Our Outlook for Media & Telecom Stocks
We continue to favor the companies with strong competitive advantages.
Quarter-End Insights
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As the end of the third quarter approaches, there are some signs that the worst of the recession is behind us. We continue to believe well-positioned firms will emerge stronger while leaving behind weaker players in media and telecom. Some of the most poorly positioned firms have seen their shares skyrocket over the past three months, though, which we believe has created potholes for investors.
As we discussed in last quarter's outlook, the cable businesses continue to hold up well. According to Nielsen (Three Screen Report) television consumption continues to rise, with average daily viewing topping five hours per day. The cable, satellite, and phone companies we follow continued to add net new television customers, in aggregate, during the second quarter, which we believe demonstrates the continued importance of this service. What makes these additions even more compelling is that subscriptions grew in a period when the unemployment rate exceeded 9%. Comcast (CMCSA) and Time Warner Cable , our favorites in the industry, continue to expand their share of consumer telecom spending in the markets they serve. These two stocks have rallied over the past three months, but we still think the shares are undervalued.
The television theme is holding up in Europe as well, where we had believed that television service was viewed as more of a discretionary purchase than in the U.S. However, we saw pay television subscription growth--with new subscribers signing up for premium packages--at both British Sky Broadcasting and Liberty Global (LBTYA).
From an advertising perspective, spending on cable networks declined by 3.6% year over year during the second quarter, according to TNS Media Intelligence. While shrinking ad revenue isn't great, the cable figure is much better than most other categories, including local television (-27%), network television (-5.5%), newspapers (-24%), and radio (-25%), again according to TNS. Several cable network executives have given commentary on ad trends over the past few weeks. Disney's (DIS) CFO stated that on a relative basis, cable ad trends look more promising than local ads. Disney owns several local television stations, but has much greater exposure to its cable networks, like ESPN. Scripps Networks' management echoed a common theme we've heard over the past several quarters: Advertisers are putting off advertising buys until the last minute rather than committing to larger ad purchases up front, limiting ad revenue visibility. We think the established cable networks are well-positioned as primetime viewership continues to shift to cable television and away from the broadcast networks. We also think the cable networks' negotiations with distributors will benefit from continued growth of telecom firms in the pay television market, adding another bidder for its content.
This quarter marked a big return in merger and acquisition activity among telecom carriers. Bharti Airtel, the largest wireless operator in India, is currently in exclusive merger discussions with MTN, the largest wireless operator in Africa. If the two can come to an agreement, the firms would create the third-largest wireless carrier in the world by subscribers, behind only China Mobile and Vodafone (VOD). As growth slows in developed markets, we expect more deals as firms look to cut costs and shore up their competitive positions. Deutsche Telekom seems to have taken the lead on this front, announcing plans to combine its assets in the U.K. with those of France Telecom (FTE) in a joint venture. The German giant is also reportedly considering a bid for Sprint Nextel , which it would combine with its T-Mobile USA unit. We doubt this deal will come to fruition given the complexity of merging the firms' various networks, but additional reshaping of the U.S. wireless industry is likely over the next year or so. Global telecom merger activity has extended beyond wireless as well, with Vivendi of France picking up GVT, a fixed-line telecom and high-speed Internet access provider in Brazil.
Though share prices aren't nearly as attractive today as they were when we highlighted the stocks last quarter, we continue to like the wireless tower industry. We recently visited the three main U.S. tower companies-- American Tower (AMT), Crown Castle (CCI), and SBA Communications (SBAC)--which reaffirmed our growth expectations. As wireless data traffic increases along with higher penetration of smartphones, so does the burden on the wireless networks, which prompts carriers to add tower sites to expand capacity. We still believe American Tower has the best competitive position in the industry.
Within the networking and telecom equipment industries, the only real piece of good news during the third quarter was that the flow of bad news has subsided. The watch-word in the second-quarter conference calls for most of the firms that we follow was "stable," and management teams began to note (almost in unison) that while spending by the telecom carriers hasn't begun to pick up yet, the carriers are at least beginning to talk about undertaking new projects. Only a handful of companies, including F5 (FFIV) and Acme Packet , reported results that we actually considered to be strong, and we think that the strength of these firms' results was primarily due to the fact that their products sell at a relatively low price point and offer a clear, quick return on investment by allowing customers to squeeze more out of their existing networks.
Valuation by Industry
Valuations are less attractive today than three months ago nearly across the board. The number of 5-star rated firms among the roughly 200 media and telecom stocks we cover has fallen to about three from around 12 in June and roughly 40 in mid-March. Some of the significant gainers that were rated 5 stars at the time of our June article include NII Holdings (up 55%), Time Warner Cable (41%), Interpublic Group (IPG) (33%), British Telecom (32%), Comcast (26%), and Disney (20%).
| Media & Telecom Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
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| Advertising & Marketing Services | 2.63 | 1.12 | 0.88 | 27% | 90 |
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| CATV Systems | 3.48 | 0.96 | 0.93 | 3% | 19 |
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| Communication Equipment | 2.88 | 1.02 | 0.98 | 4% | 74 |
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| Communication Services | 3.23 | 0.88 | 0.81 | 9% | 35 |
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| Entertainment | 2.93 | 1.06 | 0.78 | 36% | 70 |
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| Internet Information Providers | 2.99 | 0.99 | 0.88 | 13% | 61 |
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| Internet Software & Services | 2.63 | 1.10 | 0.96 | 15% | 89 |
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| Networking & Communication Devices | 2.88 | 0.91 | 1.06 | -14% | 73 |
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| Publishing | 2.58 | 1.12 | 1.02 | 10% | 93 |
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| Data as of 09-14-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of each industry's underlying stocks. (Universe=all stocks under coverage.) |
With the rising market tide lifting nearly all boats over the past three months, we've seen several stocks rise well beyond our fair value estimates. Included in this group are many "old" media names like New York Times (NYT), Belo , and Entercom (ETM). We believe investors in these stocks are banking on a sharp and swift recovery in advertising spending. While a bump in the ad market would certainly push more revenue to newspapers, local television broadcasters, and radio firms, we continue to believe these industries will continue to lose market share over the long run to newer media. Given the large debt loads common in old media, these stocks tend to be very volatile and, again, we expect leverage will catch up with several firms in this group longer term.
The entertainment and advertising and marketing services groups have appreciated the most on a relative basis as these companies have exposure to advertising spending, which is thought to have bottomed in the second quarter. Regardless of industry, we believe media and telecom tends to face relatively high uncertainty as consumer demand and technology evolve. As a result, we prefer firms with strong balance sheets and cash flow that afford the flexibility to respond or at least the ability to provide some value to shareholders rather than creditors.
Our Top Media & Telecom Picks
We've removed NII Holdings from our picks list this quarter, as the stock rallied significantly, and we recently lowered our fair value estimate for the shares after taking a fresh look at the firm. We also took American Tower off the list as its shares have appreciated close to our fair value estimate. We've added France Telecom and DISH Network as we think both stocks are undervalued at current prices. Cisco and Disney recently moved out of 5-star territory, but we'd take a keen interest if the shares trade below our consider buying price.
| Top Media & Telecom Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Fair Value | |
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| Walt Disney Co. |  | $32.00 | Wide | Low | 0.88 |
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| Comcast Corp. |  | $25.00 | Wide | Medium | 0.69 |
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| Cisco Systems, Inc. | | $26.00 | Wide | Medium | 0.88 |
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| France Telecom | | $35.00 | Narrow | Medium | 0.79 |
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| DISH Network Corp. | | $28.00 | Narrow | Medium | 0.66 |
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| Data as of 09-22-09. |
Walt Disney (DIS)
Although Disney is exposed to the 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, which garner a majority of their sales from affiliate fees. We expect both ESPN and Disney Channel to maintain a dominant position in cable television over the next decade. While its theme parks and studio entertainment results have taken a hit during this recession, we don't think Disney's brand power is any less valuable today than it was 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.
Comcast (CMCSA)
Comcast's customer growth has slowed over the past several quarters, but the firm is steadily claiming a greater share of customers' overall telecom spending, on average, in the markets it serves. We believe stealing this market share positions the firm well to continue investing in its networks and improving customer service to strengthen its position further versus the phone companies in most markets. At the same time, free cash flow has grown nicely thus far in 2009, and Comcast recently resumed buying back shares, a good use of cash, in our view, given the current stock price.
Cisco Systems (CSCO)
We expect Cisco to maintain its dominance in routing, switching, and a handful of adjacent markets, and we believe that network convergence, data center consolidation, and increased global communications needs will continue to drive demand for the firm's equipment. However, we're already seeing some strong signals that Hewlett-Packard (HPQ) and IBM (IBM) (both major players in the server market and frequent Cisco partners) are pre-emptively retaliating against Cisco's nascent foray into the server market by strengthening their relationships with Cisco competitors. While we don't think that Cisco is at any risk of losing its dominant spot in the networking world anytime soon, we will be concerned if we see the firm starting to trade low-margin server revenue for high-margin networking revenue.
France Telecom (FTE)
Our favorite international telephone company remains France Telecom. It continues to generate copious amounts of cash, which it uses to invest in new technologies and countries as well as pay a very nice dividend. France is one of our favorite wireless markets with only three operators owning their own network. FT has the largest market share, and competition is relatively mild. It has also been growing its high-speed Internet access and pay television business. It has been by far the most successful incumbent telephone operator at selling television services. It also has operations in many other countries, some of which--particularly Africa--provide the firm with growth opportunities.
DISH Network
The most compelling feature of DISH Network, in our view, is valuation. The firm trades at a steep discount to rival DIRECTV on a number of valuation measures, but we believe this gap is unwarranted. The biggest difference between the two firms is that DIRECTV controls some content that no other carrier offers, notably NFL Sunday Ticket, but DIRECTV has to pay a hefty price for this privilege. DISH has made progress fixing a number of execution issues recently and posted its first net customer gain in a year during the second quarter. We also like the firm's focus on low costs, which we believe will be key to retaining a base of customers over the longer term.
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