Description

CBS is the only stock we’ve bought in size over the past two months.  We like the business and how the model is evolving, the management team from both an operational and capital allocation perspective, and think that analysts are underestimating the number of shares the company will buyback over the next few years.

A number of factors have dragged CBS down YTD and helped create an attractive entry point:

1.  Weak-ish revenue across multiple segments in their 1Q EPS report, mostly driven by tough comps (Super Bowl aired on CBS in 2013 and not 2014)
2. Aereo / cord cutting concerns (Supreme Court ruled against Aereo, and as of this point in time The Copyright Office is not allowing Aereo to re-classify as a cable system which should be its death blow)
3. Arbs heading for the exits after receiving fewer shares than expected in the CBS Outdoor (CBSO) split-off (all should have exited by now)
4. Upfront advertising market weaker than expected (although rumors of CBS at +5% are fairly in-line with estimates but below the 7.5% increase from last year)
5. Concerns their prodigious cash flow might be used for an acquisition as opposed to continuing buybacks

With the stock down 10% YTD in a strong market for large caps, CBS is now an out of favor security after maybe being a little too popular a few months back.  This seems like a stock nobody wants to call a bottom in but everyone will love at higher prices in three to six months when the business is clicking with Thursday Night Football and a strong programming slate, mid-term political ad spending is ramping up, and the company continues to shrink the float with their strong free cash flow and a potential re-leveraging of the balance sheet.

CBS is now a pure content company that owns a wide range of media assets including the eponymous broadcast television network, thirty local television stations, Showtime, 126 radio stations, and the publishing company Simon & Schuster.  These are high quality assets and include the most watched broadcast network for the past six years, a credible rival to HBO in the premium cable space, television stations in the 7 largest markets and 15 of the top 20, and radio stations predominantly located in the top 25 markets. 

The company recently split-off CBSO to shareholders in a tax efficient manner months ahead of schedule after selling off their International billboard assets last year.  As a result, the company is close to reaching its goal of reducing advertising revenue to 50% of total revenues, and going forward will be less cyclical which bodes well for valuation.  CBS is focused on creating and monetizing premium content, and growing revenue from high incremental margin retransmission and licensing fees. 

CBS has done a great job creating and monetizing content in a variety of ways over the past few years at both CBS and Showtime, and the future looks bright.  On the content creation side, CBS has been the number one watched network for the past six years and eleven of the last twelve, and Showtime has created a number of hit shows and can be mentioned in the same breath as HBO.  Once created, content is a highly scalable asset that can be monetized in a variety of ways from international distribution to licensing to SVOD players like Netflix, Amazon and Hulu Plus.  CBS now owns, or partially owns, more of the content on their stations than ever before which will lead to more licensing revenue in out years.  The increase in the number of bidders for content helps pricing, and in recent years CBS has done a good job monetizing content via International licensing and from SVOD players mentioned above.  CBS has created a year round content model in the past twelve months.  Where previously the summer would be a time to show re-runs, CBS will be producing 90 hours of original programming this summer - up from 2.5 hours four years ago.  They used an interesting model to fund last year’s big summer hit “Under the Dome” whereby they pre-sold streaming rights to Amazon and made International deals before the show aired.  As a result, the show was profitable from day one even if viewership was poor (although poor viewership would obviously hurt their ability to do similar deals in the future).  CBS can then monetize the content for years to come and took very little upfront risk while creating a hit show.  Overall, CBS has done a good job de-risking its business model and focusing on the creation and monetization of original content.

In addition to owned content, CBS has done an excellent job locking up premium sports programming to long-term contracts.  With the advent of DVR, sports are one of the few programs that need to be watched live - making sports programming one of the best ways to ensure that people don’t cut the cord.  Coming out of the recession, CBS locked up Sunday AFC football games through 2022 and will broadcast the Super Bowl in 2016, 2019 and 2022.  CBS also owns the rights to the NCAA Basketball tournament though 2024, has SEC football rights for another decade, and will broadcast Thursday night NFL games this year. 

CBS’ focus on high incremental revenue opportunities is centered on retrans and reverse comp agreements and content licensing to SVOD’s and in the International market. 

Due to their strong viewership levels we think CBS will be able to reach their recently stated goal of $2 billion in retrans revenue by 2020, up from a previous goal of $1 billion by 2017.  Management refers to these as “100 cent dollars” as there is no incremental cost associated with retrans revenue streams.  CBS currently delivers 10% of the pay TV audience but only collects 2% of the affiliate fees so there should be room for growth here.  The remainder of 2014 is expected to be fairly retrans heavy while reverse comp has fewer deals in 2014, but that should accelerate into 2015 and 2016.  Management (mostly Les) tends to be a bit on the promotional side (he’s a sales guy) but they have a strong track record of doing what they say they’re going to do.

More owned content on both CBS and Showtime provide plenty of runway for licensing deals.  The International market has been a good source of growth and more bidders in the U.S. are leading to higher prices for what might at first glance appear to be average content.  CBS can still license 300 episodes of CSI and 200 episodes of NCIS in addition to other programs owned and partially owned.  Management has been creative with deals, making some exclusive content deals, others not, and pre-funding new shows by pre-selling streaming rights.  There will also be a minor benefit next year forward after Colbert takes over for Letterman as the content rights are more favorable to CBS with Colbert at the helm.

On the advertising front, for the first time ever CBS was able to sign deals that pay them for C-7 viewership up from C-3 (CBS gets paid for impressions 7 days after a program airs as opposed to three).  Due to the large percentage of shows viewed on DVR after the original airing, CBS successfully pushed to be compensated for these additional impressions.  It’s the very early innings here, and some commercials lend themselves better to delayed viewing than others, but management believes this can eventually be a “nine-figure” opportunity.  We’re taking a wait and see approach here but think this is an incremental positive.  The second half of 2014 will benefit from increased upfront rates for the Fall, Thursday Night Football, and mid-term political ad spending.

Overall, we think the business is as strong as it has been, and has multi-year tailwinds in the form of content licensing and retrans and reverse compensation.

And it’s not just the business that’s strong, the balance sheet looks great and a less cyclical core business should enable the company to re-lever and buyback shares as soon as the second half of this year.  Management has been focused on the successful split-off of CBSO, but now that the separation is complete, they can move their attention to balance sheet optimization.

The company is committed to returning $6 billion in 2014.  It bought back $2 billion in the first quarter, including $1.5 billion via an ASR, and retired approx. $2.85 billion via the CBSO split-off.  That leaves $1.15 billion for Q’s 2-4.  Given that the company can increase leverage by a full turn and still remain investment grade, throws off a tremendous amount of free cash, and management is shareholder friendly - we think that seems too low for remainder of the year and think 2015 buyback estimates are extremely understated by analysts. (Note: Morgan Stanley released a report as I was finishing this up stating that CBS can buyback $10 billion of shares in 2015 and 2016 which is more in-line with our thinking.)

Management has made it clear that returning capital is their number one priority for the time being and we would expect another big buyback announcement on either of the next two earnings releases.  On the low end, we expect an additional $1 billion this year and $3 billion total next year.  Depending on where management wants their leverage ratio to be we estimate they could potentially double those figures.

Valuation

Moving forward we think buybacks from free cash flow can add 6-9%/year to EPS and retrans can add another 5-7% - licensing should be good for another few points (although it will be lumpy) and you have some optionality from a pick-up in ad spending and/or collecting more from C-7 advertising as well as from adding a turn of leverage to the balance sheet. 

Analysts are in a reasonably tight operating income and EBITDA range for the next two years but we think they are off on the denominator. 

We think CBS can complete the previously announced $6 billion buyback this year (nearly $5 billion is in the bag) and do an additional $4 billion over the remainder of this year and 2015 primarily using internally generated FCF.  Taking on additional leverage, which we expect (but don’t know to what degree) would provide a further boost to our estimates.

Modeling in the share shrink and some minor advertising revenue growth, retrans and licensing we have CBS earning approximately $4.25/share in 2015 – at 17x we get to $72 share.  The stock has recently traded at just above 15x but we think the disposal of CBSO and the less cyclical nature of the business coupled with the growth opportunities outlined above leads to a slightly higher multiple.  We’d note comps trade in the 20x range.  Using a blended EV/EBITDA or OIBDA multiple we can get into the low 80’s by the end of 2015.  There has been a lot of discussion about how much HBO is worth in light of the Fox bid - if Time Warner were to IPO a percentage of HBO and shares traded at a premium valuation we think that could attract attention to Showtime and potentially result in a higher sum-of-the-parts valuation for CBS.

We think shares should appreciate 25-35% in the next year, potentially more if they maximize the balance sheet, and have the potential to keep compounding from there as CBS continues to shrink their share count and higher margin revenues accelerate into 2020.

Rumor Mill

Fox recently made a $80/share bid for Time Warner which set off a wave of takeover/disposal rumors throughout the media sector.  With cable companies consolidating it would not be surprising to see media/content companies merge in the coming months to gain scale and improve negotiating positions.  Two of the most prominent rumors were that if Fox completes the Time Warner transaction they would dispose of CNN with CBS and Disney being the two most likely buyers.  The other being that Time Warner might bid for CBS to prevent the Fox takeover.  CNN could be an interesting asset for CBS if it was acquired from a forced seller, if multiple bidders were to get involved we would much prefer continued buybacks (TWX doesn’t break out CNN’s financials and the estimated price tag varies significantly).  CNN is a strong brand with global reach/distribution that is, to put it mildly, not firing on all cylinders.  For the right price, we like the fit.  On paper, CBS looks like a prime acquisition candidate given its majority voting shareholder is 91, Les’ contract ends in 2017, and he receives $190 million from a “without cause termination” - but most don’t think Sumner is a seller.  A TWX-CBS merger would make a lot of strategic sense though.  Another common thought is that Sumner wants to bring CBS and Viacom back under the same roof, but given that there would only be one CEO post at the combined company and Sumner appears to have much more than your typical Chairman/CEO relationship with both CEO’s this seems unlikely to us. 

Risks

Weaker than expected ad spend and general economic trends: while CBS has reduced their reliance on advertising revenue it still accounts for a majority of their revenue.  In general, we’re more upbeat about the economy than the stock market/valuations.

Cord Cutting: this isn’t a new concern – we’re comforted by the long-term sports programming and the fact that CBS is consistently the #1 watched broadcast network.

Any regulatory changes to retrans and reverse comp – Aereo pulling a rabbit from a hat.

Sumner Redstone controls the voting shares and is 91.

Catalyst

Capital Allocation announcement

Continued share shrink

Additional licensing and retrans announcements

Potential for TWX to IPO part of HBO = more attention paid to Showtime