Description

Thesis for News Corporation Investment – NWS/NWS.A / Jan 2008 $15 strike Calls

The investment form:

A hybrid of NWS or NWS.A (non-voting shares) – currently priced at 16.71 or $15.79 and NWS (voting stock) options – the January 2008 $15 strike price LEAPS calls – currently priced at $3.90. Why the hybrid? Just risk adjusted returns. Our target price is $30 by end of C2008 (mid F2009) and any global slowdown during that time could delay the realization of our thesis thus impacting the option position. Else, it makes sense to simply buy the stock and the options. We have a hybrid position.

Thesis – Qualitative

NWS is being thrown out with the rest of the media industry among fears of Google Mania. Only problem is that things are not changing as fast as people think. They still go to movies and even when they don’t, they buy or rent the DVD and will eventually watch it on HBO or Fox Movies or whatever. The web is another form of media and if you go live in this modern world, you still read newspapers and magazines and watch TV and listen to music and go to movies and everywhere you go there is advertising or subscription fees or whatever. PLUS, the world is shrinking via networking but growing in affluence as China and India, in particular, grow at exponential paces. This creates new media and more and more outlets for U.S. culture – which Fox specializes in.

NWS has been range bound for years trading as low as $10 in mid 2002 to a 52-week low of $14.76 this past fall to as high as $19.41 early this year. Yet all along, earnings have been growing at 15-20% annually. The companies ability to generate new revenue streams from new businesses and take the long-term view and invest accordingly is clearly being missed by the market. Plus, the company’s web foray is being executed well and could be an incredible hidden gem.

Key Components of the Thesis

NWS is the only true international platform for media production and distribution. It provides an effective distribution platform for its own and other content (syndication) as well as a way for advertisers to reach the core 18-49 market that advertisers covet and which FOX dominates.

NWS is highly undervalued in light of (1) its high, sustainable and rapidly growing cash-flow and earnings, (2) satellite distribution assets that are just starting to throw off material cash flow, (3) its internet push, which includes what could be one of the great web property groups over time, and (4) as a corollary to (3), the expected major push of brand advertising on line – something that we believe investors are materially underestimating.

In more detail, News Corp. has and is further developing the only truly global media empire that creates, produces and distributes various forms of media across most major media distribution outlets. We are in an increasingly converged world – something that is happening at an exponential speed – not linear – one that is converging in the forms of media distribution, i.e. internet, TV, and other electronic media, as well as human convergence – think “The World is Flat.” The company has a unique ability to bring the world to its users – be they advertisers or consumers who are (1) TV watchers over SkyItalia, FoxTel, BSkyB, StarTV, DirecTV and DirecTV Latin America, or (2) internet users via MySpace, IGN, Scout, FoxSports.com, or FoxNews, The Fox Network or FX on TV/cable or (3) newspaper readers in the U.S., the U.K. or Australia, or (4) movie and TV show watchers in theaters or on DVD.

They will continue to slice and dice the media they create or acquire – by their own production or through user-generated content – and redistribute it across all platforms creating new revenue streams. For instance, 3 years ago, TV shows on DVD did not exist. This year, the company will sell over $700mm in DVDs – net to the company.


THESIS – QUANTITATIVE – INCLUDING POSSIBLE PROFIT

Once you strip out the minority owned satellite assets (DirecTV and BSkyB), News Corp. is trading at a low multiple to free cash and EBITDA. On its surface, a snapshot of NWS looks like the following:

Balance Sheet
- Cash of $6.5B
- Long-Term Investments of
o $10.4B at cost– we value much higher
o $13B at market cap
 DirecTV =
 BSkyB =
- A/R and A/P roughly equal
- Inventories of $1.7B
- Debt of $11B
- Net Debt of $4.5B
- Shares outstanding
o Class A = 2.215B shares
o Class B (voting) = 1.029B shares
o Total with dilution = 3.255B
- Market Cap of $51B
- Ownership stakes in DTV, BSkyB and Gemstar = $13B
- Net Market Cap = $39.5B
- Earnings in F2005 = $2.13B growing at roughly 18-20% per year

The company earned $2.13B in F2005 ending June 30, 2005. Street estimates are for Net Income to be about $2.6B in F2006 and $2.9B to $3.0B in 2007. None of those estimates factor in Sky Italia fairly (think World Cup in F2006 and into F2007), which could add as much as $200mm a year in incremental free cash flow for the next three years and none have any meaningful earnings from the Internet division – which could have a disproportionate effect on revenues and earnings if they effectively manage MySpace, IGN, Scout.com and any other properties they acquire. We estimate that the web could account for well over $1B in revenues and about $200mm (YHOO’s EBIT margin is low to mid 20’s) by C2008 and growing at 35-50%. And this does not include other acquisitions, which the company has clearly stated they will do.

We think the following is what it will look like at the beginning of F2009 – which is June 30, 2008 or 2.5 years from now:

- There will be roughly 2.7B – 2.8B shares outstanding – after the company buys back $3B worth of stock today (180-200mm shares from current 3.24B shares), buys back the Liberty Media stake or otherwise makes open market purchases
- The company will have earned over the past 2.75 years (dating from October 1, 2005) about $8.7B – which will essentially pay for the share buybacks and leave the current cash account near where it is (Assume in the Liberty buyback it is roughly half cash, half some passive investment – whatever it takes to get IRS approval)
- Forward earnings will be at least $3.8B to $4.2B – including minority interest income – which may be grossly undervalued – a share count of 2.75B shares (realize that with no buybacks the extra $8.7B would sit on the balance sheet and the company has made it clear the major acquisitions now will be their own stock) – and thus roughly $1.38 to 1.53 per share of income. However, cash flows could be materially higher if Sky Italia continues to grow its cash flow and the internet business continues to grow at the pace we expect.
- We believe that the market will afford a multiple to the dominant international media company of 15-18 times – considering its internet growth and its Asian growth which should be hyperbolic by then.
- This would give a target share price of between $25.50 and $27.49 for the A shares, which currently trade at $15.45 – yielding a 65-78% gain on the stock
- However, if you were to take 2/3 of your position in stock and 1/3 in the January $15 (soon June) 2008 options on the NWS B shares (currently priced at 16.70) – for which you would pay $3.90 (Bid/Ask is $3.50/3.70), your return on a 6% position would be between 6.0 and 7.5% of performance attribution or a double at a minimum.
- Note that the stock must go up only 11.3% for you to be at the money on the options.


Revenue and Earnings Growth
We expect revenue growth to continue to be in the high single digits for the foreseeable future – driven primarily by growth from cable affiliate fees, StarTV, DVD sales, Satellite revenue growth (from SkyItalia), the possible launch of a new cable channel (possibly a national sports and/or a national business channel) and most importantly the rapid growth of the internet business. We believe that the company can continue to grow its core business earnings at between 15-20% for the next five years – effectively doubling current core earnings of $2.13B


The key levers to NWS’ growth – of which you can see there are many:

- Filmed entertainment – Growing DVD sales of movies and TV shows as well as growth in international distribution
- Satellite Assets
o Slowing growth of DTV and BSkyB will yield tremendous free cash flow growth as most of capex is done. This will be very accretive to NWS’ position
o SkyItalia will start throwing off reams of cash flow starting calendar year 2006
- Cable TV
o Fox News will start renegotiating its distribution contracts, which should yield substantial growth in revenue form the current ~$.23 per sub to at least $.50 providing long-term growth. Ad rates should also improve
o FX continues its growth in advertising and also will secure higher affiliate fees
o Potential formation of a national Fox Sports Channel – from the basics of the current regional sports networks
- Network TV – Fox continues to dominate the 18-49 age category with successful shows like – House, Family Guy, The Simpsons (17 years and going), 24 and most importantly American Idol. Also, FOX’s focus on sports provides it with rich content that is not easily subject to changing viewership (VOD, DVR) and higher ad rates
- Asia Growth – Star Group Limited – is doing well in India and making progress in China and is a leading programmer in Asia
- Internet Efforts – The acquisition of MySpace, Scout.com and The Internet Gaming Network (IGN) plus the rapid growth of FoxSports.com creates one of the great internet media franchises. MySpace.com is rapidly becoming one of the most trafficked web sites with over 40mm registered and 28mm regular users with an average of over 400 page views per month. Internet related revenues are being ignored or grossly underestimated by Wall Street analysts!!!
- Big share buyback – NWS will most likely make a major buyback – possibly the Liberty Media holding worth $8B. The company has the cash and could take on more debt. If they do so, they would be buying back roughly 16% of the market cap at a low valuation plus relieve the overhang of concerns that Murdoch may use it to make a non-accretive acquisition.
- Innovator’s Dilemma – Murdoch has openly acknowledged that the web is the biggest risk to its current business model. Instead of fearing it, they have embraced it

MAIN DRIVERS OF FREE CASH FLOW AND VALUE GROWTH

- SkyItalia should add an average of $150 to $200mm of free cash flow per year for the next five years (though we use less in our estimates) as they ramp from 3.5mm subs to over 6mm subs by 2010. The company has hopes to get it up to 8mm over time, which would be roughly 40% penetration. Their core customers are dominated by high income (60% of subs – up from 50% in F2004 and heading to 67% in F2006) subscribers which should stick well despite competition from terrestrial wireless TV and some weaker IPTV offerings. The World Cup in 2006 will help subscription growth as well. Current annual churn is about 10%.
- Internet advertising revenues – currently, the company estimates internet-related revenues of $300mm during F2006 (ending June 30, 2006). Not one analyst has an accurate reflection of that figure. Further – most analysts have losses from this division and no profit growth estimates. We believe that the internet revenues can grow exponentially if MySpace, in particular, continues to grow and the company leverages its sales force to sell branded
- Fox News and Cable Assets – Fox News and FX will start to grow its affiliate revenues significantly in 2006 as contracts are renegotiated with MSOs and satellite broadcasters at approximately 2x the current rate
- Growing TV and movie content penetration – in particular international sales of the library as well as more distribution of TV content – 24, The OC, The Simpsons, Family Guy, etc. domestically This is both in the U.S. and internationally as DVD player penetration continues to grow.
- Growth of StarTV in Asia – which could come much faster and bigger than many people think


KEYS TO REVIEWING EACH DIVISION

THE INTERNET BUSINESS - CURRENTLY NEAR 0% OF REVENUES AND PROFITS

- Background: this is a growing segment for the company after the purchase of MySpace via Intermix, as well as Scout.com and Internet Gaming Network (IGN). Mix this in with Foxnews.com, Foxsports.com (via MSN). Starting next fiscal year – July 1, 2006 – the company will break out the division.
- Strengths
o Phenomenal core business in MySpace enables the company to tap into the minds and hearts of 15-30 year olds. Built originally as a music sight, MySpace is an integrated platform for personal expression – the key behind the hip-hop culture that has permeated suburban neighborhoods. It also happens to be a culture that is similar to the changes in Europe (England in particular), South Korea, Japan, China, India, etc. Just think of the personal ring-tone (which the company is not doing) craze of the past few years as a trickle before the gush of expression. Blogs are growing rampantly, but customization of one’s space on MySpace is creating incredibly sticky environments whereby users invest tens of hours uploading hundred of pictures, music choices, thoughts (via blogs), etc.
o Network effect of MySpace solidifies its position. Why go anywhere else?
o Addictive nature of the properties – MySpace for personal expression, Scout.com for sports fanatics, and Internet Gaming Network for avid gamers – a population that should not be underestimated in terms of repetitive and constant behavior – think of playing with Sega or Nintendo as a kid and think of the great marketing and superior products today and then think of the value of a hub for core gamers.
o Interaction between other properties and web – Family Guy on the web, The Simpsons on the web, IMing while watching the OC, listening to music while IMing, etc. Slice and dice the content for any platform is practically a company mantra going forward
o Created a record label with Interscope Records for bands found on MySpace. Already running live (in person) concerts around the world with 20,000 fans and no advertising. New film division that taps into this culture was announced recently – see below.
o Statistics
 Broadband penetration – 24% in 2003 up to 46% in 2006 and going to 70% by 2010
 Media consumption for people 12-24 – 30% on line vs. 24% for TV
 Fox Sports and Fox News did a combined 1B page views in October 2005 up from 450mm in January 2005.
 FoxSports.com – was doing 2.3mm unique visitors in June 2004 – now at 14.7mm unique users as of October 2005 – primarily due to MSN partnership
 Most visited sports web site was NFL Internet Group at 17.6mm users up from 6.0mm in June 2004. Think DirecTV and their long contract with the NFL through 2010
 Scout.com – 2.1mm unique visitors per month 1mm two years ago – and never been nurtured nor marketed well. Company also has 208,000 paid online and print subs
 Internet Gaming Network (IGN) had over 25mm unique users in November 2005 after peaking at the start of football season above 30mm in September. Greater than 12mm file downloads and 540mm page views per month. Do you think NWS knows anything about their customers?
 MySpace now has 40mm registered users (up from 5mm exactly a year ago) and 27mm regular users – growing at 150,000 per day vs. 100,000 per day only a few months back! Growth is accelerating
• Averages over 400 page views per month per active sub or 11.6B page views / month in November
 Fox web sites have gone from #21 in unique users in August 2005 to #6 with a combined 55.1mm users and #4 in page views with 12.9B in October 2005

- Risks
o MySpace becomes passé. Not likely but possible.
o Dumb acquisitions in the space
o Web properties slow their growth and competition takes revenues and eyeballs away

- Growth and Optionality
o Peter Chernin has said that he expects about $300mm in revenue in calendar 2006. IR has confirmed to me that Mr. Chernin does not typically over promise
o Other accretive acquisitions
o Brand advertising explodes on the web – as Yahoo, Microsoft, NWS and others think it will. We do too. Talk to ad agencies and they agree. Every major corporation is taking baby steps right now – that will soon change as they campaigns are very effective

FILMED ENTERTAINMENT – 25% (FROM 27% IN Q1F05) OF REVENUES IN Q1 F06 (AS OF 09.30.05)

- Background: consists of the production and acquisition of live-action and animated motion pictures of redistribution and licensing in all formats in all entertainment media worldwide, and the production of original television programming in the U.S. and Canada

- Strengths
o Great team running filmed entertainment production
o Great distribution network – global in nature
o Global distribution of movies provides greater theater revenues
o International distribution of DVDs, and other distribution forms is creating a revenue and profit growth
o DVD-HD provides more opportunities for many of Twentieth Century Fox’s megahit movies – Star Wars III, Gladiator, etc.
o Sustainable revenue growth rate in the various divisions north of 5%
o The company recently announced the launch of a new film division to conquer the younger crowd that MySpace is identifying for them. Typical budget will be $20mm per movie and ideas and marketing will come from and through MySpace and other web properties

- Risks
o Fewer people are going to movies these days – the growing number of media outlets – internet, HDTV’s, etc. may have created a permanent (not cyclical) decline in revenues at the theater
o All major movies have been released on DVD and DVD player penetration in the US is maturing – so expect slower growth as people simply fill out their libraries incrementally – and expect the need for help from DVD’s of TV shows
o Hit driven and competition
o Movement to interactive vs. passive entertainment is a further drain on the avid movie-goer crowd of 15-30 years old – i.e. it raises the bar on quality

- Optionality
o Continued growth of international revenues
o StarTV growing faster than people think
o Big hits – possibly Ice Age 2 and X-Men 3 and a strong lineup for next year


TELEVISION – 18% (FROM 20% IN Q1F05) OF REVENUES IN Q1F06

- Background: the operation of 35 broadcast TV stations (25 with Fox, 9 with UPN an one independent), the broadcasting of network programming in the u.S. and the development, production and broadcasting of TV programming in Asia

- Strengths:
o Fox is a great anchor for television. The company has great shows such as House, 24, The Simpsons, Family Guy, American Idol and The OC
o Affiliates still provide significant free cash flow
o STAR is providing barely any cash flow right now but that should change dramatically over the next few years. India is already doing quite well (E$350mm in revenue in F2006 and ~$128mm in operating income).
o Earnings were slightly low due to early launch of prime time lineup (amortization of costs), should rebound in Q2F06
o Significant investments in new sports programming, new international programming and channels (India in particular) are being expensed and are not showing up in associated profits yet.
o Long-term agreements for sports programming – NASCAR (thru 2010), NFL (thru 2012), MLB (new contract pending)
o Big investments in StarTV and in launching new channels on Star and higher programming costs at the network, television station group created an income loss and hide the future growth – particularly for Star

- Risks
o Local advertising is weakening – for now – pending better technology distribution by company owned NDS or OPTV that will provide more targeted advertising
o Less use of TV by 18-49 year olds drives down ad rates
o Hit driven – though they have consistently put out great shows
o DVRs threaten to lower ad rates
o Lower growth from mature ad market
o Competition from cable and other media outlets – the web, iPods, etc.
o Piracy in developing markets
o Unfavorable government regulations and currency fluctuations in developing markets
o Dependent on renewing / getting big sports contracts, which have escalating cost profiles

- Optionality
o New hit shows – a la The OC, House, etc.
o New advertising delivery for brand advertisers via set top boxes (STBs) drives much higher ad rates – probably a few years out in any material way


CABLE NETWORK PROGRAMMING – 14% (UP FROM 12% IN Q1F05) OF REVENUES IN Q1F06

- Background: consists of the production and licensing of programming distributed through cable and satellite TV in the U.S.
- Strengths
o Fox News is the pre-eminent stations growing revenues 19% this year amid wider distribution, better advertising sell through and rates and higher per sub revenues
o FX is growing at a similar clip
o AFFILIATE FEES – both FX and Fox News have relatively low affiliate fees with the MSOs and Satellite operators from old contracts that are coming due now and provide material cash flow growth going forward
o Regional Sports Nets are doing well and provide a platform for a future national Fox Sports network
o Channels include SportsNet (49% of revs), FX (21%) , Fox News (21%), Speed (5%), Fuel (2%), Movie Channel (2%).
- Risks
o Cost of launching new channels
o More sports entities (teams, LBO firms, etc.) are building their own sports networks (YES Network, etc., Red Sox, etc.)
o DVR penetration could be disruptive to current advertising model
o Dependent on renewing / getting big sports contracts, which have escalating cost profiles

- Optionality
o New Fox Sports national network
o New cable channel
o New Fox Business channel – Fox News has some major business shows that could provide the anchor


DIRECT BROADCAST SATELLITE (DBS) TELEVISION

- Background: Sky Italia consists of the distribution of premium programming services via satellite directly to subscribers in Italy. The company recently passed the 3.5mm sub mark and expects to hit 6mm subs in the next few years.

- Strengths
o SkyItalia is the only premium service provider right now
o There is no cable system in the country and there is near zero chance that one will be laid
o Generally - minimal competition

- Risks
o Growing terrestrial TV offering that is essentially free – though has only 30 channels – known as DTT. DTT is getting an increasing share of major football(soccer) pay-per-view events. DTT only offers 30 channels and is for the low income viewer
o IPTV is coming to Italy – being led by Telecom Italia – have little ability at this point to assess its impact but Sky Italia is ready for it as they move to HD and add content
o Dependent on renewing / getting big sports contracts, which have escalating cost profiles – including the aforementioned football pay-per view contracts

- Optionality
o Faster growth in satellite sales – especially as people go to more boxes in the home
o Lower churn creates higher margins – lower advertising, etc. and higher free cash flow – DVR’s historically had very low churn rates



NEWSPAPERS – 17.1% OF F2005 REVENUES

- Background: principally consists of the publication of four national newspapers in the United Kingdom, the publication of more than 110 newspapers in Australia, and the publication of a mass circulation, metropolitan morning newspaper in the United States.

- Strengths
o Australia papers are mostly locals and have devout readership – circulation as well as advertising revenues should remain strong for the foreseeable future
o U.S. paper – The Post – remains a top rag for many – especially commuters. Not a huge risk in ads
o U.K. papers are national and not subject to local classified advertising going online
o Continued earnings and revenue growth and huge cash flow generator

- Risks
o Advertising moving more and more on web – i.e. classifieds
o UK business requires a major upgrade to color to stay competitive – costing $1B over four years. While there will be some savings, it is also occurring in light of a weakening advertising market (down 5% in past year)
o Price of newsprint
o Murdoch has said that he sees the web as the single largest threat to this business (and to others as well). Yet despite that, the numbers continue to look good

Catalyst

1. Rapid growth of the internet business
2. Sky Italia growing cash flows rapidly as expected this year - World Cup will help.
3. New cable business channel
4. New national sports channel
5. Strength at DirecTV and BSkyB
6. Strong box office and TV DVD sales
7. All of the above will show up in the bottom line by F2006 year end as reported in July. Further clarification on the success of their web properties will help.
8. Buyback of the Liberty Media stake coupled with current share buyback means 20% of market cap gets bought in (potentially) this year