While we were anticipating a difficult market for media stocks in the fourth quarter and warned investors to be cautious (report entitled Climbing the Wall of Worry" dated 10/9/18), none could have predicted the devastating stock price performance.
The general market as measured by the S&P 500 Index declined by 6% for the year and by 14% in 4Q 2018. While all media sectors were down in the quarter, the notable weak performance was in the radio sector, which fell a whopping 29%. Notably, the Noble Radio Index finished down a stunning 46% for the year.
We believe that the genesis of the poor quarterly media sector performance was concern over the health of the U.S. general economy, especially given weakening Europe and Asian economies and the U.S economy nearing a record 120-month recovery. Not surprising, cyclical media stocks, especially those with some debt leverage, came under intense selling pressure. With debt leverage in the relatively high range of 4.5 to 5.5 times for many radio companies, the radio sector was hard hit. In our view, the decline was exacerbated by year-end tax loss selling and quarter end portfolio positioning. Notably, we believe that the advertising environment is not as weak as the stock prices might suggest. Retail and auto seem to be showing favorable signs into the first quarter 2019. In our view, some of the severely beaten down radio stocks, those with some debt leverage, appear to be oversold.
We would look for a New Year bounce in many media companies, with the bounce likely more pronounced in the Radio sector. TV stocks should benefit from continued elevated M&A activity, despite weak fundamentals in 2019 with the absence of political advertising. In our view, investors likely will look into the future with an eye on the anticipate heavy political advertising in 2020 (which may begin as early as the fourth quarter 2019). We believe that the publishing sector will largely be event driven. Investors likely will pay attention to potential acquisitions, which hopefully position into faster growth businesses. As such, investors should focus on companies with clean balance sheets, capable of making acquisition fueled growth.
OUTLOOK - TRADITIONAL MEDIA
Looking for another round of M&A
In the latest quarter, many of the earlier announced merger deals were closed, including the Gray Television (GTN: Rated Outperform) and Raycom merger on January 2, 2019. In addition, a widely anticipated $7.1 billion merger deal with Nexstar (NXST: Not Rated) and Tribune Media (TRCO : Not Rated) was announced on December 3rd. In our view, deal activity supported the television stocks in the latest quarter. As a result, the Noble TV Index was down roughly in line with the market in the fourth quarter, down 15% versus the general market, down 14%. We believe that there will be another round of deal activity likely to be announced in the first half 2019, which should further heighten interest in TV stocks. Among the higher profile merger announcements to watch include the Fox Sports Network and Cox Television Group. In addition, there will be television stations to be sold from the Nexstar/Tribune Media merger. The station sales should enable a quick regulatory review of the deal.
In our view, heightened M&A activity will buoy TV stocks in 2019. As such, we expect that the TV group likely will be event driven in the near term. There will not be a lot of fundamental support for the stocks, given the expectation of weaker fundamentals in 2019, a function of tough comparisons from a stellar political advertising environment in 2018. Aside from M&A activity, we anticipate that investors will begin to focus on the likely strong political season in 2020, which may begin as early as the fourth quarter 2019. There are indications that a large number of Democrats may run for President in 2020. As a result, candidates likely will spend heavily into the primary season to distinguish themselves. While we continue to focus on our favorites Gray Television, E.W. Scripps and TEGNA, we believe that investors have largely overlooked Entravision. Near current levels, the EVC shares trade a significant discount to the broadcast group and has a compelling dividend yield.
The radio industry had a disastrous 2018, capped with a stunning 29% drop in stock prices in the fourth quarter. For the year, Radio stocks were down a staggering 46%. We believe that the weakness was largely related to concerns over the health of the U.S. economy, fueled by a rising interest rate environment, exacerbated by year-end tax loss selling. High debt levered radio companies seemed to take the brunt of the stock sell-off, particularly those that were levered in the 4.5 to 5.5 debt to cash flow range. Stocks with the most meaningful latest quarter moves were Beasley Broadcasting (BBGI: Not Rated) down 46% for the quarter; Townsquare Media (TSQ: Rated Outperform) down 48%; and Salem Media (SALM: Rated Market Perform) down 39%. The shares of Entercom (ETM: Not Rated) were down 28% in the quarter, but for the year was down 47%, in line with the industry.
With the recent pullback, the radio stocks appear to be trading at recession type valuations at roughly 6.7 times enterprise value to estimated 2019 cash flow. We believe that the current fundamental environment appears more constructive than the stock prices might suggest. Retail and auto advertising categories appear more resilient into the first quarter 2019. Nonetheless, the industry still faces challenges from data driven advertising mediums, even as the industry tries to develop some applications to address its data deficiencies. We are mindful of the prospect of a classic "value trap" even as we become more constructive on some stocks in the industry based on valuation. For the most part, our valuation assumes that free cash flow will be used to pare down debt, which, in turn, should improve equity values. Such a prospect, should allow for a compelling return from near current levels. Consequently, we have recently raised our rating on Cumulus Media from Market Perform to Outperform.
Thawing M&A environment?
The publishing sector narrowly outperformed the general market in the fourth quarter, down 13% versus a 14% decline for the general market as measured by the S&P 500 Index. We believe that the stocks were buoyed by a possible merger with McClatchy (MNI: Rated Market Perform) and Tribune Publishing (TPCO: Rated Outperform). But, without any news, such a merger appears increasingly less likely as time passes.
The publishing stocks held up remarkably well against the backdrop of a largely disappointing third quarter. Most of the publishing companies were adversely affected by tariffs on Canadian newsprint, which pushed newsprint prices to soared over 25% in the quarter. The outlook for newsprint prices is much more favorable in the fourth quarter, as the tariffs were rolled back. As such, we believe that ongoing cost restructuring efforts will become more evident in the fourth quarter.
There is a disparity of debt leverage among the players in the industry, as the chart below illustrates, with Tribune having the cleanest balance sheet following the sale of its California newspaper group. In addition, we believe that the company is among the best positioned to make acquisitions to fuel the transition to faster growth businesses. Given the strong cash flow and clean balance sheet, we continue to believe that the company is a potential takeover candidate.
OUTLOOK – INTERNET AND DIGITAL MEDIA
INTERNET AND DIGITAL MEDIA COMMENTARY
2018 – A Darwinian Year for Digital Publishers
With the exception of the social media sector, digital media and marketing stocks mostly outperformed the broader market in 2018. While the S&P 500 was down 6% for the year, Noble’s ad tech, marketing tech, and digital media indices were up 40%, 29%, and 3%, respectively, while Noble’s social media index was down 25%. The underperformance of the social media sector was driven by Snap (-62%) and Facebook (-26%). While Facebook’s stock came under intense regulatory scrutiny, the company’s business continued to perform well, and its continued success, along with the emerging growth of Amazon’s advertising business appears to be taking some of the oxygen out of the room for other online publishers.
We have often written about the digital media sector and how, despite the growth of Facebook and Google (which account for 60% of online advertising in the U.S.), the rest of the industry continued to grow at a double-digit clip. In fact, this analysis still holds. For example, in November, the IAB came out with their 1H 2018 revenue analysis which showed that digital advertising grew by 23% to $49.5 billion, up from $40.3 billion in 1H 2017. Triangulating between the IAB’s estimated industry revenues and Google’s and Facebook’s U.S. advertising revenues, we calculated the residual revenues that hundreds of other digital publishers generate in revenues, as shown in the chart in the full report.
The data shows that Google and Facebook accounted for $7.4 billion of the incremental $9.3 billion, or roughly 80% of all incremental growth in the sector. This suggests that there are substantial advertising dollars available for the rest of the industry’s participants. We calculate that “all other” digital publishers accounted for an incremental $1.9 billion in ad dollars, and that this group posted healthy 1H 2018 revenue growth of 17%.
INTERNET AND DIGITAL MEDIA COMMENTARY
The Rise Amazon’s Ad Business Begins to Take Share from Other Digital Publishers
However, eMarketer recently forecast that Amazon has leapfrogged Microsoft and Oath (n.k.a. Verizon Digital Media) to become the third largest digital advertising company in the U.S. in 2018. eMarketer estimated that Amazon’s digital advertising business increased to $4.6 billion in 2018 from $1.9 billion in 2017. If we adjust these numbers for seasonality and include Amazon, the chart above becomes the chart below, which shows that the incremental advertising for “all others” grew by $0.6 billion (not $1.9 billion) and that ad revenues grew at a much smaller rate (6% instead of the 17% shown previously).
The success of Google, Facebook and now Amazon appears to have weighed on several pure-play digital publishers in the last year.
Last month, Verizon took a $4.6 billion write down on their media business, noting in an SEC filing that it “has experienced increased competitive and market pressures throughout 2018 that have resulted in lower than expected revenues and earnings. These pressures are expected to continue and have resulted in a loss of market positioning to our competitors in the digital advertising business.” The company noted that it expected 2018 digital advertising revenues to be flat with 2017 revenues.
In early 2018, digital video publisher Little Things shut down, citing 1) a Facebook newsfeed algorithm change that reduced the site’s organic reach by 75%, and 2) Facebook’s decision to emphasize users’ posts over news in an effort to improve engagement on the platform.
The same algorithmic change played a role in the sale of digital publisher Mic. In late November, Mic sold to Bustle Digital Media for $5 million. Previously Mic had raised $60 million with the last round rumored to value the company at $100 million. Like many digital publishers, Mic had pivoted to a video-centric model, but Facebook’s decision to reduce its emphasis on publisher content in favor of user content was instrumental in a 90% decrease in Mic’s video views.
In early November, Defy Media, owner of sites such as Smosh and Clevver, shut down. Defy Media was created via the merger of Alloy Digital and Break Media in 2013. In September 2016, Defy raised $70 million, bringing total capital raised to $100 million. Defy distributed original programming across 25 video platforms including YouTube, subscription VOD services and TV networks. The company’s in-house studio produced 75 regularly scheduled shows. Defy was looking to find new homes for several of its shows.
Later in November, Disney wrote down the value of its investment in Vice Media by $157 million. Vice is one of the few pure-play digital media companies that had made the leap into traditional media with its own cable network.
2018 proved to be a year of survival of the fittest for digital publishers. Several digital publishers learned the hard way the downsides of hitching their success to Facebook. While Facebook proved to be a great way to achieve scale rapidly, it also proved to be the undoing of several publishers when Facebook changed algorithms to favor user posts rather than news content. Scale is clearly important in the digital advertising space, so we would expect continued consolidation in the coming quarters.