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The Science of Hitting
The Science of Hitting
Articles (623) 

Why I Want to Sell Fox

Some thoughts on the media company's prospects and current valuation

February 25, 2020 | About:

Why I’m selling Fox

At the time of writing, I’m an investor in Fox (NASDAQ:FOX) - but I think that is likely to change.

Before explaining why I’m likely to part ways with this investment, let me provide a bit of background. I first invested in 21st Century Fox in 2016. In late 2017, CNBC reported that The Walt Disney Company (NYSE:DIS) was interested in acquiring a majority of the company's assets. Over the next year, Fox shareholders became the beneficiaries of a back and forth bidding war between Comcast (NASDAQ:CMCSA) and Disney. When Disney ultimately emerged as the winner (the deal closed in March 2019), Fox shareholders were left with a stub position in New Fox.

The primary assets of the new company were Fox News and the Fox broadcast network. My belief, as I wrote in an article in May 2019, was that these strong brands would ultimately give Fox the ability to more than offset the slow decline in pay-TV subscribers with outsized growth in affiliate fees, retransmission consent and reverse retransmission consent revenues. In addition, their reliance on live news and sports protected them from the ratings pressure being felt by the entertainment-focused networks, which offered some protection for ad revenues as well.

So, what has changed in the past year? There are three primary issues that I believe could be a problem for Fox shareholders.

The first is the accelerating declines in the pay-TV universe. The pace of cord cutting has ramped up in recent quarters, with large cable and satellite companies losing more than 5 million traditional pay-TV customers in 2019, according to the Wall Street Journal. As shown below, the largest distributors have seen significant traditional pay-TV customer losses in recent quarters.

While these declines have been partially offset by growth among virtual MVPD’s like YouTube TV, ATT TV Now (formerly DirecTV NOW) and Hulu + Live TV, the overall pay-TV universe is now reporting year-over-year subscriber declines of roughly 4%, inclusive of virtual subscribers, compared to 1% - 2% year-over-year sub declines back in 2017 and 2018.

Fox will still generate revenue growth in the face of subscriber declines through outsized rate increases, but the net growth rate has been – and will continue to be - impacted by cord cutting. Personally, I’m not confident that this pressure will lessen anytime soon – and as major content creators like Disney, NBCUniversal and AT&T's Time Warner (NYSE:T) launch over the top offerings supported by their most highly sought after entertainment programming, it may worsen further.

Second, I have some lingering concerns about the company’s sports programming rights. The idea that Fox (and its peers) need to digest higher sports costs with each renewal is nothing new. What has changed, in my opinion, is the state of the industry – most notably, the combined risk from cord cutting and the potential for new competitors (bidders). That includes the tech giants, as well as media companies that may be looking for additional marquee sports rights across their networks (for example, it sounds like Disney has an interest in expanding its NFL coverage to strengthen ABC). Between those two factors, I have concerns about the long-term relationship between revenue and expense growth for channels like Fox broadcast that rely on sports programming rights (in my opinion, this is where a channel like Fox News really stands out).

Consider the following from a recent CNBC article on the topic of NFL TV rights:

“Rates on Sunday afternoon games may double, jumping from $1 billion annually to $2 billion annually. ESPN pays $2 billion annually for Monday Night Football and may need to pay $3 billion to keep the package, two of the people said. Renewals will likely be seven or eight-year deals, the people said.”

Depending on how that shakes out, you’re looking at a mid-to-high single digit annualized increase in the cost of NFL TV rights. If recent trends hold, that suggests that the companies paying for those rights will effectively need to negotiate 10% or higher annual rate increases on a per sub basis to cover the incremental cost. To the extent they are able to do this (by passing higher rates to end customers), it could put incremental pressure on the pay-TV universe.

In short, I think rising sports rights programming costs could become an issue for a company like Fox, and my sense is that most of the major media companies would choose to bear the risk of overpaying in the next round of NFL rights negotiations than the alternative.

Finally, I have some doubts about the capital allocation decisions from the management team at Fox. On the most recent conference call, CEO Lachlan Murdoch said, “We have begun allocating capital to expand our revenue base.”

That seemingly innocuous comment bothered me. I assume Lachlan was referring to some of the company’s recent investments such as Credible and The Stars Group. In addition, the Wall Street Journal recently reported that Fox is considering a deal for advertiser-supported streaming service Tubi, which would likely come with a price tag north of $500 million.

My problem is that I don’t see how these investments are related to Fox’s core business. Instead of focusing on share repurchases as a primary use of excess cash, which would increase our ownership of assets like Fox News, it appears that Lachlan plans on using much of the cash being generated by the business to fund investments in new areas. While it’s still too early to suggest that the strategy will be ineffective, I already have my doubts. The attempt to suggest that Credible was an extension of the current business strategy seemed irrational to me as well.

Conclusion

Collectively, these concerns have changed my perspective on Fox. I’ve become concerned about the top-line headwinds associated with accelerating cord cutting, while simultaneously thinking that their ability to contain sports rights costs may come under more pressure than I previously assumed. Finally, I’m unsure that the prodigious free cash flow generated by the business in the next few years will be put to use in the ways that I previously assumed.

But, with all that said, I think the market has more than accounted for these headwinds. I think the equity looks very cheap at the moment. That’s the only reason why this article wasn’t called “Why I Sold Fox.” I think they will generate north of $4 per share in free cash flow in a few years, even assuming a less than ideal level of repurchaes. At $34 per share, I simply think the stock is undervalued.

That said, this is the kind of investment that I would dispose of at the right price. If the stock moves up 25% - 30%, it’s unlikely that I will still be a shareholder.

Conclusion: Long Fox, Disney and Comcast.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

ciba
Ciba - 1 month ago    Report SPAM
Science,

thanks for your thoughts! Although I have no good background on US media companies I can perfectly reenact your reasoning. The arguments make sense to me, feels like a classic example when industry dynamics change to the worse. Got no clue how your media companies have established business in EU, but as a pay tv user here I must say that antitrust regulations did a great disservice for end users and companies alike. Sports rights for example are fragmented to such a degree that customers don't know how and where they can subscribe for next years season. With bidding wars for tv rights, cordcutting on the rise and the permanent pressure to produce better hit shows than competitors I'm left wondering why Klarman ramped up his portfolio with these companies. But he's Seth Klarman (Trades, Portfolio) and I'm just ciba, he'll know what to do :)

Thanks again for sharing!

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