Size matters in the media business as much or more than almost any other sector. As one of the largest media companies in the world, Viacom’s (VIAB) distribution and reach puts the company in a very strong competitive position.
Nevertheless, the market greatly undervalues the cash flows of the company. To be specific, the current value of the stock (~$50/share) implies the company’s after-tax cash flow (NOPAT) will permanently decline by nearly 25%.
In other words, the market is predicting that Viacom’s cash flows will take a major dive and never recover. Figure 1 plots a comparison of the stock to its economic book value, which is currently $66/share. This is the value of the stock if Viacom’s NOPAT never grows beyond its 2012 level.
Figure 1: Impressive Margin of Safety
Sources: New Constructs, LLC and company filings
Bears will point to the company’s recent disappointment in fourth quarter revenues. Total revenue of $3,363 million in 4Q2012 dropped 17% versus 2012. That is a big drop to be sure, but earnings still rose by over 14% over the same period.
Rising earnings despite a rather large drop in revenues suggests the company is focusing its business more on the profitable segments (affiliates) than the unprofitable segments (movies). By focusing more on scaling their existing brands into new markets as well as investing more in digital content and distribution, Viacom’s future cash flow prospects look great to me.
The merits of this strategy are proven by the rising trend in the company’s return on invested capital(ROIC). This impressive trend shows the company is becoming more profitable not less profitable as the market suggests. Figure 2 plots VIAB’s ROIC versus its weighted average cost of capital (WACC) over the past seven fiscal years.
VIAB’s 2012 ROIC was 14% compared to just 2% for Time Warner, Inc. (TWX) and 10% for Disney (DIS). Neither TWX nor DIS have achieved as strong or consistent an ROIC as VIAB over the last several years. And both of those stocks are much more expensive than VIAB.
Figure 2: Business Is Growing Stronger
Sources: New Constructs, LLC and company filings
If one looks only at the reported earnings of the company in 2012, one sees a decline in earnings. On the other hand, assessment of the company’s economic earnings shows an increase. Figure 3 compares the company’s 2012 GAAP earnings to is economic earnings.
Figure 3: Economic Earnings: Diligence Matters
Sources: New Constructs, LLC and company filings
The primary difference in GAAP and economic earnings for VIAB in 2012 is the removal of non-operating items dug out from the footnotes and MD&A as well as a normalization adjustment to the company’s reported taxes. The take away is that doing a little extra digging reveals a company whose profits are on the rise and not likely to fall the nearly 25% that is implied by the stock’s valuation.
I get the strong sense that management agrees with my thesis and is putting their money where their mouths are. Over the last two years, the company has repurchased 121 million shares or 20% of outstanding shares. In 2012 alone, it bought back approximately $3.4 billion of stock or about 14% of the company’s total market cap.
For fiscal year 2013, the company plans to repurchase roughly the same amount as 2012. Combined with a dividend yield of 2.2%, the repurchase program offers a 16%+ return to equity holders. Not bad.
If nothing else, the dividend yield and buyback commitment put a strong bottom on the stock. Or as I see things, they add significant upside to what is already a very undervalued stock.
VIAB gets my Very Attractive rating because of its rising profitability and cheap valuation. The risk/reward of this stock is also compelling because of its 2.2% dividend and management’s buyback program.
My regular readers know that I also cover 400+ ETFs and 7000+ mutual funds, and I like to point out the ETFs and mutual funds that allocate most to the stocks I recommend to buy or sell.
For VIAB, there is only one mutual fund (and zero ETFs) that allocates significantly to VIAB and gets an Attractive or better rating: Managers AMG Funds: Yacktman Fund (YACKX). This finding is not too surprising given that the Telecom Sector ranks eighth out of ten sectors per my Sector Rankings for ETFs and Mutual Funds report. There are simply not many good Telecom ETFs or mutual funds. You canaccess all of my sector reports here.
Disclosure: I do not currently own VIAB but plan to buy shares within the next 72 hours. I receive no compensation to write about any specific stock or theme.