News Corporation Gives the Crowd What It Wants

With no debt and more than $2 billion of cash on the balance sheet, it is not surprising that

We have incorporated the semiannual dividend of $0.10 per share beginning from fiscal 2016 (that is, from the September quarter of 2015). The impact on our earnings estimates is not material and certainly not enough to change our $18 fair value estimate.

News Corporation shares continue to trade below our fair value estimate, notwithstanding the positive initial response to the dividend announcement. We remain fully cognizant of the challenges facing the company's traditional media properties--the very reasons for our no-moat rating. However, we believe the current stock price is not sufficiently reflecting the strength of News Corporation's digital businesses, management's diversification efforts, and the potential for a step-up in the intensity of capital-management initiatives down the track.

When News Corporation was first split from Twenty-First Century Fox in mid-2013, it held almost $2.6 billion in cash, had no borrowings, and was generating just over $400 million in free cash flow per year. Consequently, there has been market pressure from day one to liberate the excess capital. Management has rightly deferred any such moves, arguing the need for financial flexibility in the face of structural headwinds facing the legacy print media businesses and its desire to diversify into the digital space.

But today, the company is still pumping out $400 million-$500 million in free cash flow a year. It is also still sitting on more than $2 billion of cash with no debt, despite recently forking out $950 million for Move, the third-ranked online real estate portal in the United States. Given these robust financials, it is hardly surprising that News Corporation has now bowed to investor demands and will institute dividends over and above the current $500 million buyback program. While such moves will not lessen the prevailing cyclical and structural headwinds buffeting News Corporation, they clearly show a company boasting the financial strength to stabilize its legacy print media assets and diversify into new industries, while returning capital to shareholders during the whole transformation process.

We believe the aforementioned cyclical and structural headwinds will continue to be evident in fourth-quarter results, to be unveiled in early August. Indeed, we expect all the factors damping News Corporation's operating performance in recent periods (newspaper earnings decline, easing underlying growth in Australian digital real estate, services and lower contributions from 50%-owned Foxtel, and a strong U.S. dollar) to remain a feature. This is the reason our estimates for earnings before interest, tax, depreciation, and amortization are considerably lower than consensus for the next two years, although we believe the risks are more than adequately reflected in the current price.

Better Positioned Than Most in a Challenging Industry News Corporation is operating in an industry undergoing unprecedented changes, with the traditional print-based publishing business model being dismantled by proliferating news and information outlets in the digital space. This is exacerbated by ever-improving means for consumers to access those outlets, driven by mobility and continuing device innovation. Consequently, News Corporation, with half of its core operating earnings still sourced from the print publishing industry, faces enormous structural headwinds, with consumers migrating from newspapers to the digital arena and advertisers following suit.

We believe News Corporation is better placed than most peers to transition its publishing business to the digital age. It has some of the most venerable masthead brands in the industry (The Wall Street Journal, The Times), and boasts significant editorial resources, especially compared with those of its rivals, which have been dwindling. Importantly, the company's financial position is strong, having split in 2013 from Twenty-First Century Fox with no debt on the balance sheet and an enviable excess cash pile, and able to transition the business to the digital age while also exploring opportunities to diversify away from the traditional newspaper business.

While News Corporation grapples with the structural challenges facing its publishing business, the company is partly shielded by its dominant Australian pay television operations in Fox Sports and 50%-owned Foxtel. Furthermore, the 62%-owned REA Group's growth outlook remains robust in the online real estate classifieds space, both in Australia and, to a lesser extent, Europe. Lastly, management is actively looking to diversify the company's revenue base, with the Amplify business set up to exploit the digital education market and the 2014 acquisition of Move increasing its presence in the digital real estate classifieds space in the United States.

No Economic Moat The company generates around 50% of its core earnings from the newspaper and print publishing market--one that is undergoing monumental structural changes. With increasing disintermediation caused by developments in digital technology, the Internet and mobile devices, the industry's traditional stranglehold on consumers is waning rapidly in most developed countries. With a dwindling audience for print-based products, advertisers are following the eyeballs to the digital arena and migrating away from the medium. Indeed, classified revenue has all but deserted the publishing industry while display advertising is following fast. Furthermore, with declining newspaper and advertising sales, printing presses are being downsized and in some cases dismantled altogether, eliminating one of the main entry costs that traditionally deterred new players from entering the industry.

Some properties within News Corporation boast economic moats. The Wall Street Journal, housed under the Dow Jones operating unit, is a venerable brand name, especially in the world of global finance. Fox Sports and 50%-owned Foxtel enjoy dominant positions in the Australian subscription television programming and distribution market, respectively. In addition, the company owns 62% of REA Group, far and away the number-one digital player in the lucrative Australian real estate listing and advertising space. However, qualities of network effect and efficient scale in these assets are collectively not significant enough (about 20% of the earnings base) to warrant assigning a moat to the entire company.

Losing Audience Is Biggest Threat The biggest risk facing News Corporation is that the company fails to hold onto its audience base as the industry migrates to the online environment. Even if management succeeds in doing so, it is critical that the cost structure is recalibrated in timely fashion so that the reduced advertising yield in the highly competitive digital space can be offset by a step down in the expense base. Slippage on any of these fronts is likely to have a significant impact on News Corporation's bottom line.

The ability of technology-centric companies to aggregate news and information and more efficiently disseminate them to consumers also represents a key risk for News Corporation. It reduces the mastheads' control over readers and diminishes advertisers' ability to properly value News Corporation's content.

Modern consumers are reluctant to pay for content in the digital age and younger generations appear to have a penchant for social media and short-form news. If these trends persist, the ramifications for News Corporation could be material, given the vast editorial cost structure embedded in its business model.

Finally, the flip side of having a strong balance sheet is the risk that efforts to diversify the business mix away from print publishing could fail or lead to overpaying for assets. However, even after adjusting for the excess cash, News Corporation's return on invested capital is currently still well below its cost of capital.