Name That Trade – $VIA/B: The Content Provides

by Enis November 13, 2014 12:56 pm • Commentary

Viacom is one of the worst performing large cap stocks in the S&P 500 in 2014, down around 17% year-to-date.  The company reported earnings today that slightly beat estimates, and the stock is up 5% so far today.

Viacom is one of the major entertainment content producers in the world.  It owns numerous cable networks, including MTV, Nickelodeon, VH1, BET, Spike and Comedy Central, as well as the Paramount Pictures movie division (with the recent Transformer movie its biggest hit of 2014).  The cable channels provide nearly 75% of revenues, with half of that from advertising and half of it from affiliates fees, while the movie division generates a bit more than 20% of revenues.

VIA/B is valued at a trailing 12 month P/E of 13.5, and expected EPS growth of 10-15% over the next 2 years.  What’s the reasoning behind such a major valuation discount relative to the broader market for what has historically been a relatively consistent media business?  Two main issues stand out to me when considering the reasons for VIA/B’s weak performance.  

First, global ad revenue was down 2% in this quarter, led by domestic ad revenue, which declined 5%, its worst quarter since late 2012:

[caption id="attachment_48031" align="alignnone" width="600"]VIA/B Domestic Ad Revenue change year-over-year, courtesy of Bloomberg VIA/B Domestic Ad Revenue change year-over-year, courtesy of Bloomberg[/caption]

This is an issue for the entire industry, as advertising revenues gradually shift away from TV and print, and more towards the Internet.  Investors are concerned that the secular shift is just beginning, hurting the long-run profit potential for a cable-heavy media property like Viacom.

Secondly, the bulk of Viacom’s EPS growth over the past 3 years has been via buybacks rather than sales growth.  In fact, Viacom had $15 billion of revenues in 2011, vs. an expected $14 billion in 2014.  However, calendar year EPS in 2011 was $3.83, vs. an expected $5.61 in 2014.  The lower share count from buybacks is a major reason for EPS growth, though margins have improved as well.  Management expects to buy back $2.5 billion of stock in 2015, which accounts for nearly half of the expected earnings growth.

On a valuation basis, VIA/B has never been a high P/E stock, and it is now in the middle of its 10 year range:

[caption id="attachment_48032" align="alignnone" width="600"]VIA/B trailing 12 month P/E, courtesy of Bloomberg VIA/B trailing 12 month P/E, courtesy of Bloomberg[/caption]

However, on a relative basis in an overall expensive market, VIA/B shares look downright cheap.

GS research noted the valuation differential vs. peers and the broader market in a recent October note:

Since June 30, VIAB’s stock has declined 21%, making it the worst performer among our large cap media stocks. Although we think there are valid reasons for the sell-off (e.g., TV ad concerns, soft television Upfront, declining ratings, sustainability of affiliate fees), these factors are ubiquitous across media and we believe that VIAB has been oversold. (1) Despite concerns about the sustainability of VIAB’s affiliate fees (e.g., Cable One and Suddenlink dropped VIAB channels in April and September), we see Cable One’s recent subscriber losses as an indication of VIAB’s value to pay TV subscribers. (2) We think VIAB valuation is compelling relative to history and peers. VIAB is trading at 11.3X NTM P/E, a 10% discount to its post-recession average. VIAB is also trading at a 34% discount to the large cap media group, 20 percentage points higher than its historical 14% discount. Moreover, VIAB is trading at a 25% discount to the S&P 500 versus a 9% discount historically. (3) Although ratings trends have been negative in 2014, poor ratings have been realized across the group (i.e., VIAB may be unfairly penalized). VIAB faced the most difficult comps of the year in 3Q, but those comps should moderate in 4Q, while new original programs in the current TV season should help stem the ratings decline.

In terms of the long-term view on VIA/B, the real question is whether Content is in fact King.  If so, then Viacom should benefit from more online offerings, which management has emphasized in its recent partnerships.  Since Viacom owns high quality content, the shift in distribution should not hurt a content provider as much as it hurts the original distributor (as in the cable company bundlers).  If Content is King, then VIA/B stock is cheap, though it does still carry the risks of any stock in a fast-changing industry.

Add it all up, and the high probability scenario looks like a stock trading between $70 and $80 in the coming months.  One possible trade would be the Jan15 70/75/80 call butterfly for around $1.65, which is decent risk/reward targeting the $75 midpoint of the range.  Options are somewhat wide in VIA/B, so a patient limit order makes sense in a trade like this.