Newsletter Media Sector Review January 2018
Media multiples likely to rise in heightened M&A Environment
Media stocks faced some headwinds in 4Q 2017 from weak auto sales, which declined in December to a run rate of 1.7% below that of 4Q 2016. This suggests that one of the key drivers to the advertising rebound may be losing some gas.
We do not believe that auto advertising is going to fall off of a cliff. There is a positive economic backdrop and it appears too early to connect the dots between auto sales and advertising, given that there will likely be a step up in promotional spending, especially from auto dealerships. On a positive note, retail sales appear to be better than expected, which may lead to improved retail advertising budgets into 2018. Overall, we expect that core advertising will be somewhat lackluster into 2018.
Media stocks shrugged off the shifting winds on the advertising front as investors focused on the prospect of a heightened M&A environment and the cycle toward another political advertising year in 2018. It is typical that media stocks perform well in the fourth quarter of the year prior to an Olympic and election year. The fourth quarter 2017 was no exception, as described in the media sector commentary below. In our view, the fundamentals in the media sector support a constructive view in 2018 and the M&A activity is likely to heat up, providing added luster to investing in the space. In a heightened M&A environment, media multiples will likely rise.
OUTLOOK - TRADITIONAL MEDIA
There was a nice recovery in the television sector in the fourth quarter 2017, but it was a little too late to lift the year performance. Television stocks declined 4.4% for the year, better than the 11% decline the stocks had heading into the fourth quarter. This represents another disappointing pre-election year cycle for the stocks. Historically, over the past nearly 30 years, the television stocks were up on average 29% the year prior to an Olympic and election year. Given the positive movements from the FCC to lift television ownership restrictions, one would think that the stocks would have performed better.
In our view, investors have been concerned, (likely overly concerned), about the state of auto advertising and that of retransmission revenue. The lackluster auto advertising prospect was discussed earlier in this report. On the retransmission revenue side, the third quarter results reflected some weakness in retransmission revenue relative to expectations. The cable industry, or MVPDs, indicated that it lost 1 million subscribers in the quarter. In our view, these subscriber losses were mostly in large metropolitan markets. As such, the impact of the subscriber losses were not evenly felt by all TV broadcasters, or by broadcasters which had a high level of retransmission contract renewals at market rates during the year. It is expected that a large portion of those losses are due to OTT program providers, which rolled out services in that quarter. We believe that the “shortfall” in retransmission expectations is temporary. The nature of the payments for retransmission revenue over OTT platforms is not the same as the traditional MVPDs. The OTT service providers pay the network who then pays the broadcast television station. This creates a lag in the payments. Given that the net economic benefit from OTT service providers for retrans is virtually the same, we do not believe that there will be an adverse impact from the entrance of OTT services. While there may be uneven quarters due to subscriber shortfalls from MVPDs, we believe that retransmission revenue, or better net retransmission revenue will be back on track toward run rate expectations.
This will leave investors to look forward toward a heightened M&A environment and improved fundamentals, with a boost from political advertising in 2018. Companies, like Gray Television, appear to be preparing balance sheets for acquisitions. Again, we believe that a heightened M&A environment will serve to expand cash flow multiples and broadcast TV stock valuations. As such, we remain constructive on TV stocks.
We believe that the radio industry is still trying to find its “voice.” While listenership levels have remained consistent, if not growing in certain key advertising categories (18 to 34), the industry seems to be stuck in the 0% to 1% revenue trough. Radio listenership levels are impressive when considering the fragmentation of television and loss of overall live TV viewers. So, what is the problem and why haven’t advertisers come to radio with greater spend? We believe that advertisers have shifted toward data driven advertising metrics, which certainly favors digital advertising. In our view, there are significant opportunities for radio as it develops its data analytics capabilities. That is one of the promises from the Entercom/CBS Radio merger, which plans to invest and develop data analytics platforms to be rolled out in the first quarter 2018. One of the other problems plaguing the industry has been the over-leverage of the largest radio players, Cumulus and iHeart Media. The theory goes that both of those companies are not driving rates as both take revenues at any price because of the need to pay interest on massive debt. It is quite possible that investment decisions to support revenue growth may have been impacted by the need to service debt, as well. This theory will be put to the test: Cumulus Media filed for Chapter 11, which will allow the company to restructure, and, hopefully, focus management attention on growing revenues and cash flow versus managing its balance sheet.
While investors seem to have shunned radio stocks, which were down nearly 15% for the year in 2017, versus a general market gain of 19.4%, we would not write off radio for 2018. In our view, many of the issues that plagued the industry in 2017 will improve in 2018: 1) the introduction of data analytics could help turn the tide toward the value proposition of radio, 2) the benefit from a shift toward call to action and sales promotion advertising in 2018, especially from the auto industry, 3) the debt deleveraging of the industry which may enhance rate cards, and 4) the likely heightened M&A activity which tends to follow as companies reposition station portfolios. We look for an improved performance from radio in 2018 and remain constructive on our favorite radio plays.
The “dinosaurs” came roaring back in 2018. Publishing stocks rose 33.4% in 2017, outperforming all of the other media sectors and the general market, which increased 19.4%, as measured by the S&P 500. The individual publishing stock performance was spotty, however, with the smaller players such as McClatchy and Lee Enterprises underperforming. One the best performers in the group was tronc, up 32% for the year. In our view, the company took the necessary steps to cut overhead costs and tackle one of the biggest cost issues, the LA Times paper. Investors appeared to overlook the lackluster digital performance and weighed heavily on the company over achieving cash flow expectations. Despite the spotty stock performance, the industry appears to be on a better footing. In our view, the stronger than expected cash flows, not just for tronc, but for many in the industry, put the industry on a footing that it will be around for a long while. Debt levels appear to be manageable now and these companies do not appear to be at risk from going under, so to speak.
It is important to note that the above average stock performance for the sector was also notable because it was not driven by heightened M&A activity. Looking forward toward 2018, we believe that investors will turn their focus on moderating revenue trends, rather than over achieving cash flow expectations. As such, it is a possible bright spot for the industry that retailers may have had a better 2017. This may imply that there could be some advertising stabilization from that sector, which could help to moderate newspaper retail advertising trends in 2018. Should retail advertising growth rates moderate a range of 8% to 12% declines from the range of 15% to 20% declines in the past 2 years, the publishing industry would be on a path toward stable revenues. The question will be: “What will digital revenues do?” We believe that publishing managements are focused on improving digital revenues trends in 2018. Those that will be successful, we believe will have the strongest stock performance in 2018. We remain constructive on the publishing stocks for 2018.
OUTLOOK – INTERNET AND DIGITAL MEDIA
INTERNET AND DIGITAL MEDIA
In our previous quarterly media newsletter we noted that consolidation in the advertising technology space was necessary and that M&A had begun to pick up in two notable ways: 1) several publicly traded ad tech companies were acquired (Maxpoint, Rocket Fuel, and Yume were all acquired), and 2) for the first time private equity firms were becoming active acquirers of ad tech companies. We expect that consolidation in the ad tech sector will continue as, much like traditional media, scale will have added importance as brands, agencies and publishers seek to reduce the number of vendors/middlemen they work with.
As we look out to 2018, we expect traditional media and entertainment companies to become more active in the internet ecosystem, exploring both subscriber based business models as well as mobile and video-centric advertising models. While the traditional means of distributing content isn’t going away, cord cutting is beginning to have an impact: PayTV providers lost over 400,000 subscribers in 3Q 2017. Disney’s purchase of Twenty First Century Fox’s film and TV studios, satellite TV and cable network assets appears to be logical extension of Disney’s August 2017 decision to 1) end its distribution agreement with Netflix, 2) buy a majority stake in BAMTech, and 3) launch a Disney branded direct-to-consumer streaming service. Disney’s move came 2-3 years after other media companies had launched OTT services: Time Warner launched HBO Now in April 2015; CBS launched CBS All Access in October 2014 and launched the Showtime streaming service in July 2015. The requisite scale and deep library required to keep consumers engaged likely prompted 21st Century Fox to conclude that they did not have the requisite scale to compete with the likes of Netflixe, YouTube and Amazon Prime Video.
Direct-to-consumer subscription models will likely remain the domain of the largest media companies. For smaller traditional and digital media companies finding a way to tap into the tremendous growth in mobile and online video advertising will remain paramount. In 2017 numerous digital publishers pivoted to video-centric content strategies, as CPMs for online video are substantially higher and have held up much better than CPMs for banner ads. From an M&A standpoint, companies that enable the distribution and monetization of mobile and video content will likely be in strong demand, particularly as more and more media companies pivot to video-centric content strategies.
INTERNET AND DIGITAL MEDIA COMMENTARY
2017 was a strong year for stocks in the internet and digital media sectors. The S&P 500 finished the year up 19%, and 3 of the 4 internet and digital media subsectors we follow significantly outperformed the broader market. The digital media, social media, and marketing tech sectors posted stock price increases of 33%, 48%, and 54%, respectively. Ad tech stocks, which were strong through the month of September (up 29%), slightly underperformed the S&P 500, finishing the year up 17% as shares in ad tech bell weathers The Trade Desk and Criteo struggled in 4Q 2017. Excluding the performance of several ad tech companies that were acquired during the year, ad tech stocks finished the year down 3% (as shown in the chart on the previous page).
Several stocks contributed to the strength of the digital media sector, including Interactive Corp (IAC; +89%), Leaf Group (LFGR; +51%) and Alphabet/Google (GOOG; +33%). IAC shares were up due to strong operating results and the merger of its subsidiary by its HomeAdvisor subsidiary with Angie’s List. Google benefited from investor demand for tech sector leaders, most notably the FAANG stocks: Facebook, Apple, Amazon, Netflix and Google. The FAANG stocks were up on average 49%, and Google’s 33% gain was the lowest gain in the group. The only digital media stock whose shares fell during the year was Pandora (P; -63%) as audience growth slowed and the service continues to lose listening share to Spotify.
Social media stocks finished the year up 48% driven by shares of Facebook (FB; +53%); Match.com (MTCH; +83%), and Twitter (TWTR; +47%). Twitter shares were only up 4% through September but added another 42% in Q4 2017 on the strength of better than expected earnings and user growth. Shares of Snap (SNAP) finished the year down 14% since its March IPO. The company missed revenue expectations in each of its first three quarters as a publicly traded company. Shares of The Meet Group (MEET; -43%) finished down as the company lowered 2H 2017 guidance following a 1H 2017 acquisition, though shares rebounded in the last two weeks of the year on news that the company’s results would hit the high end of guidance in 4Q 2017.
Marketing technology stocks were the standout sector in 2017, finishing the year up 54%. Hubspot (HUBS; +79%) was the strongest performing stock in the group, followed by Adobe (ADBE; +45%); and Salesforce (CRM; +37%). The newest addition to the group, Yext, finished the year up 20% since its IPO. Laggards in the sector included Akamai (AKAM; -27%) and Marin Software (MRIN; -26%).
Finally, advertising technology stocks finished 2017 up 17% which was disappointing given that the index was up 29% through September. 2017 performance was driven by The Trade Desk (TTD; +65%) and M&A related gains for Maxpoint Interactive (+131%), Rocket Fuel (+52%), and Yume (+33%). The relatively weak finish to the year was driven by the highest market cap weighted stocks – The Trade Desk and Criteo. Shares of The Trade Desk decreased by 26% in Q4 2017 as, for the first time, the company did not raise guidance upon reporting 3Q results in November. Criteo shares decreased 37% in 4Q 2017 due to the company’s mid-December announcement that Apple’s launch of a new “Intelligent Tracking Prevention” feature in the new Safari browser would have a greater impact of the company’s results. While ad tech investors seem to have “thrown the baby out with the bath water”, this reminds us of what happened in the year or two following the doc.com bust: many internet stocks that were left for dead continued to see their businesses grow rapidly and proved to be great entry points for investors.