Taking stock of News Corp

If there was a relationship between analytical effort and results, then our News Corporation recommendation would have been a shining success. Since our initial Buy recommendation almost six years ago, analysing the company has consumed hundreds of hours of analytical time.

It's a complicated company. News Corp consists of at least seven separate businesses; far more if you count the nooks and crannies into which the company has extended its tentacles. There are newspaper businesses in three countries, an Australian subscription television business, a book publisher, and online real estate listings businesses in Australia and the USA.

Getting to grips with each and every business has been a task, I tell ya.

Here we are - six years later - at almost the same share price. While the recommendation hasn't been a disaster, it clearly hasn't been a success. There's an opportunity cost in holding a stock that goes nowhere for so long, particularly given the miserly dividends.

Last October we covered the reasons for the stock's also-ran status in News Corp: the ultimate barbecue stopper?. In summary, the phenomenal growth of the digital real estate businesses has been offset by the decline of the structurally challenged media businesses. As we explained then, that decline - in valuation terms at least - has largely run its course.

We concluded that News Corp remained below our valuation, and that it should remain a Buy. We're no longer comfortable with the second part of that. To earn its place on our Buy list a stock should be a 'best idea', and we now believe a greater margin of safety is warranted. So what's changed?

Even more negative

The first issue is Foxtel, which sits in the 'Subscription Video Services' segment. We've valued this segment, net of debt, at a negative $200m. It's been clear for a while that Foxtel is structurally challenged, with programming costs soaring at the same time as inexpensive new streaming services are set to place greater pressure on average revenue per user (ARPU).

Foxtel has been busy launching its own streaming services like sports service Kayo and Foxtel Now. While these services have grown subscribers to more than 700,000, they will surely begin cannibalising the legacy Foxtel product, which still generates ARPU of $79 per month. The launches have been costly, with Foxtel likely to spend almost $500m in the 2019 financial year.

This wouldn't be a problem if News Corp forced Foxtel to stand alone. But there's now concrete evidence that News is prepared to fund Foxtel, despite the latter's increasingly tenuous financial position. Last month it lent Foxtel $300m to cover loan maturities.

So there's an increasing risk that Foxtel becomes a capital vortex into which News Corp shovels money. Foxtel's deals to broadcast the NRL and AFL are also about halfway through now; from 2022 it will need to fund these rights again. While Foxtel's annual revenues of $3.1bn keep falling, its programming costs are rising; this year they will exceed $1.6bn. With profits plummeting, Foxtel barely broke even at the net profit line in the first half of 2019.

It has, of course, always been one of the risks with News Corp that the Murdoch family funds media losses for longer than a purely profit-focused owner might. The same might eventually become true of the Australian and British newspaper assets too, should those businesses become consistently loss-making.

But hasn't the News Corp story been more about the potential growth from the online real estate assets, like REA Group and Move?

More cautious

Yes it has, but here too we are growing slightly more cautious. REA Group remains a wonderful business, but it's hardly obvious value on a 2019 prospective PER of 38. While market sentiment towards the Australian online real estate listings sector has turned quickly following the election and interest rate cuts, a great deal of growth remains baked in at REA's share price of $90. It's hard to see REA producing strong returns for shareholders - including News Corporation - over the next five years.

In the US, Move has been a decent acquisition. But business models appear to be in flux, with a shift in the way leads are referred from main player Zillow and second-ranked Move to real estate agents. Move's recent acquisition of Opcity, which refers pre-qualified leads to agents, is part of this potentially defensive shift. It's hard to know how it will play out but the US real estate listings market appears more dynamic - and therefore less stable - than Australia's.

So while our valuation is unchanged, we must acknowledge that the returns have been less than stellar. It's also more difficult to see how News Corp will generate adequate returns to justify its continued inclusion on our Buy list given the risks. We're therefore going to insist on a greater margin of safety than before.

We're reducing our Buy price from $20 to $15 and our Sell price from $30 to $25 as a result. That implies a downgrade to the recommendation, although we highlight that the stock is still much closer to our new Buy price than the Sell price.

We continue to believe there is long-term upside in News Corporation. In a break-up News Corporation would likely be worth significantly more than the current share price but that is of course unlikely to happen under current management. A merger with the Murdoch family's US-listed Fox Corporation remains another long-term possibility.

But it's hard to conclude News Corp is a 'best idea'. Existing shareholders can sit tight at this price but we don't think they should buy more. HOLD.

Note: Our Model Growth and Model Income portfolios own shares in News Corporation.