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The Science of Hitting
The Science of Hitting
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Fox: The Value of Must-Have Content

A look at the company following its first investor day event

Fox Corp. (NASDAQ:FOX)(NASDAQ:FOXA), which was formed in March following The Walt Disney Co.’s (NYSE:DIS) acquisition of the majority of 21st Century Fox, held an investor day event on May 9. What remains at Fox following the Disney deal is the television business (the eponymous broadcast network and 28 television stations) as well as a few cable channels (primarily Fox News, Fox Business and Fox Sports).

In terms of the financials, revenues will be roughly split between affiliate fees (contracted, 3-5 year agreements with multichannel video programming distributors like Comcast (NASDAQ:CMCSA) and virtual MVPDs like AT&T's (NYSE:T) DirecTV Now that set the rate paid per subscriber to carry Fox’s channels) and advertising. On ad revenues, note that roughly 70% of the business is attributable to live news and live sports - the type of content that has been least susceptible to the rise of services like Netflix (NASDAQ:NFLX). For Fox, that means more than 80% of revenues are from affiliate fees or live event advertising. That’s a long way of saying the business aligns with management’s vision for “a consistent focus to differentiate through appointment viewing.”

The company’s strongest brand is Fox News, which has been the leader in cable news for 17 years. Fox News has also been number one among all cable channels for the past three years (only behind the broadcasters). As discussed at the investor day event, management believes the engaged fan base leaves room for future growth: “Our viewers are hungry for more. We are only beginning to monetize this engagement at anything near its true potential.”

Importantly, Fox has secured broad distribution across the emerging platforms, which has helped stem the impact of subscriber losses among traditional pay-TV customers (the economics on a traditional and a digital pay-TV subscription are similar for Fox).

As it relates to future growth, the company will lean heavily on rate increases (higher per subscription affiliate fees). As management noted at the investor day, “We are no longer lending the potency of our marquee brands toward any other initiative or new brand / channel development.”

CEO Lachlan Murdoch expanded on those thoughts at the MoffettNathanson conference:

“What we've done over the last several years in the bigger company is we used our retransmission consent rights to support many of our emerging cable channels. So, whether it's supporting National Geographic or supporting FXX or FXM, some of these smaller cable channels. Now as a focused company we don't have to spread out the leverage that we get from retransmission. We can focus it on revenue.”

With Fox’s simpler structure, the primary focus is driving rates. As Chief Financial Officer John Nallen put it, “No longer lending the potency of our assets to anything else… we’re looking to maximize the assets of Fox, Fox News, Fox Sports, and the stations.” Considering the dominance of Fox News, it seems plausible the company should be able to negotiate large increases in per subscription affiliate fees from the $1.5 to $2 range the channel earns today (by comparison, ESPN brings in roughly $8 per subscription). As management put it at the investor day, “We are confident that there is considerable head room for further rate growth.” At the same time, the cost to operate Fox News should increase at a moderate pace, resulting in margin expansion and outsized profit growth for the banner. (Some of this will be offset at the corporate level by the costs for key sports rights like WWE, especially in the short term.)

We’re already seeing rate increases flow through the income statement. In the first nine months of fiscal 2019, revenues from distributors (includes both cable affiliate along with retransmission consent and reverse retransmission consent revenue) grew by 14%. That speaks volumes for the quality of the assets it has assembled. With two of the five most-watched networks on TV, Fox comes to the table with an enviable hand.

On the balance sheet, Fox raised $6.8 billion in debt, with $6.5 billion transferred to Disney as part of the 21CF deal to cover tax obligations. The debt has a weighted average duration of 14 years and an average cost of less than 5%. Management expects to operate with gross leverage up to roughly 3 times earnings before interest, taxes, depreciation and amortization (currently around 2.6).

Finally, Fox also has some non-core assets (most notably, the Fox lot in Lost Angeles and a stake in Roku (ROKU)). These are rough estimates, but it seems likely those two assets are collectively worth somewhere around $2 billion (compared to a current market cap of roughly $23 billion).

Conclusion

As noted above, Fox’s strong brands give it 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 (and in the case of reverse retransmission, Fox has negotiated some fixed fee deals as opposed to agreements based on per subscription calculations). In addition, Fox should be able to keep its non-sports programming costs under control. The business will generate about $2 billion per year of free cash flow out of the gate (helped by a sizable tax shied), with the opportunity to repurchase a significant number of shares over the next several years if that’s the route the board decides to pursue. If this all plays out as I expect, the company should generate significant growth in per-share free cash flow over the next five years.

Disclosure: 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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