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The Science of Hitting
The Science of Hitting
Articles (488) 

An Update on 21st Century Fox

A look at the company's 2nd quarter results

February 09, 2018 | About:

21st Century Fox (FOX)(FOXA) reported earnings after the close on Wednesday.

I thought the results were mixed, and downright ugly in the Television and Studio Entertainment segments (to be fair, these segments are prone to wide swings in any ninety day period, largely due to the timing of outsized revenues or expenses). The focus of this article will be on the Cable Network Programming segment, which accounts for the vast majority of the company’s value.

Cable Network Programming reported a low double-digit increase in revenues. The most encouraging number within the segment result was 12% growth in Domestic affiliate fees -- the highest print that the company has put up in at least two years (with that period of time helped by the launch of FS1 and the consolidation of the YES Network). For context, here’s what domestic affiliate fee revenue growth has looked like over the past six quarters: +8% in Q1 FY17, +7% in Q2 FY17, +8% in Q3 FY17, +10% in Q4 FY17, +11% in Q1 FY18, and now +12% in Q2 FY18.

Management has delivered on their promises for an acceleration in domestic affiliate fee growth rates by negotiating higher subscriber rates across their slate of channels. In addition, Fox is benefiting from growth outside of the traditional pay TV cable bundle: Management noted on the call that they are approaching 4 million virtual MVPD subscribers, which offset traditional sub losses and enabled the company to maintain its domestic subscriber levels in the quarter.

But the growth in domestic affiliate fees has come at a cost: Large investments in content (most notably sports rights) drove a mid-teens increase in expenses. In addition, domestic advertising revenues were a headwind on the top line (-3%) due to lower general entertainment TV ratings. As a result, domestic profits in Cable Network Programming were only up 1% in the quarter. While management deserves credit for delivering on the top line, there’s a legitimate question as it relates to where we stand on content investments (my assumption is they will keep pressing).

We saw a similar outcome (albeit to less of an extreme) outside the U.S.: International affiliate fees and advertising increased 13% and 14%, respectively. However, due to outsized growth in expenses (primarily higher sports programming costs at STAR), International profits in the Cable Network Programming business increased high-single digits.

Speaking of virtual MVPD’s, management noted on the call that Hulu, which recently exceeded 17 million subscribers, has added more U.S. subs than Netflix in each of the past two quarters (Fox owns 30% of Hulu). This implies at least 2.8 million net subscribers added in the past six months, good for an annualized growth rate of roughly 40%. Looking back a bit further, Hulu has nearly doubled its subscriber based in the past two and a half years. Over that period, it's added roughly 8 million net subscriptions, compared to roughly 12 million for Netflix. While there’s still work to do, it sounds like Hulu is gaining some traction (that growth is coming at a cost: Hulu’s losses attributable to Fox have increased by 72% through the first six months of the fiscal year).

Management didn't have anything new to say on the pending Fox-Walt Disney (DIS) deal. The only item of note is that the estimated close is still 12 to 18 months from the deal date.

Finally, there were some interesting comments on taxes. CFO John Nallen noted on the call that “New Fox” is likely to have an effective tax rate close to the statutory rate (after accounting for state and local taxes, an all-in effective tax in the mid-twenties). In addition, he said that “New Fox” is likely to have cash taxes “substantially below that” due to the tax shield the company will have for 15 years from writing up the value of the retained assets and recording a larger depreciation expense (“around $1.5 billion of each year’s taxable income will be sheltered”).

Then there’s the dividend to be paid from “New Fox” to 21st Century Fox just prior to the deal close. The initial estimate of the tax liabilities was roughly $8.5 billion. Based on changes in the tax code, the new estimate of the tax liability (per Nallen) is roughly $6 billion. The first $2 billion of the adjustment lower will be removed from the dividend payment (said differently, “New Fox” will make a smaller payment and have less outstanding debt than anticipated).

After the first $2 billion, the difference between the minimum debt level at “New Fox” ($6.5 billion) and the estimated tax liability ($6 billion) will be compensated for by an adjustment to the exchange ratio. As noted in the press release for the deal, “Such adjustment could increase or decrease the exchange ratio, depending upon whether the final estimate is lower or higher, respectively, than the initial estimate.” If I understanding this correctly, that will result in an adjustment higher in the exchange ratio. Getting the mechanics exactly right isn’t what matters. The point is that Fox shareholders will be $2.5 billion better off as a result of this development.

Conclusion

As I noted in a recent article, Fox is my preferred route to a stake in Disney. I opened my position in Fox in late 2016 and haven’t done anything since. That changed on Thursday afternoon when I bought some more shares of Fox. If this recent market volatility becomes more than just shaky knees, there’s a good chance I’ll be buying more in the near future.

Disclosure: Long FOXA and FOX.

About the author:

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

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