PORTFOLIO POINT: Ten may benefit from improved market conditions, but the TV network owner needs to make up a lot of lost equity ground for its shareholders.
If you read the financial press regularly (and there are good reasons not to), one topic that may have caught your attention is the difficulties faced by our main free-to-air commercial television networks.
Channel Nine, struggling under the weight of a private equity capital structure, has led the charge, but Seven and Ten have followed not far behind. The news for all three has focused on earnings disappointments, equity raisings, asset sales, and various other “restructuring” initiatives – none of them good for equity holders.
A lot of the difficulties have been sheeted back to a weak advertising market, which suggests that patient shareholders need only wait for conditions to improve and normal service to be resumed. “We apologise for this interruption.” While I agree that advertising conditions are weak, I think the issues for shareholders are more systemic than this.
Structurally, we liken the free-to-air TV market as three brusque men locked in a room with no windows playing a perpetual game of cards. Inevitably the chips will accumulate with one player until another gets a good run of hands (TV programs), at which time the chips will start to accumulate in that player’s pockets. Because the game never ends, no-one can ever take their chips off the table and walk away.
Operating one of three free-to-air TV networks, in a country with a population of just 22 million people, means that growth is constrained and any growth that does transpire is usually at the expense of one of the competitors. Revenue is related to viewers, which in turn is related to content, and because that content will inevitably ebb and flow in terms of its resonance with viewers, there are no permanent competitive advantages.
The result of this structure is reflected in the economics of the companies that participate, as I will illustrate in a moment.
When we consider investing in any company, the first question is always directed at the quality of the underlying business. Fig 1. below, shows my quality and performance scores for Ten Network over an extended period. On average, the business has scored “C4” on a scale that ranges from A1 down to C5. We need to be comfortable that a business sits in the high end of this scale before we begin to consider valuation.
Fig. 1 – Quality and Performance Scores
I focus on these measures because I am convinced that, over the long term, high-quality businesses are more likely to provide a rewarding experience for investors. Starting with an objective measure of business quality allows me to steer clear of companies that don’t earn high returns on equity, don’t generate strong free cash flows and don’t have robust capital structures. If John West was an equity investor he would probably feel the same way.
Returning to Ten, the company’s long-term share price performance (Fig 2) might surprise some readers. The peak was in late 2004 – almost eight years ago – and the current level is lower than at any other time in the past 15 years. As I write, Ten’s share price is more than 80% below its 2004 peak and the company has a market capitalisation of just $720 million, down from around $2.5 billion. Additionally, a significant part of that current market capitalisation is owed to a recent $200 million equity raising.
And speaking of capital raisings, the total market capitalisation of Ten today is just half of the $1.55 billion of new equity that the company has raised from its owner-shareholders in the decade since 2003. Would you invest in a scheme that offered to halve your money over 10 years? These are the economics that are the result of the structural influences I described earlier.
The economics are no different for the other two players, so even though Nine is owned by private equity and Seven is mixed up with other assets, such as print and publishing, the economics of their TV businesses are likely to be very similar over long periods of time.
Fig. 2 - Share Price and Estimated Intrinsic value
There may be better times ahead for Ten shareholders: the share price has rallied several times over the years, and improved market conditions in the near term may provoke another rally. However, from a quality and valuation perspective, the longer-term view is not encouraging. Ten needs to improve significantly on its track record if shareholders are to be appropriately rewarded for the capital invested in the business.
A further consideration is the potential impact of technological change. While the outcomes are difficult to predict, increasing internet bandwidth combined with new models for content delivery can only mean a tougher competitive environment for free to air television. In this context, the challenge of significant performance improvement looks daunting.
For me, the key point is this: It doesn’t matter how large or well-known a business is, nor does the profile of its management and major shareholders matter. In the long run, investment returns answer to financial performance, and a dispassionate assessment of underlying business economics is a good first step in understanding future financial performance.
And if I can complete this week’s column with a warning to SMSF operators: There are many other blue-chip companies that don’t look very ‘blue chip’ at all when viewed in this way.
Roger Montgomery is the founder of Montgomery Investment Management and author of Value.able – How to Value the Best Stocks and Buy Them for Less Than They’re Worth, available exclusively at www.rogermontgomery.com