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June 01, 2008

Selling Disney and News Corporation

On Friday, I sold all Northlake client positions in Disney and News Corporation. This is a big deal fro me as media stocks are my area of expertise and I believe that these are the two best managed, fast growing companies with the most optimistic long-term competitive positioning. I've owned Disney for more than three years and purchased News Corp last December.

The primary trigger for my sale was Viacom's announcement that it was lowering its 2Q08 forecast for advertising growth at its cable networks from 6-7% to 3-4%. As recently as May 2nd, when it reported good 1Q08 earnings, Viacom had reiterated its 2Q ad growth forecast. The implication is that national advertising has suddenly slowed. If this is the case, spillover to even the best media companies is likely.

Viacom's guidance reduction was not an isolated incident. On its own March quarter conference call, Disney stated that June quarter ad growth at ESPN would slow below recent trends before accelerating again in the September quarter. There have also been anecdotal comments about softening in the scatter market for national TV advertising. Lastly, commentary surrounding the recent upfront presentations by the major broadcast networks suggests that upfront ad sales will be down versus a year, possibly sharply.

Also worth noting is that Viacom's national advertising exposure is concentrated in cable networks, an area that has been more resilient than other national ad media for several decades. Not only that but Viacom's cable networks have enjoyed ratings growth for the past six to nine months. If a seemingly well positioned national advertising medium is seeing a sudden slowdown, it is hard to believe that a broader slowing is not underway.

Weak consumer spending patterns and poor consumer confidence reinforce the risk to ad expenditures. Advertising at the local level has been in negative territory for over year as newspapers and radio and TV stations have encountered cyclical and secular challenges. National advertising normally lags local advertising by three to six months as pointed out by numerous media analysts, most notably Merrill Lynch's Jessica Reif. The timing of Viacom's seems a little too perfect to just be a coincidence given that the economy slowed to virtually no growth late in 2007....

....According to UBS Media analyst Michael Morris, Disney should get about 22% of its total revenue advertising. Another 23% comes from theme parks, which are exposed to similar cyclical headwinds as advertising. News Corporation receives a higher 38% of its revenue form advertising, including a significant exposure to newspapers. Viacom's exposure is 35%. Time Warner has the lease ad exposure of major entertainment companies at 19% (though that goes way up following the split of Time Warner Cable). CBS is most exposed with 70% of revenue coming via advertising.

There is some reason to believe that Viacom's slowdown may not flow through to the rest of the industry. Viacom's cable networks have very narrow demographics which limits the diversity of its advertiser base. A more concentrated advertiser base means the company could just be feeling the effects of a few major advertisers cutting back.

On the other hand, Mike Morris points out the Viacom has relative less exposure to the most exposed areas in advertising such as consumer discretionary and financial. As a result, Viacom might be expected to hold up better than its peers.

The bottom line is that the risk-reward trade-off for the major media companies has soured. Disney and News Corp face headwinds in a number of their businesses and risk to earnings estimates has heightened. P-E ratios are near historical lows but that assumes estimates hold. Furthermore, if negative estimate momentum develops, there is no guarantee multiples will not contract further.

At current prices, I see no more than 20% upside in the shares of both companies even if estimates hold and Viacom's national advertising slowdown is a head fake. Disney has downside to the upper $20s, a level it reached earlier this year. I look for a risk-reward tradeoff of better than 2 to 1 to the upside for a long position. Besides Disney's exposure to national advertising, ABC has clearly lost momentum with the recent season showing double digit ratings for key shows and no recovery after the writer's strike was settled. Disney also faces tough comps at its film studio and its first major release of the summer, The Chronicles of Narnia: Prince Caspian, is headed to just 60% of its predecessor at the North American box office.

News Corp has more downside and more upside due to its operating and financial leverage. The company is facing a number of issues including a dramatic slowing in recently rapid operating income growth, questions over acquisition strategy, and concerns that monetizing MySpace will prove more difficult than expected.

I'd happily buy back both stocks at higher prices if my confidence in fundamentals returns. Northlake's strategy does not involve shorting but if fundamentals continue to deteriorate and Viacom's warning is the start of a trend shift, investors who do short may find profits at Disney, News Corp and other media stocks. I am not making a call to short the stocks now. They may go lower but I don’t see significant downside presently. I do fear a prolonged period of lagging relative performance and what I promise my clients is that I'll beat the market. Given that mandate I'd rather be in other names or cash for at least the next few months.

Posted by Steve Birenberg at June 1, 2008 04:27 PM in DIS