Newsletter media sector review July 2016

We believe that the media stocks are in an oversold position, following a 1.5% selloff in the group over the past quarter. In our view, the fundamentals of the media companies appear favorable, although the second quarter is not expected to be as strong as the first quarter.

This is largely due to soft Political advertising in the second quarter. The first quarter benefited from the primaries for both parties. Notably, political advertising will likely be heavily spent following the Democrat and Republican conventions. For those that may believe that Trump will not find donors, his campaign recently indicated that it raised $51 million in the last month. In our view, investors have downplayed the potential upside from Political advertising which we believe will set records. Given the historic low stock valuations for media companies, we believe that there is significant upside surprise potential, especially in the television group which would benefit the most from Political advertising.


Television Broadcasting
The FCC indicated that the voluntary reverse auction was a success and that it was able to secure 126 mhz of spectrum for a whopping $86.4 billion price tag, more than anyone expected. The market initially reacted favorably, but then the broadcast television stocks pulled back. Some analysts indicated that the those participating in the forward auction would not be able or willing to spend that amount for the spectrum. Interestingly, there was some misinformation that companies may "sit out" the first round auction and participate in the second round in an effort to buy spectrum at a lower rate. This is not true. You cannot play in the second round if you were not in the first round. We find it interesting that the market has not reacted to the prospect of such a transformative opportunity for the Television Broadcast industry. Many stocks do not reflect any value for the potential spectrum proceeds or what companies may do with such a windfall. Will the Telecommunication and Technology companies really sit out or not "buck up" on this important opportunity? Should investors give zero value for the opportunity from spectrum proceeds? We encourage investors to take the bet. Seems downside risk in the television stocks appear to be low.

Radio Broadcasting
The Noble Radio Broadcast Index was up 6.1% in the latest quarter, but there was a disparity among the players in the industry. Companies with high debt leverage underperformed, while those with less debt outperformed the industry averages. It is clear that investors are concerned about a rising interest rate environment and/or a potential downturn in the U.S. economy. We do not believe that the share price weakness was related to fundamentals. Most radio companies are expected to report favorable second quarter results, albeit with a modest amount of Political advertising in the quarter. Consequently, it is not a surprise that most radio broadcasters have indicated aggressive debt pare down strategies in an effort to bring debt leverage down to 4 or below in the coming 12 to 18 months. Given the strong free cash flow generation of many of these companies, such a move would indicate an average 30% increase in stock valuations from near current levels should every dollar of debt reduction improve the equity value. Without the prospect of an economic downturn on the intermediate term horizon, we are constructive on the radio industry.

Gannett (GCI: Rated Buy) threw a curve ball in its aggressive acquisition strategy with a planned purchase of marketing services company ReachLocal (RLOC: Not Rated) for $156 million or $4.60 per share. The company has been on an acquisition binge following its spin-off in June 2015, but has concentrated on other publishers. In our view, we view the move favorably given that publishers are likely to build up digital marketing services to aid in the digital transformation. We believe that this planned acquisition, however, highlights the value of another marketing services company that we follow, Harte Hanks (HHS: rated Buy). ReachLocal is very similar to Harte Hanks in that both companies have had declining revenues and is in the midst of a turnaround. We believe that Harte Hanks, in many ways, has stronger customer relationships. Based on the 0.5 times revenues that Gannett is paying for ReachLocal, Harte Hanks would be worth over $4 per share. As such, we view Harte Hanks as a compelling value play near current levels.


Internet and Digital Media
Internet advertising in the U.S. continued to grow substantially in the first half of 2016. In June, the Internet Advertising Bureau (IAB) reported that first quarter internet advertising grew by 21% year over year to $15.9 billion, up from $13.7 billion in 1Q 2015. Public company guidance suggested more of the same for 2Q 2016. Interestingly, growth in the sector stems primarily from the sector's two largest players, Google and Facebook. For example, we estimate that Google's domestic ad revenues grew by $1.4 billion in 1Q 2016 to $8.4 billion from $7.0 billion while Facebook's domestic revenues increased by $1.0 billion to $2.6 billion from $1.6 billion. As a consequence, the lion's share of the industry's incremental revenues ($2.7 billion) came from these two leading platforms.

Also in June, Magna Global raised its 2016 U.S. advertising outlook to 6.2% growth (up from +5.0% in its December 2015 outlook) driven by +15% growth in digital advertising, led by 45% growth in mobile advertising, 44% growth in social media, and 40% growth in online video advertising. Search, the largest digital segment, is projected to growth by 14% in 2016. As a consequence, Magna Global now estimates that online advertising ($67.9B) will nearly rival television advertising ($68.2B) in 2016, and will likely surpass it ($76.2B to $64.8B) in 2017.

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