News Corporation: Dead Money Until Serious Questions Are Resolved

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By Richard MacDonald :

The article below details how the News of the World scandal impacts News Corp.'s ( NWS ) value .

Current Price per share

Net debt (cash) per share

Current Price + Net Debt=Enterprise Value

$16.07

1.41

$17.48

Investment Conclusion

Dead Money Until Serious Questions Are Resolved

For shareholders, no good can come of the utterly unnecessary self-inflicted wound involving widespread and seemingly indiscriminate phone hacking at the News of the World (and now apparently the venerable broadsheet The Sunday Times) of politicians, celebrities, dead soldiers and murder victims. Without question, the revelations and subsequent penalties either criminal, civil or strategic will impair earnings performance, earnings multiples and asset value for who knows how long.

We do not expect any upside in the shares until the issues surrounding the News of the World scandal play out--this despite an announced $3.2 billion increase in a planned share repurchase program to $5 billion this year. The company has the capacity to comfortably execute the repurchase program--net debt of $1.41 a share as of the latest quarter - most of its $15 billion in debt is in very long maturities and it has $11 billion in cash--but the size of repurchase program is a concession that the BSkyB (BSYBF.PK) project is dead. At the same time, the return of $5 billion while beneficial is only likely to cushion a decline in the shares, not reverse its course.

Still, we feel betrayed by a management who we have followed for decades with admiration. The good news is we believe the company can find a way out of this mess and become something quite different. Aggressive hard hitting journalism has been at the root of this company's culture since its inception. There is nothing illegal or immoral about it. However, what happened at News International went beyond aggressive journalism and was illegal, immoral and unnecessary to achieving the strategic goals of the company. And a damn shame!

Why All This Matters

Consequences of the Scandal

Ok, a few people got hacked--why does this matter--aside from potential criminal liability? Those particular consequences are completely unpredictable. But the damage there will be in earnings, loss of strategic opportunity, possible contagion in News' US businesses and reputation lost.

Penalty to Earnings.

In terms of numbers, it is hard to estimate the impact of the shut down of the News of the World but it is clearly negative. (In our view it seems unlikely that The Sunday Times will meet the same fate.) Presumably there will be redundancy costs for 200 or so people let go. Then there will be the loss of income for the closure. Reportedly the Sun--a six day a week tabloid--will launch on Sunday, and there will be costs associated with that. The other tabloids in the market will seize, no doubt, the opportunity to move into the Sunday market. And presumably there will be fierce cover price discounting which will damage operating income. But News should prevail, because it is the most financially robust of the companies in that market.

Strategic Consequences.

NWSA has withdrawn its offer to consolidate the 60% of British Sky Broadcasting that it does not own. While full ownership of BSkyB (LON: BSY: GBP 673.88 52 week hi-lo: 663.50 - 850.77 ) would bring cash flow on the income statement, it would not immediately have boosted asset values or earnings in the near term. In the long term, consolidating BSkyB was central to the company's global strategic objectives of owning leading positions in electronic media worldwide.

Before the scandals, News was in a terrific position to consolidate BSkyB because of its existing ownership and commitment to the enterprise. Full ownership would have allowed the company to further accelerate BSkyB's evolution. Now, as an unconsolidated sub, the ability of the company to grow BSkyB and to create benefits across the full portfolio of News' business continues to be limited.

The Contagion Effect.

Of course, great risk also exists/existed in a possible contagion effect on News' US Broadcast assets if the scandal widens or if the OFCOM (the British Media Regulator) had declined to allow the buyout of BSkyB because of the scandal. If it had deemed the company no longer a fit person to own a UK broadcast property, then the FCC might still come under similar pressure to scrutinize News Corp.'s US activities in its oversight of the broadcast operations. Fair and balanced had frankly better be the case without any phone hacking or other illegal or unethical tactics.

Damage to the Company's and Mr. Murdoch's Reputation.

Finally, the scandal matters because News Corp., and particularly Mr. Murdoch, has spent the last thirty years trying to convince the investment community to accept News as a blue chip diversified media company. For the most part he had succeeded. The scandal which has now widened to include The Sunday Times (after further disgusting allegations about fraudulent requests for information about former prime minister Gordon Brown's accounts at Abbey National Bank) seems for the moment boundless and to have undermined practically all of that 30-year effort.

Target Prices.

Enterprise Value of $21.49

We believe that News is still at the top end of its potential target range even before considering the impact of the scandal on earnings. We first look at asset values based on long term projections of free cash flow discounted back to the present, subtract debt and add back investments.

Based on historic growth in earnings and free cash flow, (and not factoring in the shutdown of either NOTW or the recent sale of MySpace) our estimate of the private market value for News at the mid point for terminal value and discount rate based on publicly estimated beta is $21.49. It also does not include BSkyB on a consolidated basis and does not account for its ownership at about $2 per share at current prices.

Arguably, however, these are still generous multiples given the mix of the company's business and the decreasing predictably of its earnings.

Enterprise value

Terminal Value

Discount rate

10

12.5

15

18.10%

$17.71

$20.23

$22.75

16.85%

$18.77

$21.49

$24.20

15.60%

$19.92

$22.85

$25.78

At current prices the shares are trading about a 30% discount. This is an intriguing but not compelling discount. We like to see somewhere around a 50% discount before getting excited. Moreover, the Murdoch family clearly intends to retain control of this company as it has for sixty years.

As we pointed out, the company's substantial cash position and long term debt with very long term maturities is sufficient to execute a $5 billion share repurchase plan this year. It is not enough to take the company private without new debt. It is doubtful that the family could raise that kind of debt from public markets under the current cloud of scandal and liability. (If the family does not tender its shares it will increase its interest and control of the enterprise in any case without paying a substantial premium.) Therefore there is no possible strategic event likely to happen which could realize the full value of this company. Certainly not at current prices.

Earnings Performance and Multiples.

Historically, News has grown very rapidly, if inconsistently. Here are the five and ten year compound average growth rates.

Period

Sales

EBIT

Depreciation

Total Net Income

EPS

EBITDA

10 years

6.09%

NM

6.62%

16.98%

14.99%

24.86%

5 years

5.29%

-5.48%

8.86%

-2.02%

2.20%

-2.74%

While the company's television interests around the globe--particularly the US cable networks--have grown rapidly, the acquisition of Dow Jones and MySpace have weighed on earnings during that time. The newspaper publishing business has lagged on a fundamental basis in both the UK and Australia, but currency translations have been favorable to earnings.

We projected future earnings based on historical sales growth and margins. We have not talked to the company about projections because historic performance seems frankly the best guidance for an enterprise that has been run by the same management for sixty years. Our model, by its nature quite mechanical, however seems to produce estimates close to current consensus estimates by major Wall Street brokerages as reported on Google. Here are the projections.

EPS

Earnings per share current and projected based on extrapolation of historic sales and margins

Consensus EPS

Annual estimate based on prior quarter (point or tangential estimate)

Prior Year

$1.11

Current year

$1.13

$1.12

$1.09

Next year

$1.20

$1.33

$1.48

EPS Historic Growth Rate

14.99%

EPS Projected 5 year Growth Rate

7.21%

Here are the price earnings multiples:

P/E

based on extrapolation of historic sales and margins

based on consensus EPS

based on prior quarters (point or tangential estimate)

Prior Year

14.43

Current year

14.26

14.35

14.72

Next year

13.37

12.08

10.83

The company's multiple of earnings has been declining since 2005. This reflects the decline in overall equity valuations and a decline in media valuations because of increased competition from new media for advertiser dollars and paid entertainment purchases. To some it may also have reflected the company's determination to expand rapidly through acquisitions like Dow Jones and BSkyB. Frankly, this is the way Mr. Murdoch has expanded his business for sixty years. Investors should not have expectations that he will proceed any differently in the future.

Target prices based on a median multiple of 18.82 during the whole period. The median however is higher than than the high end of the last two years.

Here are the target prices and subsequent returns based on these projections.

Target price

based on extrapolation of historic sales and margins

based on consensus EPS

based on prior quarter's annualized EPS

Prior Year

$17.46

Current year

$17.73

$17.62

$17.18

Next year

$18.91

$20.92

$23.34

Total return from current price

Prior Year

4.25%

Current year

7.54%

6.86%

4.23%

Next year

14.55%

26.59%

41.01%

We just don't see further upside from current prices. We think that consensus earnings estimates for next year are very high and will be brought down significantly once the impact of the scandal is incorporated. We also believe that the company's latest earnings report reflected a number of one-time positives that distorted the model to the upside and so we do not expect this set of estimates to be realized. Finally we think that multiples will continue to remain in a downward trend until the impact of these long standing and disastrous practices are investigated and resolved.

We do not own stock and don't know if we will even at lower prices. It's hard to tell how this whole thing will play out.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

See also 21Vianet: Good Margins Along With Risky Outsourcing Contracts on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: NWS , NWSA

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