future decline and pin the decrease on the company's lost content deal with Disney and the end of Spartacus.

Beginning in the summer of 2012 Starz began a $1.8 billion payout to a unit of Liberty Media Corporation. In addition to cash payments, the company issued $500 million in senior notes with a 5% yield. While I expect 2013 net income to come in at $425 million, interest payments could crimp margins if net income comes in lighter than expected.

Technical Breakdown?
Year to date, Starz is up over 40%. However with the recent breakdown in the overall market, Starz is showing some technical weakness with the stock breaking below the 50-day moving average. If the stock doesn't retest its upper band of $23, we could drop to $19 a share.

Repurchase Program
Since authorizing the buy-back program, management has re-purchased 940,000 shares at roughly $21.51 a share. Under the current program the company is expected to buyback an additional $379 million (Representing 15.38% of the total outstanding float at current levels). While this is a positive trend, I don't expect the company to continue the re-purchase program anytime soon given its cash position. With only $18 million cash on its balance sheet the company could easily find itself in a cash crunch. Raising more debt could be expensive if market conditions worsen.
Investors should watch this figure very closely during the next earning release.

Since going public there has been rampant speculation that Starz may be acquired. The question however remains by whom? While CBS or Time Warner are the obvious candidates, they aren't likely to bid for Starz. However Disney (NYSE:DIS), Comcast (NASDAQ:CMCSA), or an overseas cable content provider may want to kick the tires. In my analysis the company could fetch upwards $32.25 a share, A hefty 49% premium ($4 billion total market value). This would represent an expensive 10 times revenue or 35 times net income. Yet a media company with deep pockets could help leverage STARZ strengthens. Like I mentioned above, original content will be the driver of earnings going forward. With a parent company, they could scale content and advertise across multiple platforms, which would ultimately drive subscription growth and reduce overall fees. Recently Comcast finalized its purchase of the 49% of NBC Universal it didn't own. Disney on the other hand acquired Lucas Films the maker of Star Wars. These companies may not be done, and may take advantage of low borrowing costs to finance future deals.

Many of Starz's direct competitors are owned by much larger media conglomerates like Time Warner (TWX), CBS Corporation (CBS), Disney (DIS), and AMC Corporation (NASDAQ:AMCX). All of which command much higher premiums. While I believe this discount is justified, the primary reason is because Starz is a standalone firm. Starz cannot afford a budget for its shows like competitor Time Warner can with its HBO unit which has had huge success with Game of Thrones, despite the huge costs.

Despite Starz's stellar year to date performance, the company remains a very compelling investment. However I remain concerned over the company's debt position, low cash, and strength as a standalone if a bid for the company doesn't materialize. My analysis suggests that Starz could be fairly valued at $32 a share, based on a multiple of 16 times 2014 expected earnings. With that said, I wouldn't invest more than 2.5% of my total portfolio in this name, operating and financial cash flow issues could weigh on the company's performance going forward.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I once owned shares in Starz, However I sold my position in Q4 2013.