Description

We don’t often come across a household name with multiple near-term growth prospects, aligned long-term owners, and a sizeable discount to peers. We think Twenty-First Century Fox is one such opportunity. FOX trades at around 8.6x FY ‘17E EV/EBITDA-- this multiple excludes the hidden value in several equity stakes. We feel there is a large disconnect between the quality of the assets and the corresponding growth potential, and where the market values the stock.

What has created this opportunity?  Box office flops, a CEO “resignation,” deceleration in affiliate fee growth, the dismissal of Greta Van Susteren, RSN & skinny bundles concerns, worries over Hulu cannibalizing MVPD rates, and on top of that, an ever growing sex scandal. While the headlines have been difficult to look at, we think the market has overreacted, thus creating a compelling opportunity for long-term holders with a 2-3 year horizon. FOX trades at a slight discount to its peer group, but if adjustments are made for the equity stakes, the valuation gap widens even further.

Overview of business:

Twenty-First Century FOX (formerly News Corp.) is a diversified global media and entertainment company with geographic operations in the U.S., Continental Europe, U.K., Asia, and Latin America. The company operates in three primary segments: Cable Network Programming, Television, and Filmed Entertainment, as shown below.

Source: 10-K filing

Source: 10-K filing

Cable Network Programming is FOX’s bread and butter, making up 52% of LTM revenue and approximately 74% of OIBDA. The growth in Cable Network Programming can be mainly attributed to increased affiliate fees (both domestic and international) from cable and satellite companies. Affiliate revenue should grow in the high-single digits in FY ’17, Q4 ’16 grew at 6.6%, slightly above consensus.

Television has been growing at mid-single digits, though last quarter broadcast TV advertising was weaker than expected.

Filmed Entertainment has been the biggest overall drag to results, as summer box office sales have largely been disappointing.  Independence Day Resurgence, X-men Apocalypse, and Ice Age: Collision Course largely fell short of expectations at the box office, compared to a relatively strong performance at the box office in 2015. FOX mentioned on the call that they had replaced film leadership, looking for more consistency from the newly implemented team.

Source: 10-K filing

Affiliate fees represent the lion share of revenues by source at 41% compared to the remaining proportion at an almost equal split between advertising (28%) and content (29%). Going forward, we think there is decent visibility for mid-single digit growth in both affiliate fee growth and advertising. We believe these expectations remain conservative, given FOX’s “must-have” content in both news and sports. FOX News is essentially the only game in town for conservative news; conversely, there are many news networks competing for ad dollars which have a more liberal slant. For companies that want to target that demographic, it is fairly easy to see the premium FOX can charge for creating a good value proposition for advertisers. The other “must-have” programming is FOX Sports; it is one of the few programs left that people continue to watch live. FOX has established national and regional rights with long-term contracts to broadcast MLB, NASCAR, NFL, soccer, golf, UFC, and collegiate conferences. Furthermore, FOX is the largest regional sports network programmer in the U.S.--  it has rights to telecast live games for over half of the 81 U.S. professional sports teams in the MLB, NBA, NHL, as well as numerous collegiate conferences. Given the live nature of sports, we think advertising revenues are significantly more insulated than other areas of the television ad market.

Diamond in the rough

STAR India is the largest business for FOX in Asia and the largest single market outside the U.S. on a wholly owned basis. STAR has almost one quarter of all television viewers in India, well ahead of number two player Zee Entertainment Ltd. There are three real components to STAR India. First is the entertainment business with roughly 20% market share. Second is the sports business which recently emerged from a large investment phase comprised of the National Cricket Team, Pro Kabbadi league, and international sports such as, the English Premier League, Formula One access, Tennis, and Badminton. Third is Hopstar, STAR India’s mobile viewing application, which has had over 65m downloads (50m active) in the past 12 months. Hopstar provides full access to mobile viewing of full length TV shows and movies as well as high quality sports content, i.e. Cricket, EPL. 

At a recent Alliance Bernstein conference, CEO James Murdoch described STAR India’s growth pattern as akin to a “hockey stick.” For many years, it had been investing almost all operating profits into sports content and rights for live exclusive content. Much of the success of STAR India, therefore, has been masked by tremendous reinvestment into the sports side of the business. This investment phase in additional sports content is coming to an end, and management is thereby focusing more effort on generating EBITDA growth. For the trailing twelve months, STAR India has generated just over $200m in EBITDA. FOX management models roughly $500M in EBITDA by 2018 and $1B by 2020 for STAR India, reflecting fixed cost leverage as it garners more scale.

“Profit gross at Star in India is accelerating. The business is in good health and the peak investment years are behind us as profitability towards our target progresses. We'll continue to invest in Hotstar, our over the top mobile video service, with over 50 million active users currently, we see this is a key opportunity to achieve real leadership in an important category. In addition, we plan to expand its service beyond India this year targeting the global South Asian Diaspora.” -James Murdoch

For valuation comparison, Zee Entertainment Enterprises Ltd, the second largest player in the Indian TV market, is currently valued at around $7.4bn on LTM EBITDA of $250m. Forecasts are for Zee to do roughly $480m in EBITDA in 2020-- less than half the earnings guidance of STAR India. We think a conservative valuation range for STAR India would be in the $10-12bn range, representing roughly one quarter of FOX’s market cap at the midpoint. We understand the multiples are high, but this progressive pay TV market has a long growth runway for the foreseeable future.

Equity Interests and Valuation

FOX is a unique and diversified media company with an amalgamation of various assets in six different continents. Valuing these assets is quite difficult, given the interdependency between various operating segments. What we think many investors are overlooking or attributing little value to, is these various equity interests not necessarily properly reflected in the financials. STAR India, for instance, is wholly owned; however, it has shown little in profitability to the parent. Other investments such as Hulu have continued to be cost centers as they go through a rapid growth transition. Total equity earnings of affiliates in 2016 was ($34m), including +$383m from Sky and ($417m) from other equity affiliates. Collectively, we think these equity interests are conservatively worth around $10.5bn, with Sky making up the lion share.

·         39% interest in Sky PLC.  Sky is the U.K.’s leading entertainment and communications provider, operating the most comprehensive multichannel, multi-platform pay television service in the U.K.,           Ireland, Germany, Austria and Italy. Current stake valued at $7.5bn.

·         30% ownership stake in Hulu, valued on TWX’s recent 10% investment. Current stake worth $1.74bn.

·         Endemol Shine CORE Joint Venture, with an aggregate carrying value of approximately $830m.

·         30% interest in Tata Sky Limited which owns and operates a DTH platform in India (IPO proposed)

·         Minority interests in Vice and Draftkings--small valuations, but large potential upside.

While we feel FOX already has a fairly compelling valuation profile prior to any adjustments, we think it is at least reasonable to adjust for the value of SKY LN. With a current valuation of approximately $7.5bn, backing this out yields an EV of $55bn with $7.2bn in FY ’17 EBITDA. This yields 7.6x EV/EBITDA, a full turn and a half less than the average peer group-- all this while giving very little credit to STAR India’s tremendous growth runway.

Source: Bloomberg

FOX has historically had one of the least levered balance sheets among its peer group, although it has been returning capital back to shareholders faster than annual cash flow generation during the last three years. Therefore, we think that the 8.5% buyback rate in FY2016 is unsustainable looking ahead. At the end of the quarter, there was approximately 10% remaining of the outstanding $5bn buyback—that, in addition to the $3bn announced buyback, would equate to roughly $3.5bn remaining on the buyback. This would essentially match free cash flow estimates for FY 2017. Additionally, on the most recent call, management stated its intention to stay within the 2.5-3.0x target leverage ratio.

Source: Bloomberg

Source: 10-K filing

Summary:

We believe FOX’s first rate channels will continue to have decent performance over second tier channels that consumers likely won’t want in a skinny bundle. We think the business has been under earning with large investments in sports (FS1), FXX, Hulu, as well as STAR India starting to tail off in FY 2017. Year-over-year comparisons should be much more favorable in FY 2017, given a moderation of growth capital investments being made as well as easier top-line comps with 6-7% growth expected. FOX, at today’s prices, represents a compelling value with heavily aligned owners, decent long-term growth prospects, and a well known franchise that trades at a sizable discount to average market multiples. While there are some short-term headwinds with regards to box office sales, strength of the dollar, and uncertainty on how customers will consume media in the next decade, we think the market has more than discounted these variables. 

Risks: 

·         Downward affiliate fee pressure from Hulu and Sling TV offering a substitute product.

·         Cord cutters/shavers.

·         Advertising dollars continually moving from television to the internet.

·         Netflix, Amazon, other OTT providers getting into live content.

Catalyst

Star India meeting growth targets, realization of SKY LN ownership stake, and success of Hulu's virtual MVPD offering.