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August 17, 2009

Stability Without Recovery Defines Second Quarter Media Earnings

Most media companies report quarterly earnings in a two week span beginning with the last week of the first month of each calendar quarter. Below is a two-part recap of second quarter earnings season that was originally published on the Dow of Steve Blog at SNL Kagan Interactive.

Week One Recap: July 27 – July 31

Entering second quarter earnings seasons media stocks faced a very high bar due to their leadership in the rally off the March lows. Most media stocks entered earnings season trading at post-crash highs with the pace of gains accelerating since first-quarter earnings reports suggested fundamental decline had ceased and management commentary offered hints of recovery.

In general, media earnings reported the last week of July met or exceeded expectations. Trends in advertising and consumer demand for media products and services were quite similar to the first quarter, supporting the idea that media stock fundamentals have reached a bottom. However, there were few signs, if any, that fundamentals have begun to improve. In fact, compared to first-quarter commentary, media management teams seemed less sanguine about a recovery in demand. Given the big run in the stocks, this setup led to selling even though the results themselves were OK and forward estimates are little changed.

Selling of media stocks might have been worse last week except for a strong underlying bid for stocks in general and growing investor acceptance that the economy was beginning to recover. Friday's gross domestic product report showing a decline of just 1% confirms that the economy will likely grow in the second half of 2009. This should provide solace to media investors hungry for improved fundamentals, as most drivers of media demand are sensitive to broad trends in GDP. As a result, barring a negative shift in investor sentiment toward the economy, I do not see significant downside in media stocks relative to the market.

There are still many important media companies that will report earnings this week, including Comcast Corp., DIRECTV Group Inc., Scripps Networks Interactive Inc., News Corp., CBS Corp. and the Liberty Media Corp. complex of tracking stocks. I suspect we will hear more of the same, with the best news coming from the cable networks companies and DIRECTV. I also expect the stocks to respond similarly to last week unless any company indicates that demand is actually improving.

Here is a brief recap of the key earnings reports from last week:

Viacom Inc. led things off on Tuesday and reported improved results in its cable network business offset by another rough quarter at Paramount and very weak sales of Rock Band video games. Domestic ad trends improved to -6%, 300 basis points ahead of the first quarter. Ratings are also on the upswing offering hope that trends will continue to improve. I was pleased that excluding Rock Band cable network operating margins appear to be improving. I thought Viacom's results would cheer investors. Initially, the stock popped more than 3%, but when it reversed those gains in a few hours, I realized that media stocks faced a tough go of it this earnings season. The expectations bar had been raised too high.

Time Warner Inc. followed on Wednesday morning with a better-than-expected report. Most of the gain was fueled by filmed entertainment, with "The Hangover" already benefitting results. Cable networks were a bit better than expected with domestic trends flat, as entertainment networks had positive advertising gains while news networks declined due to tough comps from last year's elections. Analysts and investors were quick to discount the positive surprise by noting that the third quarter was going to prove tougher. Furthermore, analysts pointed out that there were several small one-time benefits that made the numbers look better. I think the reaction to the results is indicative of investor unwillingness to bid media stocks ever higher without concrete signs of fundamental improvement. These same results reported a few weeks ago would have been met with a nice upward move in Time Warner shares.

Walt Disney Co. reported Thursday, and it had the worst numbers of the big three. Partially this is due to the greater economic sensitivity of its business operations. Weak trends at ABC, the local TV stations and theme parks are no surprise. However, a 10% decline in ad spending at ESPN is troublesome compared to other cable networks. Disney management is responding capably to the economic headwinds. Dramatically less margin pressure at theme parks amid still weak demand is impressive. Unlike Viacom and Time Warner, where I felt the drop in stocks was related mostly to expectations, at Disney I think there are reasons to be a seller. While the company has an impressive set of assets and management team, in a tougher economic environment, the premium accorded the shares is less warranted. Furthermore, the other conglomerates are reorienting their asset mixes and operating strategies and starting to look more like Disney. For the stocks, I think this resolves itself with a smaller gap in relative valuations. As the expensive stock in the group, I think, Disney struggles until a demand-driven economic upturn is at hand.

Regal Entertainment Group reported in-line results, reflecting the positive box-office trends in the second quarter. The shares sold off sharply, however, because profit margins are under pressure from the digital upgrade and higher interest expense. I think Regal is making the right decision to accelerate the digital upgrade rather than wait on the industry consortium to arrange financing. 3-D movies are proving their ability to bring premium ticket prices, but the premium may shrink over time as moviegoers become accustomed to 3-D. Digital upgrades are costly to earnings estimates and coming at a time when the box office has cooled considerably and year-over-year comparisons are deeply in negative territory. I'd be a buyer of Regal on further weakness toward the $10 level.

Cablevision Systems Corp.'s report was overshadowed by the formal announcement of the spinoff of its Madison Square Garden assets. Going ahead with the spin unlocks value and comes as a relief given past missteps by the company and the Dolan family regarding restructurings. The company's cable results were in line with estimates and show that it is coping well with competition from Verizon Communications Inc. Cablevision's business cycle is running a few years ahead of the other major cable companies, so the fact that free cash flow is expanding rapidly as growth slows is a sign of the future for cable. I think it is an attractive financial profile, but cable stocks remain in transition between growth and value investors. What would really help the group is better-than-expected results this week from Comcast. I am not expecting that to happen, but if it does, look for a strong positive reaction in the group similar to the bounce in AT&T Inc. (up 8%) since it reported solid second-quarter results.

Week Two Recap: August 3 – August 7

The second week of the latest quarterly earnings season for media stocks looked a like the first. Most earnings reports met or slightly exceeded expectations. Positive news came from cost cutting, operating margins, and improved balance sheet liquidity. The news on revenues was mixed at best. Many companies fell shortly of Wall Street estimates and there was no evidence that demand for advertising or consumer spending on media had improved.

Against this backdrop, media stocks performed well again as they did during the first week of earnings season. Over the past week, the SNL Kagan Media and Entertainment Index has risen 3.7%, against a gain of just 45 basis points for the S&P 500. TV and Radio station stocks led the way but all Kagan Primary Focus and Business indices beat the S&P 500 except for Publishing and Theaters. Publishing stocks took a breather after newspaper stocks exploded higher following Gannett's better than expected results. Theater stocks suffered following a mediocre report from Regal and negative year-over-year comps at the box office.

Radio and TV station stocks rebounded from severely depressed levels as there were continuing signs that local ad markets were improving. Most companies reported a several hundred basis point in the rate of decline of ad spending and indicated that third quarter trends continued the improvement. Keep in mind revenue declines still range form mid-teens to upper 20's depending on the media. However, as far as Wall Street is concerned what matters is trend, not level. For now, the street is willing to be on the improvement trend proving sustainable at least through year end.

Conference calls were uniformly cautious. As during week one of media earnings season, commentary was less sanguine than on first quarter calls. Management teams noted slight improvement in demand and revenue drivers but were less willing to call the possibility of a return to positive growth.

The one exception was CBS. Keeping in mind that CEO Les Mooves is always optimistic and spins hard to support the outlook for his company, his comments were notably optimistic. Only Les could show emotional excitement about the Collector's Edition DVD of the first six seasons of NCIS!

Moonves indicated that CBS was seeing a strong recovery in network and local TV. He said scatter is up 30% and at a premium to last year's upfront. He indicated that CBS would sell about 65% of this year's upfront inventory with flat revenue. He noted that Cash for Clunkers and political were unexpected and material boosts to advertising demand. CBS stock responded strongly, peaking at a gain of 34% above the closing price just prior to the earnings report.

Overall, here are my key takeaways from second quarter earnings season:

• Advertising trends have stabilized but only minimal improvement is evident. Easier comparisons not better demand from advertisers is the reason for trend improvement.

• There is no pattern to ad trends by TV networks. Networks with ratings gains like Fox News or CBS or Discovery are seeing no or minimal difference in ad demand than weak networks. For example, CBS and ABC both reported -6% ad demand despite ratings gains for CBS and double digit ratings loss for ABC.

• Expense control is in line to better than expected across the board. Cuts appear to be in fixed and variable expenses.

• Wall Street is excited about positive operating leverage due to expense control. This is the fuel behind the outperformance of media stocks.

• Cable industry subscriber trends remain under pressure but free cash flow is benefiting from less new subs. It is unclear how this plays out for the stocks as growing data, voice, and digital TV subscribers can last only so long if analog TV subs continue to fall.

• Initial signs of ARPU pressure at DirecTV emerged.

• Foreign exchange headwinds are moderating and could shift to modest tailwinds in the fourth quarter if recent U.S. dollar.

• Video games are no longer an unequivocal positive. A rising tide no longer is lifting all boats. Consumer demand has slowed and the individual title is now what matters.

• DVD demand remains weak although pricing is holding up on animated titles. Animated titles are down in units but holding up better than live action.

Exiting earnings season I am maintaining a less than usual exposure to media stocks. I am comfortable with current valuations but further upside in the stocks from here relative to the S&P 500 is going to require definitive signs of a turn in advertising.

I have made no changes to my media holdings as a result of earnings season. I still own the CBS/Discovery Communications barbell giving me a leveraged cyclical play and a defensive/growth play. I am considering trimming my position in CBS given that the stock is up 75% since I bought it in early July. I also continue to hold Liberty Media Entertainment. The outlook for the indirect play on DirecTV is a little worse but the stub is looking better after a big positive surprise at Starz in the second quarter.

Disclosure: CBS, Discovery Communications, and Liberty Media Entertainment are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Posted by Steve Birenberg at August 17, 2009 07:57 AM in Media