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Magic Formula Stock of the Week: CBS
Posted by: Paul Andrews (IP Logged)
Date: November 14, 2011 12:09PM
CBS (CBS) is one of the largest and most well known corporations in America. Along with ABC and NBC, they formed the core of the “Big 3” networks that dominated the TV scene for decades and enjoyed some of the widest and deepest moats in business. In fact, their moat was so wide that Warren Buffett would eventually invest in rival ABC. Today, however, their moat is shrinking. First, cable came along and gave viewers more options than just the big three networks, which reduced the Big 3’s share of eyeballs. Now, Internet television is changing viewer habits and drastically affecting how networks can monetize their products, and new innovations like YouTube, video games and social networking are competing for viewers’ entertainment time.
Despite those concerns, this is still a great business with fantastic returns on capital. The company generates massive free cash flows, which they’ve used to retire 25% of their shares over the past seven years, in addition to paying some hefty dividend. And CBS still owns a very diverse and attractive set of businesses that are perfectly positioned to enjoy a big upswing in profits as advertising rates continue to recover as the economy gains steam. In fact, famed investor David Einhorn saw enough catalysts on the horizon and attractive properties at a cheap enough price to pick up a big position in the stock during the third quarter.
In other words, CBS has many of the properties that we’re looking for when putting together GuruFocus’ own Micro-Cap Magic Formula newsletter. It’s a great magic formula stock.
So what makes CBS such a great business?
Basically, it benefits from incredible scale that would be difficult, if not impossible for a newcomer to reproduce. Think about it— over the past 50 years, the “Big 3” has become the “Big 4.” In other words, in 50 years only one other network has succeeded in truly entering CBS’s business. That type of difficulty in entry is among the clearest signs of a competitive moat.
Then start thinking about how CBS monetizes its business. This is a very simplified description, but CBS basically makes money from advertisers, who pay them to reach consumers. The more consumers CBS reaches, the more advertisers are willing to pay to run ads on CBS’s network. The marginal cost for CBS to reach a viewer is basically zero; it costs CBS the same to run programming whether they’re reaching one million people or ten million. So as CBS adds viewers from increases in television viewing time (which has been going up for decades and shows no sign of slowing down) or population growth, their revenue grows while expenses stay flat, resulting in huge bottom-line growth.
The same logic applies for advertising rates: It costs CBS the same to run their programming whether they are getting paid $1 per 30-second ad or $10,000,000. So as advertising rates go up, either from inflation or general economic growth causing greater demand for advertising, revenue grows and falls straight through to the bottom line. This fact is especially important: It makes CBS very economically sensitive. When rates go down during a recession, CBS’s profits suffer. But as the economy eventually picks up strength and grows, profits and cash flow grow very quickly.
Because the business is so economically sensitive, it probably doesn’t make sense to look at CBS on a trailing 12-month basis. To sort of smooth out the economic ups and downs, let’s instead look at their average cash flows.
Over the past five years, CBS has averaged just over $2.4 billion in EBIT per year. In normal times, for a business with this large of a moat, investors would be willing to pay at least 10x EBIT for the company. After backing out their debt and some investments, that would imply a stock price of over $31 per share, or almost 20% upside from today’s price. Given how poor the economic environment has been over the past five years and a bit of a conservative multiple, that valuation will likely prove too conservative in the near future.
Still, it’s instructive of just how undervalued CBS looks at today’s prices. No wonder Einhorn is buying at these levels.