I think it was Benjamin Graham that said you should be extra careful when seemingly obvious value stocks present themselves during strong bull markets. Media company Viacom (NASDAQ:VIAB) is one such candidate. In fact it’s absolutely screaming value on my stock screener at the moment, and if you drag up the fundamentals you’ll see what I mean. The stock is currently trading at 7.8x last year’s earnings, sports a 4.15% current dividend yield and trades at a fraction above its annual revenue. By all accounts the numbers point to this being extremely cheap right now.
When you come across these types of stocks there’s usually three things that can explain why they’re on seemingly deep discount. The first is that the quality of their earnings might not be that high. In other words there’s a good chance that the long-term outlook is unpredictable and so the discount is entirely justified. The second is that it’s a classic peak earnings trap. In energy stocks and miners this will happen at the top of a commodities cycle when conventional valuation metrics look cheap only because of blowout earnings due to high commodity prices. The third is that some kind of external shock has hit the company and its stock.
With Viacom you get the feeling that there’s a little bit of all three going on here. The quality of their earnings is generally great as they’ve got some very attractive brands in their stable. Brands that include names like Comedy Central, MTV, Nickelodeon and Paramount Pictures.
Check out the library over at Paramount – it’s packed full of big name movies. I’m also pretty sure I spent countless hours as a kid watching Nickelodeon shows like Hey Arnold!, Are You Afraid Of The Dark? and Kenan & Kel. Under the traditional media business model that represents very lucrative real estate for advertisers and affiliate fees (the fee that cable providers pay for broadcast rights).
The problem is that there’s a feeling that the company have let these brands slip. Top talent like Jon Stewart and Stephen Colbert left Comedy Central, and fewer kids are watching MTV and Nickelodeon in the digital era. If media content becomes less valuable then ad revenue and subscribers will follow.
Rather than address those issues they have loaded the balance sheet up with debt to go on a stock buyback bonanza. Back in 2011 there were 595m shares outstanding and the company earned total net income of $2.14bn. That comes out to earnings-per-share of $3.61. In total the buybacks have reduced the count by a third between then and now. The thing is though that despite reducing the share count to below 400m this year’s earnings-per-share will come in around the $4.00 mark. In other words actual income is on a stagnant/downward trend whilst earnings-per-share have seen a modest boost via a lower share count.
In the background you’ve got a climate of fear around cord cutting. Online streaming services like Netflix are slowly eating the lunch of the traditional network companies. More eyeballs using Netflix and abandoning television means less eyeballs on traditional subscription based TV services and less eyeballs for advertising. So far the buyback splurge plus the fact they could raise the rates that advertisers pay to get a slot has meant that earnings-per-share have been kept intact. With the current leverage they have on the balance sheet that’s not going to occur to same extent going forward.
In addition you’ve had what can only be described as a mess at the boardroom level. Viacom’s majority shareholder, 93 year old Sumner Redstone, was engaged in a lengthy power struggle with CEO Phillipe Dauman involving various lawsuits going in both directions. That’s only added to the total vacuum that is Viacom’s corporate strategy. Even beforehand the company was too slow in responding to the digital era and spent too much on buybacks rather than original media content. All of it has contributed to the fact that the stock has underperformed its major peers.
So to sum up the downside points you’ve got: formerly stellar brands that have slipped in terms of quality; a threat to lucrative traditional business model of media companies relying on TV ad revenue and affiliate fees; and a power struggle at the top that did nothing to help address the points above.
Despite all that I actually think Viacom is a decent value play. If those earnings estimates play out as expected you’re looking at a 2017 P/E ratio of 8.7. This year you’d collect a current dividend of $1.53 and let’s just say the same again over the next four years. On a current stock price of $37 that’s means getting 20% of your investment back within five years. The pay-out ratio in that scenario is below 40% of free cash flow so there’s still plenty to pay down debt. That could also be supplemented by offloading underperforming brands.
Now you could debate the cord cutting phenomenon until the cows come home. Whatever happens there though consider these four points. Firstly, it’s likely to be a fairly slow process even if “old” TV does goes the way of the dodo. Secondly, it doesn’t take into account alternative means of monetization. Thirdly, Phillipe Dauman is now gone as CEO so someone fresh will be able to take over the reigns. Finally, there may be scope to unlocking value with potential M&A activity.
At this price Viacom isn’t priced for anything other than decline. For comparison the average P/E ratio in the good times was somewhere around 15-16. Today it’s less than 9x annual earnings. Sorting out the mess at the top of the company now that the CEO has gone, moving to more aggressive ways of dealing with the digital era and building around their core brands will be enough to arrest that. Add in a dividend yield over 4% and you’re in a situation where stagnation is going to represent serious outperformance at these levels.
A couple of years ago when the stock was trading at damn near $90 a share that wasn’t the case. The level of stock buybacks helped push net income per-share to $5.43 in 2014 with the valuation at 16x earnings. That didn’t reflect the deteriorating balance sheet, headwinds facing the underlying business and the boardroom mess. There was minimal protection if things went south. Today’s value of under 9x annual earnings gives you that, with all the potential upside that will come with even modest outperformance.