Our Outlook For Media & Telecom Stocks
The weak are starting to fall by the wayside in media and telecom.
Quarter-End Insights
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Last quarter we highlighted the extreme divergence between the good and the bad within the media and telecom sector, and things have only gotten worse for weaker firms over the past three months. Most notably, the bleak picture we painted for telecom equipment vendors, especially Nortel and Alcatel-Lucent , is now painfully visible. Nortel filed for bankruptcy protection in January and Alcatel-Lucent limped to the finish line in 2008, posting yet another weak quarter, with sales declining and cash flow anemic. We're still skeptical that Alcatel can turn its business around any time soon, if at all, in what will likely remain a very challenging environment through at least the first half of 2009. Ciena (CIEN) CEO Gary Smith nicely illustrated the woes in the sector after his firm reported weak quarterly results, stating that many service providers are now setting monthly, rather than annual, equipment spending budgets in response to ongoing uncertainty in global economies.
Few firms have escaped the downturn in equipment spending and Cisco (CSCO), our industry favorite, is no exception. The firm experienced a sharp decline in demand in its first fiscal quarter, and it expects a 15%-20% year-over-year decline in second-quarter revenue. Cisco recently confirmed long-standing rumors that it will indeed enter the server market and singled out Hewlett-Packard (HPQ) as its primary competitor. While we doubt this move will meaningfully change Cisco's near-term operating results, the long-run implications could be significant. The server industry is mature and highly competitive, and we think Cisco will have a difficult time earning an acceptable return on the capital it deploys for these efforts. Moreover, Cisco may be placing a portion of its enterprise networking revenue at risk as HP, IBM (IBM), and Dell re-evaluate partnerships. We'd like to see Cisco spend more time tending to its wide moat, beating up on weakened rivals; the planned acquisition of Pure Digital, a maker of handheld video cameras aimed at consumers, adds to our worry that the firm is pushing into unattractive markets in search of growth. Cisco's advantages relative to the competition are so great, however, that we still believe the firm will extend its lead over the next couple years.
The recession also continues to take a toll on media firms, especially those that rely heavily on advertising, and we remain bearish on most "old media" stocks, especially newspapers and radio. These firms have been hit by a triple-whammy: large sales declines driven by the economy, ongoing secular shifts away from traditional advertising, and--most devastating--highly levered balance sheets. The fallout from past excesses in these industries continues to mount, with E.W. Scripps' (SSP) Rocky Mountain News closing its doors in February and Hearst's Seattle Post-Intelligencer ditching its print product this month. Both firms failed to find a buyer for their respective papers in recent months and decided to put an end to 150 years of tradition rather than spill yet more red ink. We've assigned a $0 fair value estimate to three additional media firms over the past quarter, bringing the total to 14, or about 20% of our coverage list in the sector.
We don't think any media companies are immune from the weak ad spending environment that will persist during 2009. For example, we made a slight reduction to our fair value estimate for Google in January to account for lower sales growth in 2009. We still like the long-term growth prospects for search advertising, however, and we believe Google's moat in this key business continues to widen. Advertising spending on cable television networks grew around 3% in 2008, but we think sales are likely to decline slightly in 2009. However, unlike newspapers and radio, we like the long-term prospects of cable networks, which garner stable subscription fees in addition to ad dollars. Some of our favorite media names such as Disney (DIS), Time Warner , and Viacom own attractive cable networks.
Even firms with businesses that have held up relatively well haven't been able to escape the effects of excess debt. Charter Communications (CHTR), like its cable peers, has seen only a modest slowdown in growth recently. We mentioned last quarter that cable companies were starting to gain significant ground in the battle for customers with telecom rivals, including giants AT&T (T) and Verizon (VZ), but that the telcos were fighting back by cutting prices. The result was a shift in market share back toward the phone companies during the fourth quarter. We don't believe price cutting is a viable long-term strategy for the telcos--both phone giants saw margins in their fixed-line businesses contract sharply in the fourth quarter--and we expect cable will continue to gain share in most markets over time. In this environment, however, any sign of weakness is big trouble for firms as heavily levered as Charter (debt roughly equal to 10 times operating income, excluding depreciation and amortization expenses). With grim refinancing prospects, Charter is seeking bankruptcy protection.
Outside of the U.S., most phone companies face less-intense cable competition and these businesses continue to hold up fairly well as more customers adopt wireless and high-speed Internet access services. Although we have seen growth suffer recently as customers cut back on wireless usage, most of the telecom carriers we follow continue to generate significant amounts of free cash flow, which we expect will provide stability through the downturn. Some of the more leveraged international firms, such as BT Group , Telecom Italia (TI), and Telenor (TELNY), have seen their stock prices pummeled on concerns about their ability to service debt, in addition to select company-specific issues and negative currency swings. We believe there are telecom opportunities outside the U.S., but investors can afford to be choosy.
Valuations by Industry
Valuations in the media and telecom industry headed mostly lower again during the first quarter, but volatility was much less severe than it was in the previous quarter. The radio industry jumps out as an exception and the figure below seems to indicate that the industry got a lot cheaper over the past three months. That isn't the case, however. Our calculation excludes stocks with $0 fair value estimates to eliminate the impact of deadbeat companies on what otherwise might be an attractive industry. We've added to the number of $0 fair value estimates in the radio industry recently, and eight of 10 firms we cover now fall in that bucket. We don't consider the remaining two-- Cox Radio and Entercom (ETM)--particularly attractive. Broadcast television and publishing exhibit similar characteristics, as their relatively low average star ratings indicate.
| Media & Telecom Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty | |
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| Advertising | 4.0 | 0.61 | 0.64 | -5 | 35.4 |
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| Broadcast Television | 2.8 | 0.52 | 0.59 | -12 | 78.7 |
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| Business/Online Services | 3.5 | 0.66 | 0.58 | 14 | 66.9 |
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| Cable TV | 4.3 | 0.53 | 0.63 | -16 | 20.5 |
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| Data Networking | 4.3 | 0.49 | 0.56 | -13 | 14.2 |
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| Media Conglomerates | 3.5 | 0.57 | 0.67 | -15 | 33.1 |
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| Publishing | 2.8 | 0.83 | 0.82 | 1 | 44.9 |
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| Radio | 1.5 | 0.78 | 1.51 | -48 | 19.7 |
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| Telecom Services | 3.8 | 0.67 | 0.74 | -9 | 45.7 |
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| Wireless Equipment | 3.8 | 0.73 | 0.61 | 20 | 63.8 |
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| Wireless Service | 3.8 | 0.60 | 0.69 | -13 | 48.0 |
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| Optical Equipment | 4.0 | 0.45 | 0.49 | -8 | 34.6 |
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| Data as of 03-13-09. *Market-Weighted Harmonic Mean |
The cable and data networking industries look especially cheap right now. In both cases, we believe the largest firm in the industry by market capitalization--Cisco and Comcast (CMCSA)--offer compelling valuations. Data networking and optical equipment also include a number of firms trading at or near the value of cash, net of debt, on their books.
Our Top Media & Telecom Picks
We've made one change to our list of top picks since last quarter: We've replaced eBay (EBAY) with Google. We recently attended eBay's analyst day and walked away happy with the firm's decision to focus more attention on its core platform, catering to used and overstock items, rather than its efforts to attract retailers of new merchandise. We made a significant cut to our fair value in January as we had clearly overestimated the market opportunity in the U.S. auction business, but we still think eBay is undervalued. Although it's not rated 5 stars, Google offers a wide moat in a business that continues to grow nicely.
| Top Media & Telecom Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ | |
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| Walt Disney Co. |  | $34 | Wide | Low | 0.52 |
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| Google, Inc. |  | $500 | Wide | High | 0.66 |
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| Comcast Corp. | | $25 | Wide | Medium | 0.52 |
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| Cisco Systems, Inc. | | $31 | Wide | Medium | 0.53 |
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| NII Holdings, Inc. | | $43 | Narrow | High | 0.36 |
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| Data as of 03-19-09. |
Walt Disney (DIS)
Although Disney is not immune to a slowdown in consumer spending, we like the long-term prospects of this wide-moat firm. About half of overall operating profit comes from its cable networks, headlined by ESPN and Disney Channel, which garner a majority of their sales from affiliate fees. While its theme parks and studio entertainment results are taking a hit during this recession, we don't think Disney's brands are less valuable today than they were a year ago. The strength of these brands allows the company to exploit its characters and franchises through box office and home video sales, theme park attendance, and merchandising.
Google (GOOG)
We believe Google's wide moat comes from its dominance in search advertising. While we expect growth to slow in 2009, we think the inherent advantages of search and the continued growth of Internet usage will lead advertisers to allocate more of their ad budget to search, resulting in solid growth prospects for years to come. It was also encouraging to see Google show discipline in controlling costs in the fourth quarter of 2008. New hiring has come to a halt, capital expenditures are down, and the company is cutting back on resources allocated to business units with weak prospects. While some may view these moves as a signal that Google's growth prospects are permanently impaired, we think the company is finally focusing on its best opportunities and less on science projects.
Comcast (CMCSA)
Customer growth slowed sharply during the fourth quarter, but Comcast continues to expand its share of consumer telecom spending (Internet access, phone, and television services) relative to its phone company rivals. We believe the firm's solid financial position and growing cash flow position it well to remain a step ahead of the phone companies in most of the markets it serves.
Cisco (CSCO)
Weak near-term demand and concerns over Cisco's entrance into the server market continue to weigh on Cisco's share prices. Although we are skeptical that Cisco can succeed in the server market, we expect the company to maintain its dominance in routing, switching, and a handful of adjacent markets. Longer term, we expect network convergence, data center consolidation, and increased global communications needs to drive demand for Cisco's equipment.
NII Holdings
Weak currencies in Latin America have hurt NII as most of its revenues are generated in Mexican pesos and Brazilian reais. While the firm continues to see strong subscriber growth and increased revenue in local currencies, the majority of those gains have been lost when translated back into U.S. dollars. In addition, the firm has more U.S. dollar-denominated debt than cash held in U.S. dollars, which exacerbates the situation. With the U.S. Federal Reserve planning to buy government bonds, the U.S. dollar has recently weakened against most currencies, which should benefit NII over the near term. We also think the firm still has lots of growth potential left and that the current stock price reflects undue concern over future currency moves.
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