Description

I believe Twenty-First Century Fox (“FOX”) represents a high quality franchise at a reasonable price. FOX is currently trading at 10x forward EBITDA with good visibility into low double-digit (12-13%) EBITDA growth for the next 3 years. An under levered balance sheet is driving share buybacks at an annual pace of 7-8% of current market cap. Thus, FOX shares should deliver annualized returns of about 20% assuming constant valuation multiples.

Looking at revenue by source, FOX has relatively low advertising revenue exposure (27% of total revenue), with the remaining revenue split between affiliate fees (37%) and content (33%). Of the 3 revenue buckets, advertising revenues are the most economically sensitive and also have the most secular risk as ad dollars move from television to the internet. However, I believe FOX’s advertising revenue is safer than television advertising in general due to FOX’s heavy sports programming. Sports is one of the few genres of content people still watch live, so advertisers have more confidence their ads are actually being seen. Over the last few years, FOX has invested heavily in sports rights and now has the second best sports portfolio behind DIS/ESPN. FOX has national rights to broadcast NFL, MLB, NASCAR, college football/basketball (e.g. Pac-12, Big East) as well as other sports (e.g. soccer, Golf, UFC). In addition, FOX‘s 22 regional sports networks “RSNs” have local rights deals with 45 MLB, NBA and NHL teams (out of a total of 53 teams in FOX markets). Due to the multi-year nature of these sports rights, FOX also has good content expense visibility for the next several years.

Affiliate fees are generated from payments from cable and satellite channels to carry the FOX cable channels and “retransmission” revenues to carry the FOX broadcast network. FOX affiliate fees have been growing in the mid-teens and I believe there is good visibility for continued double-digit (10-11%) affiliate revenue growth for the next 3 years. This growth is driven by in the U.S. by re-pricing cable and satellite company distribution agreements and internationally by continuing subscriber growth. It appears FOX’s “must have” sports content as well as highly engaged audience for its cable networks (e.g. Fox News) give FOX a strong negotiation position with cable and satellite companies.

The 33% content revenues are from FOX studios which produce both films and TV shows (roughly 50/50 split). Of the major Hollywood studios, FOX’s has the most consistent profitability with 14-16% EBITDA margins in each of the last 4 years. EBITDA from the FOX studio has been between $1.3-1.4bn FY 6/12 to FY 6/15e and I am forecasting it stays in this range. Note that this is hit-driven profit stream that will have some natural volatility.

Looking at FOX from a reporting segment perspective, the crown jewel of FOX is its cable network segment. This segment includes U.S. cable networks (e.g. Fox News, FX, Fox Sports channels and National Geographic) as well as international cable networks in Europe, Latin America and Asia. The cable network segment generates over 70% of total company EBITDA and is the key growth driver. Over two-thirds of cable network segment revenues are affiliate fees, so I believe cable networks revenue should grow 10-11% for the next 3 years. Over the past 2 years (FY 6/14  and FY 6/15e), cable network expense have been growing 17-18% per year primarily due to sports rights investments and the launch of a couple new US channels (Fox Sports 1 and FXX). Thus, cable networks’ EBITDA has been growing 6% per year. Over the next 3 years, cable network expense growth should slow to the mid-to-high-single digits as there are no new sports rights or large channel launches entering the cost base. Thus, I forecast cable networks EBITDA growth will accelerate to mid-teens growth for the next 3 years.

There is a hidden gem within the cable network segment, the Indian cable network business STAR. STAR has ~23% share of all television viewership in India, which is one of the most dynamic pay-TV markets in the world. I estimate STAR will break even on EBITDA FY 6/15e but will grow to $500m EBITDA by FY 6/18e ($500m guidance was reiterated by FOX management in March 2015). This big swing in EBITDA should come from STAR leveraging new sports rights and other recent content investments. I would guess STAR might be worth $7bn (10% of FOX’s entire market cap) if it were a separately traded company. The #2 Indian cable network company (Z IN) is valued at almost $5bn and is a smaller, inferior asset. Note that I am not expecting a spin-out of STAR, but wanted to point out the hidden value of this asset.

There are a couple concerns that serve as an overhang and create the opportunity to invest in FOX. One is the fear that FOX will spend its $8bn excess cash on a large acquisition. This fear is real as FOX surprised everyone by making an offer for TWX last summer. While I can’t completely rule out this risk, I am comforted by a couple facts. 1) TWX is now trading at $84 (+18% from pre-offer price and near FOX’s $85 offer) and FOX’s shares are only 5-6% higher than when they made the offer, so if FOX didn’t think it made sense to pursue the deal then, the relative economics have only gotten worse. 2) The highly-regarded activist investment firm, ValueAct, took a $1bn stake in FOX after FOX made their surprise bid for TWX. I would guess that ValueAct may have had conversations with FOX management and advised against value-destructive M&A.

I think the other primary market concern has to do with FOX’s longer-term guidance. At an August 2013 analyst day, FOX gave a FY 6/16 EBITDA target of $9+bn. Subsequent to that, they sold the German and Italian satellite businesses, the Fox broadcast network deteriorated, and the US dollar strengthened (which hurts them as 1/3 of FOX’s revenues come from outside the U.S.). Thus, in February 2015 FOX revised their FY 6/16e EBITDA guidance to “mid $7bn range.”  I think the market is still nervous that guidance may have to come down again due to continued US dollar strength and continued ratings weakness at the Fox broadcast network. I think this nervousness is “in the stock.” Let’s assume the consensus FY 6/16e EBITDA goes from $7.5bn to $7.3bn (this is still “mid $7bn” range). This would be a -3% reduction in EBITDA and thus FY 6/16e EBITDA would “only” grow 12% instead of 15%. This wouldn’t be the end of the world considering the current valuation and my forecast of similar 12-13% EBITDA growth in FY 6/17e and FY 6/18e.

FOX has $8bn of excess cash on its balance sheet due to last summer’s sale of its German and Italian satellite television companies to SKY LN. FOX continues to own 39% of SKY LN which is worth $11bn. Thus, at 1.4x net debt/EBITDA, FOX has a very clean balance sheet compared to most other large-cap media companies who are levered 2-3x EBITDA. I assume FOX will continue to buy back $6bn worth of stock per year which would shrink share count by 7-8% per year and results in a modest increase in leverage to 2x net debt/EBITDA.

Catalyst

Execute on business plan which has good visibility towards 12-13% EBITDA growth.

Continued stock buybacks of $6bn/yr which shrink share count by 7-8% per year

No big dumb M&A deals