TV stocks have had a good rally in the past week for the first time since May. Among Northlake positions, this includes Disney (DIS), CBS Corporation (CBS), and Nexstar Media Group (NXST). Each has rallied between 5-10% off of at or near 2017 lows. The challenges facing TV have metastasized this year. The issues are cord cutting, cord shaving, weak TV ratings, and poor advertising trends. All the major media companies reported earnings the past two weeks and for TV stocks there were a few signs of improvement. When combined with horrific sentiment among investors and extremely bearish positioning in the stocks, this has a triggered a rally.
Northlake has a lot of domestic media exposure including cable operator Comcast (CMCSA). It has been a rough ride of late but we reaffirm that we own the very best positioned companies given the secular headwinds. This was evident in recent earnings reports from all four companies. Our recent report on CMCSA can be found here (http://northlakecapital.com/2017/10/27/comcast-posts-solid-results-despite-increased-competition/). Below are comments related to recent results from DIS, CBS, and NXST:
Three items are supporting the recent rally in TV related stocks. First, there appears to be material uptake of OTT services providing a boost to subscriber counts for networks and stations that are included in the new packages. DIS, CBS, 21st Century Fox (FOXA), and AMC Networks (AMCX) each indicated that affiliate and/or retransmission fees were beginning to see some benefit from OTT subs. These subs act to offset losses due to cord cutting when a customer switches from traditional cable or satellite subscriptions to an OTT service. Second, the outlook for fourth quarter advertising growth has improved. Ratings remain weak but October was strong, lapping political displacement a year ago, and early pacing for November and December are positive on a year-over-year basis.
The third positive relates to investor sentiment and positioning. We cannot emphasize enough how bearish the outlook has been for traditional media stocks. Analysts have downgraded many stocks and reduced estimates and price targets. The valuations on the stocks against earnings and cash flow are at levels not seen since the 2007-2009 Great Recession. One analyst we respect noted that NXST was trading as though its prodigious free cash flow would disappear in six to eight years. The TV industry may be in tumult but that is an awfully pessimistic view. The bearish sentiment was so overwhelming that when fundamentals did not deteriorate and the stocks went up on weak earnings, a countertrend rally developed. We think the rally will have legs, especially in our portfolio names given they have the best competitive positioning versus the secular challenges.
DIS reported worse than expected and laid out further detail on its 2018 outlook. The stock initially traded down 3-4% but reversed ruing the company’s conference call and is up 2% now on the morning after they reported. One positive was a lower rate of sub losses for ESPN, down -3% versus a recent accelerating trend that saw the prior quarter fall by -3.5%. Management also laid out further detail on expenses related to its recent BAMtech acquisition and the rollout of its direct-to-consumer services for ESPN and Disney. The upfront losses in 2018 appear less than many investors anticipated. DIS also faces a slower rate of programming expense growth at ESPN as the huge step up in NBA rights fees occurred in the past year. All of this clears the deck for what should be a huge year for DIS’s studio with two Star Wars, three Marvel, and two Pixar films hitting theaters. These films should support continued solid trends at the company’s theme parks and acceleration in the consumer products business. Northlake does not see a ton of upside for DIS in the next year or two during the transition phase from traditional distribution via cable and satellite to OTT but in the near-term the relief rally could build. If that happens, it will be time to make a tough call on holding DIS shares.
CBS remains much less exposed to secular headwinds than other TV network companies as it owns no cable networks and has a head start with early success from its own OTT services CBS All Access and Showtime. In addition, broadcast networks like CBS remain sharply undervalued as far as retransmission fees compare to their popularity with viewers. CBS will double its retransmission fees in the next three years which not only can drive operating income growth but also reduces the company’s exposure to secular and cyclical challenges for advertising. Among the large traditional media companies, we find CBS the most attractive given its assets, strategy, execution risks, and management.
NXST is the second largest owner of local TV stations in the United States serving mostly small and mid-size cities. We have a long history with NXST at the Entermedia hedge fund and find their management team to be the best in the business. Even in a cheap group of local broadcasting stocks, NXST stands out as a great value. Free cash flow per share is about 20% of the current stock price even after a 10%+ rally in the shares. Local TV faces many of the same issues as other traditional media with the added challenge of rapidly rising payments to the big four networks (ABC, CBS, FOX, and NBC) for the right to maintain their affiliations. Nonetheless, many positives exist including the ability to create shareholder value from the massive free cash flow by paying down debt, increasing dividends and share buybacks, and buying more stations in highly accretive transactions. Each of these positives should become more evident in the year ahead when the FCC loosens local station ownership rules (expected later this month) and political advertising drives the biennial boost to revenues an cash flow.
CBS, DIS, NXST, and CMCSA are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. CBS, DIS, NXST, and CMCSA are net long positions in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.