Market Musings - December 4, 2017

We continue our blog series: Market Musings, Volume 1, Edition 11, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Further Thoughts on Viacom.

We previously presented our long thesis on Viacom's B shares (ticker VIAB) via a 20+ page writeup in late October (for reference, see here). We followed this up about a month ago with a blog post comparing Viacom to Netflix (ticker NFLX) (for reference, see here). Since our initial calls on VIAB, the shares have appreciated about 20%:

While it always feels good when people agree with you (or, at least, move incrementally in the direction of your views regarding valuation, etc.), it is a lot more important to be right on a company's fundamentals and intrinsic value, since price and value will inevitably converge over time. Thus, even if one experiences quick unrealized gains on an investment, this should not be confused with "being right"--the investor could simply be the beneficiary of a random market fluctuation that has nothing to do with underlying value. Only over a fairly decent interval (at least three years, in our opinion) can one determine whether any investment was intelligent or not (sorry, bitcoin speculators!).

With those thoughts we turn (yet) again to Viacom and note the following further points for consideration with respect to our previously articulated long thesis:

1. To Hold or Not to Hold, That is the Question - We admit that we have been a bit torn about this investment. On the one hand, clearly cord-cutting is here to stay, which arguably will erode the value of VIAB's cable properties, the company's cash cow. On the other hand, we believe that VIAB should be able to gradually transition its content to the Internet TV realm, so the company is not entirely in the position of, for example, a newspaper publisher 15 years ago (solely reliant on a monopoly over print media in a particular market). However (on the third hand?), we have to admit that there are parallels to the demise of newspapers when we look at cord cutting, the chief of which is that cable franchises historically enjoyed monopolies in their respective geographic markets, which are obviously threatened by skinny bundles delivered over the Internet at vastly lower price points. Notwithstanding the foregoing (fourth hand, anyone?), the cord-cutting phenomenon is no surprise to investors and should have been fully incorporated into VIAB's stock price a long time ago. Yet (fifth hand?) rarely a day goes by when we don't hear further anecdotal evidence that cord-cutting is increasing--so perhaps it actually hasn't been fully priced in(?). However (sixth hand), Viacom has large divisions not affected by cord cutting, principally its fast-growing international television operations and Paramount Pictures; in addition, the decline in the number of cable customers can be partially offset through price increases on remaining customers, not to mention the potential rescinding of the Net Neutrality rules by the FTC (for which, see point #2 below), so perhaps things on the cord cutting front won't so bad for VIAB after all. Which all leads us to the inevitable conclusion: Man, our head hurts!

2. Net Neutrality - As always, the media landscape continues to change. Even since our writeup on VIAB, significant events have further muddied the picture. One obvious change is that the FTC recently announced that it would overturn the Net Neutrality rules (or, as they put it, they are "Restoring Internet Freedom") established in 2015:

The above-linked draft order runs 210 pages, so this is obviously not a simple issue to understand. As predictably happens with respect to complex issues, people have turned Net Neutrality into a political football, with Democrats lining up behind Net Neutrality (and thus opposing the FTC proposed ruling) and Republicans in favor of discarding it (and siding with the FTC).

What is Net Neutrality? Let's consult the Oracle of the Internet, our dear friend Wikipedia (link here):

So basically Net Neutrality prevents ISPs (such as the cable or telco companies) from charging Internet data hogs more or otherwise discriminating against consumers who download lots of online data. On the surface, then, the demise of Net Neutrality would appear to be quite bearish for Netflix, Facebook and Amazon (and other data-streaming companies), and bullish for established Internet infrastructure providers such as the cable companies. In other words, the "free ride" that Netflix has enjoyed on the Internet for the last two decades--subsidized by non-data-hogging cable customers, who pay for the pipes that bring data into the household of the data hogs (since these capex charges inevitably get passed on to the end customer)--could be ending.

So our initial view would be that, on balance, VIAB will likely benefit from the FTC's proposed order (since VIAB's customers will no longer be subsidizing data-hogs), while NFLX would probably be hurt by it (since NFLX's data-hogging subscribers may face additional charges, more accurately reflecting their data usage). Alternatively, one could make the argument that the demise of Net Neutrality might actually help NFLX, by cementing its first mover status in streaming TV (NFLX now has adequate scale to compete with the cable and telco companies, whereas upstart streamers may not). Finally, the rules will likely shift in the future, as administrations change and court rulings come down. Time will tell.

3. SpringOwl Activist Presentation--A Look Back - Early last year hedge fund SpringOwl Asset Management (see SEC filings here) took an activist stake in Viacom, issuing a lengthy presentation entitled "How Many Photo Ops Does It Take To Cut A Stock In Half? Bringing Viacom Back" (see here for full PDF). One slide in the presentation contained a SWOT Analysis (acronym for "Strengths, Weaknesses, Opportunities, and Threats"). We thought it would be interesting to revisit this slide, which is reproduced below:

Under the Strengths column, all five of these items are still at work (including, unfortunately, the low valuation multiples), with the caveat that the long-term effects of cord-cutting are still unknown. Viacom still has major cable networks with high-margin contractual (i.e., locked-in) cash flows for the immediate future and mid-term. Paramount remains a major studio (albeit unprofitable recently), and the company's international assets are thriving. So 5 out of 5 there (although whether the 5th item is "good" depends on whether one is a buyer or seller of VIAB shares).

Under the Weaknesses category, there has been clear progress over the past 2 years on the first two bullet points. First, the controlling shareholder issue is less of a problem, since Sumner Redstone's daughter Shari Redstone appears to be firmly in command now at National Amusements Inc. In addition, new CEO Bob Bakish has been at the helm almost 12 months, replacing ex-CEO (and complete disaster) Philippe Dauman (see December 2016 appointment PR here). And on the last bullet point, the company has managed to de-lever the balance sheet, with long-term debt declining from $12.3B (net debt $11.8B) as of September 30, 2015 to $11.1B (net debt $9.7B) as of September 30, 2017.

With respect to the Opportunities column, we have seen clear progress on all of the first five bullet points (new CEO, refreshed board of directors, significant international growth [e.g., acquisition of Telefe in Argentina], new carriage deals with Altice and Charter, and announcements regarding OTT services like Philo). While there has not been any AMC merger (6th bullet point), we discuss this category of opportunity in point 4 below. On the 7th bullet point, Paramount announced that it had lined up slate financing for 25% of its costs for the next 3 years with a consortium including Hasbro Inc., Skydance Media and SEGA (see full PR here). Lastly, we note that MTV recently relaunched TRL (Total Request Live) and that Trevor Noah at Comedy Central's Daily Show has seen increased ratings this year (for example, see here).

Finally, under the Threats Category, we note that Viacom renewed its Dish contract in April 2016 (see here) and ratings have improved over the past 12 months (see here). The other threats, though, remain.

4. Consolidation / M&A - Consolidation in the media sector appears to be picking up, with AT&T's attempted buyout of Time Warner (which may be blocked by the FTC) and Disney's interest in Fox's media and studio properties. Just today we saw the following news (source here):

As media companies like AT&T and Disney (and perhaps fellow deep pockets Comcast, Verizon, Amazon and Apple) attempt to achieve greater scale and reach with consumers, this could indeed be bullish for smaller content producers such as Viacom, who could become takeout targets (although it should be noted that Viacom is a controlled company).

5. Dividend Yield / Payout Ratio - While we didn't emphasize it much in our prior discussion of Viacom, the company pays out a quite healthy dividend of $0.80/share per year. At the current share price, the yield on the company's B shares (VIAB) is around 2.75%, which is 38 basis points higher than the 10-year Treasury rate of 2.37%. Moreover, the payout ratio is low, just 20%, meaning that the dividend should be safe for the foreseeable future (the dividend was cut in half due to poor capital allocation decisions made by the prior CEO--see here for details). So VIAB holders are compensated at a rate above 10-year Treasuries while they wait for the improving fundamentals of the business to be reflected in the stock price.

DISCLOSURE: Long VIAB, short NFLX.