Media Armageddon & How to Play It: Part I

Written by R. Scott Raynovich - Light Reading

Tuesday, July 8. 2008 at 04:05 PM EDT Post a comment

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The mainstream media stocks have been crushed in the past year, and with a recession starting to bite the consumer wallet, it seems hard to find reason for enthusiasm. Is the slaughter warranted?

On Monday, Lehman Brothers analyst Anthony DiClemente issued a brutal research note downgrading the entire industry, pointing to the potential long-term adverse effects of digital distribution: aka, "people ripping stuff off."

DiClemente's main thesis is that the decline in "packaged media" -- such as DVD sales -- will outpace the growth in digital media sales. "The question is the rate of decline; we believe the decline in packaged media revenues will dramatically outpace growth in digital media revenues in the next two years," writes DiClemente in his report.

Set aside for the moment that DiClemente's own investment bank is under siege -- and that all of Wall Street is melting down. Let's focus on whether media Armageddon is occurring.

DiClemente has one idea that seems about right: Maybe there's reason to doubt the conventional wisdom that somehow, the film and TV business will manage to avoid the fate of the music industry, which was pummeled by iPods and P2P pirates. Factual evidence would indicate that film and TV is doing OK and not getting hit by piracy as hard as music. DiClemente seems to be saying that such optimism is unwarranted.

Indeed, the market might be discounting these stocks in anticipation of some sort of catastrophic event. Many media stocks have experienced astonishing declines. And even in cases in which the companies appear to have made "intelligent" decisions -- such as News Corp. (NYSE: NWS) buying MySpace just as the social networking space was taking off -- the smart deals haven't done much to help these share prices.

Let's just look at some of the numbers. Here is the performance (or lack there of) of some of the major entertainment media stocks over the past 52 weeks:

• CBS Corp. (NYSE: CBS): down 48 percent.
• News Corp.: down 36 percent.
• Viacom Inc. (NYSE: VIA): down 32 percent.
• Time Warner Inc. (NYSE: TWX): down 31 percent.
• Walt Disney Co. (NYSE: DIS): down 13 percent.
• Yahoo Inc. (Nasdaq: YHOO): down 12 percent.

After I tallied some of these results, I was surprised by a couple of things. First of all, the sheer size of the declines for relatively large, mature media companies such as CBS and News Corp. Granted, when compared, to say, Bear Stearns, which had 98 percent of its equity vaporized over a weekend, these losses may seem minor. But if you had money in these companies, the losses are certainly not trivial. [Disclosure: At the beginning of this year, I disclosed that I owned some CBS stock. I sold it a while back. Whew!]

Another surprise, for me, was to discover that Disney and Yahoo are down the least. I did not expect those two to be the best "performers" if you could call it that.

The CBS decline looks especially egregious in light of the fact that CEO Les Moonves was recently declared the second-highest-paid CEO in 2007 by the Associated Press. I find this shocking. For the shareholder benefit of having the share price pummeled by 36 percent, Mr. Moonves was paid a modest performance fee of $67.6 million. In other words, while CBS was vaporizing billions in shareholder equity, Mr. Mooves was feeding at the trough. Stunning.

Is there a bottom to any of these stocks soon? Should you consider buying them? Well, you might give it a go if your idea of weekend fun is juggling chainsaws. In other words: Wait a while, and see how the markets shape up.

I ran a couple of screens to see whether you could view any of these stocks as values, and here's what I found: Several of these stocks are starting to get very cheap in terms of the free cash flow, and you could start to consider looking at them, if the market begins to stabilize. The only two stocks that I would consider would be CBS and Disney, though the "Moonves Effect" is certainly disconcerting.

Here are the price/free cash flow ratio for the stocks in this group:

• CBS Corp. : 6
• News Corp.: 24
• Viacom: N/A
• Time Warner: 9.5
• Disney: 13
• Yahoo: 22
  Source: Smartmoney.com, Morningstar

The big problem, of course, is that a prolonged recession could bring down the earnings of these companies in the future. Part of Lehman's thesis is that they will suffer in "packaged media," as the Internet siphons off more entertainment revenue.

The interesting thing is that, at least according to Wall Street, the earnings power of these companies hasn't been that badly damaged, recession or not. The 2009 earnings estimates for CBS, for example have gone up over the last 12 months. Another example: Disney's earnings per share (EPS) have gone up in the last three quarters -- although, believe it or not, much of that has been due to the performance of its theme park business. The company earned $1.1 billion in the March quarter. Problem? What problem?

Can these earnings come down? Of course. But that's why the stocks have already been crushed, on a fear of a prolonged consumer recession. The bad news is being baked in -- or in some cases -- seared in.

The bottom line? I believe the fear of "Media Armageddon" is largely overdone for many of these companies and that some of these media stocks are setting up for great buying opportunities in the next several months. Even though they will be pressured by the move to digital, some of them, including Disney and News Corp, are positioned quite well for the move. At any rate, earnings disasters are being priced in pretty well by the general market decline, so it may soon be feasible to profit from the despair.

Would I buy any of them now? Gun to my head, I would take Disney, which appears to be the in the best shape of them all.

I'll continue the look at "Media Armageddon" tomorrow, discussing some of the larger trends and the impact of the Internet.