CBS reported better than expected results for 2Q16, beating consensus estimates on both revenue and EPS.  The upside came from the sales of owned content, especially the Star Trek to Netflix.  Advertising growth at the CBS TV Network grew 2%, slightly below expectations for 3% growth.  Wall Street is focusing on the advertising shortfall and the shares are about 3% lower as we write this update.  Media shares have rallied this year on the back of a surprisingly strong advertising market for national TV.  Recently, concern has arisen that the second half of the year would see decelerating growth despite a strong upfront for the fall TV season.  Continued ratings erosion for most major TV networks is exacerbating the worry about advertising.  CBS shares seem to be taking a hit as renewed worries arise about the long-term health of the TV network business model.

Northlake shares the secular concerns but believes they will play out slower than bearish investors anticipate. CBS remains the best positioned TV network company for the more challenging environment given that it has only one major network that will be included in all bundles, whether they skinny and offered by cable and satellite companies or new OTT providers.  In addition, CBS appears to have a good start on its own OTT services.  With the earnings report, the company announced it had about 1 million subscribers for each of its Showtime and CBS All Access services.  This gives confidence to management’s long-term view that these businesses can produce $800 million in high margin revenue.

Future growth will also be driven by continued gains in retransmission fees earned from cable, satellite, telco, other non-CBS OTT services, and local affiliates.  This revenue is very predictable and does not face risk similar to those of cable TV networks owned by most of CBS’s peers.

If retrans grows from $1B in 2016 to $2.5B in 2020 and the new OTT services reach $800 million in the same years, CBS can still grow operating income even if advertising flat lines.  Share buybacks will leverage the operating income growth into faster EPS growth.  Divestiture of the radio business later this year will also enable a large share buyback.  Management showed its confidence in the outlook by announcing a 20% dividend increase a new $6 billion share buyback.

In our view, today’s decline in the shares is not warranted.  We think CBS can trade into the low to mid $60s based on 15X 2017 estimated EPS.

One thing to keep an eye on is whether CBS is merged with Viacom.  This possibility exists because Sumner Redstone controls both companies and is involved in several lawsuits as he attempts to exert his control over a very weakly performing Viacom.  We have mixed feelings on the advisability of CBS taking over Viacom.

CBS is 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 is a net long position 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.