Newsletter Media Sector Review April 2018
Facetime With Congress
There has been a recent uproar over individual privacy related to the collection and misuse of personal data by Facebook (FB: Not Rated) and Google (GOOG: Not Rated).
Data profiles on individuals have gone well beyond the types of those that were amassed in the 1980s and 1990s, which allowed advertisers to “target” ads based on demographic characteristics, like income, age, gender and education. Facebook and Google have rich individual data profiles that include interests, purchases, search, browsing and location history -significantly valuable to advertisers. According to eMarketer, Google and Facebook make up 63 percent of all digital advertising and accounted for 74 percent of the digital advertising growth in 2017. In the fourth quarter 2017, revenues for Facebook and Google were up 47.1% and 22.8%, respectively, compared with revenue declines for most traditional media companies. The question will be whether there will be a groundswell for Congress to act and to protect individual data collection. This would be a significant benefit for traditional mediums. If history can be a guide, however, the United States is lax on privacy laws and consumers seemingly have accepted that their personal data is widely available. As such, we would follow the trends in Europe in terms of regulations on this front.
OUTLOOK TRADITIONAL MEDIA
Gauging the Political Winds?
On the heel of our investor meetings during the annual NAB conference in Las Vegas April 9th & 10th at the Aria Resort, we came away reaching for the bottle of dopamine. While everyone was betting on strong political advertising in 2018, no one was willing to provide any guidance for political. The industry was caught off guard from the 2016 elections in which political advertising vastly underperformed expectations and guidance. Lesson learned.
Investors, however, are looking for some reason to buy the stocks. Certainly, the near-term fundamentals of the industry appear lackluster at best, with large advertising categories such as auto and retail, all pacing down in the first quarter and much lower than originally thought. In addition, there is only slight improvement in the second quarter, which appears to be pacing down as well. As such, the industry appears to be the victim of a maturing economic cycle in a rising interest rate environment. This will not likely get investors to get up from sitting on their hands.
Furthermore, even the prospect of heightened M&A activity fueled by the FCC’s relaxation of ownership rules does not appear to be helping. The long-awaited approval of the Sinclair (SBGI: Not Rated) and Tribune Media (TRCO: Not Rated) merger seems in jeopardy at the DOJ, which, we were told is using antiquated methods such as a market “voice” test. This merger was to open the flood gates for deal activity.
Furthermore, there were some experts at our meetings that anticipate the House may flip to the Democrats in the mid-term elections. While this will not directly affect the Republican majority at the FCC, it will cast a pall over the deregulatory environment and the prospect that Congress will impose ownership restrictions. While it is likely that the quadrennial media review will indicate a deregulatory recommendation for TV and radio ownership, this review which is expected in the Spring 2019, may be greeted with resistance from Congress. Consequently, we encourage investors to be selective in the space and focus on companies with strong balance sheets that could make accretive acquisitions, such as E.W. Scripps (SSP: Rated Buy), and Gray Television (GTN: Rated Buy).
Wishing on a Star
Broadcast radio executives that participated in our investor meetings during the NAB appeared optimistic about the industry in anticipation of the two leading broadcasters, iHeart Media and Cumulus Media, coming out of reorganization at some point. In their view, these companies depressed the industry by overreaching for revenues by increasing spot loads and taking advertising at any cost in order to service heavy debt loads. As these companies emerge with improved balance sheets, the theory is that these companies will become better actors in the local market, which should support higher prices for radio. One radio exec bemoaned that radio CPMs in some markets are below that of a local newspaper, which suffers from declining circulation. Although this paints a hopeful sign, the current advertising environment appears lackluster, albeit seemingly better than television.
On the competitive front, the industry plans to develop more data analytics to more effectively compete with digital media companies. This is a process which likely will take time, and, as such, investors should not factor revenues from this opportunity until 2019. In addition, industry executives painted an optimistic picture of the prospect of further radio deregulation, which would potentially allow additional in-market consolidation. This optimism seemed baseless, at least in the very near term, given that our meetings with FCC Commissioners indicated that there was nothing before the FCC that would deal with Radio ownership rules. It is possible that the Quadrennial Media report may include the prospect of relaxed local radio ownership limits, but that report is not likely until the Spring 2019.
In looking at the past quarter, radio stocks underperformed the general market, down 9.2% versus the general market decline of 1.2%, as measured by the S&P 500 Index. We are constructive on radio stocks given that it is likely that deal activity will remain heightened as the consolidation wave is expected to continue.
Looking for Green Fields
If you haven’t noticed, there is a lot going on in the industry. No, it is not related to fundamentals. The fourth quarter was largely in line with our thoughts, despite retail advertising being lower than expectations. Notably, fourth quarter revenue performance was buoyed by earlier acquisitions. Of our followed companies, fourth quarter revenues were up 2.7% on average and cash flow was up 1%. The cash flow performance will be hard to replicate in 2018, given a likely significant rise in newsprint prices and given that cost cuts will become increasingly difficult to find.
So, what are managements doing about this? Most companies in the industry have refinanced debt, sold assets or plan a secondary offering to reposition balance sheets. For instance, tronc (TRNC: Rated Buy) sold its Southern California newspaper group, which included the LA Times, for $500 million and the assumption of $90 million in pension liabilities. Gannett (GCI: Rated Buy) refinanced $200 million of debt with convertible notes, to free up its revolver for acquisitions. And, New Media Investment Group (NEWM: Not Rated) raised $99 million from a follow-on offering. We believe that managements are under pressure given the weak fundamental outlook to more aggressively seek growth. As such, we believe that the industry will accelerate its transformation toward digital and growth-oriented businesses through acquisitions in the coming months and quarters.
Importantly, investors are still warm to the sector. Publishing stocks were up 2.9% in the first quarter, better than the general market (down 1.2%) and other media sectors we track, which underperformed the market. We liken the current industry environment to a farmer that has largely tapped out its harvest yield from its current land and is now looking to buy green fields to enhance growth. We remain constructive on the publishing industry, which appears to be trading at low valuation levels. Furthermore, in our view, the market tends not to differentiate between organic growth and acquisition fueled growth, especially if that growth is accretive to cash flow. As such, we believe that acquisitions could enhance the growth profile of the industry and help to expand multiples.
Internet and Digital Media Commentary
As noted earlier, data privacy has become a bigger issue. This is something all companies in the digital advertising ecosystem are dealing with, particularly if they operate in the EU, where on May 25, 2018, the EU’s General Data Protection Regulation (GDPR) goes into effect. GDPR was adopted by the EU in 2016 as a means of giving EU citizens more control over their personal data and make companies that collect, process and store personal data far more liable for data breaches.
Under previous EU rules, personal data was defined as name, picture, e-mail address, phone number, physical address, or personal ID numbers. GDPR broadens the definition of personal data to include any information that could be used to identify a person, including location data or mobile device IDs. EU citizens have always had the right to ask a company to delete their data and GDPR expands that right to the right to be forgotten, which requires that data controllers take reasonable steps to ensure that data is also deleted by the third parties it is shared with.
Companies in the EU will be able to process data lawfully if they have 1) consent and 2) a legitimate interest. Ad tech vendors often don’t have direct relationships with consumers, so obtaining consent will require relying on publishers and marketers to get consent on their behalf. The new IAB Europe consent standards were created primarily by ad tech companies such as MediaMath, AppNexus, Oath, Conversant, Quantcast and others. Now ad tech companies need for publishers to understand that data-based advertising buys drive higher ad rates, and that publishers will earn more if their digital advertising vendors can target audiences with consent.
Increased regulatory costs will act as a burden on ad tech and martech companies that operate in the EU. Significant engineering costs are already being incurred to set up standards to meet the May 25th deadline, but these increased costs will remain as a cost of doing business in the EU. Some vendors with marginally profitable businesses in the EU may determine it is better to exit the market than carry on. It will be interesting to see if in the second half of 2018, some vendors choose to forego their European business opportunities and focus on (presumably more profitable) markets where the regulatory oversight is less burdensome.
The EU’s attempt at leveling the playing field may only result in the big (Google and Facebook) getting bigger. On April 6th, YouTube announced that it will no longer support third party ad serving in Europe beginning May 21st. As a consequence, advertisers will have to use Google’s DoubleClick Campaign Manager to host video on YouTube. This follows on the heels of Facebook’s announcement on March 28th that it will stop using third party data providers like Axciom and Experian. Facebook is focused on cleaning up its handling of data and weeding out potential vulnerabilities. However, the recent announcement would not have changed the outcome of the Cambridge Analytica scandal. Skeptics see Google and Facebook using GDPR as a cover for requiring advertisers to use their own ad tech, which is probably not an outcome that regulators had intended.
1Q 2018 Stock Price Performance of Internet and Digital Media Sectors
1Q 2018 started off strong for stocks in the internet and digital media sectors. As recently as mid-March, each of the four internet and digital media sectors we monitor were significantly outperforming the market. However, by quarter end, the S&P 500 finished down 1%, while the marketing tech, digital media, ad tech, and social media sectors posted stock price returns of +18%, -1%, -7% and -7%, respectively.
Several stocks contributed to the strength of marketing tech sector, including Adobe (ADBE; +23%), Hubspot (HUBS; +23%) and SendGrid (SEND; +17%). Investors clearly seem to like the SaaS-based recurring revenue stream business model deployed by the MarTech companies. The sector is currently trading at an average revenue multiple of 5.5x 2018E revenues, with Adobe (11.5x), HubSpot (8.1x) and SendGrid (7.0x) trading at even higher multiples. EBITDA has yet to become the prevailing financial metric for valuation as only 6 of the 10 MarTech companies are projected to be EBITDA positive in 2018.
The next best performing sector was the digital media stocks, which finished down 1%, in-line with the broader market. Key contributors to growth were InterActive Corp (IAC; +28%) and Pandora (+4%). For the first time in several quarters, Google did not contribute to the digital media sector’s outperformance. Shares of Google decreased 1.5% for the quarter. Only 2 of the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) posted positive returns in 1Q 2018: Netflix (+54%) and Amazon (+24%).
Advertising technology stocks finished 1Q 2018 down 7% and it would have been worse if not for The Trade Desk (TTD; +9%) which also accounts for approximately 45% of the market cap of the entire sector. Every other ad tech stock declined in 1Q 2018. The next best performer in the ad tech space was Criteo, whose shares decreased 1% in the quarter. Five of the dozen ad tech stock we follow currently trade below $2 per share, which likely accounts for the volatile quarter. The sector’s revenue growth was also volatile, with companies such as Telaria and The Trade Desk posting 45% and 42% revenue growth, respectively, while The Rubicon Project posted a 57% revenue decline.
Social media stocks also finished 1Q 2018 down 7%. As always, Facebook shares were the driver of the sector’s performance. Facebook’s performance (FB; -9%), more than offset the strong quarters posted by Match.com (MTCH; +42%), Twitter (TWTR; +21%) and Snap Inc. (SNAP; +9%). Facebook’s shares tumbled following Cambridge Analytica scandal, in which up to 87 million users had their data accessed and used to try to influence elections. Facebook’s margins may be at risk as they face increasing costs associated with possible increased data regulation.