CBS Stock: The Peak Earnings Trap

Remember when Peter Lynch warned us in his book “One Up On Wall Street” that mom and pop investors get into big trouble when they buy stock in familiar names at a cyclical high? The specific example he gave was Ford Motor (F), which is the type of household name that catches the attention of new stock market participants after they’re no longer scared by the previous recession. These people start to see some of their friends buy new cars, and they catch snippets on CNBC about the market hitting new highs. They want in on the action. And so they buy the stock.

Within a year or three, the business cycle turns, earnings fall, and the stock price gets hammered as it shifts from selling at a premium to selling at a discount. It’s a very seductive type of business mistake for people that have generally sunny and optimistic views about the future and also have a bit of mathematical fluency to see the high earnings, high dividends, and low P/E ratio as a signal of logic confirming the gut’s intuitions.

I was thinking about the famous Lynch passage on Ford when I saw the investor reaction to the blowout earnings posted by CBS yesterday. CBS grew revenues 10%, saw a 12% hike in network advertising, earned a huge jump in retransmission fees from CBS affiliates to the tune of 42%, and posted overall earnings gains of 16% compared to this time last year.

Given that it is a presidential year in relatively prosperous economic conditions, it would not surprise me to see CBS earn $3.60 by the end of 2016 compared to $2.87 last year (an earnings gain of almost 25). You might look at the stock, sitting there at $55, and might think you’re getting a fair shake buying something at 15x earnings that seems a lot more reasonable than the other household names.

Don’t fall for it. Even though CBS likes to brand itself as a diversified media giant by noting its syndication and streaming licensing sources of income, it remains that 61% of its profits come from selling advertising.

This profit source is incredibly fickle. A turn in the business cycle is exceptionally harsh on advertising income. From peak to trough during the last recession, CBS saw its earnings fall from $1.88 to $0.53. A whopping 71% decline. The stock fell from $35 to $3, a paper loss of 91% (that’s what happens when an earnings collapse is accompanied by a shift from overvaluation to undervaluation).

Even if you don’t disqualify CBS from consideration because of Sumner Redstone’s 79.5% ownership of the Class A shares, the $8.4 billion in debt with only $323 million in cash should scare you away. CBS could make $1.5 billion in profit this year, a leverage ratio of 5.6 that might be tolerable if there is no deep recession on the horizon.

The real risk is if there is a deep recession between 2021 and 2024 that causes CBS advertising earnings to stumble. Most of the debt on the CBS balance sheet is deferred, with only $2 billion due between now and 2021. But after that, there is going to be over $6 billion in required payments during a three-year stretch, which doesn’t even take into account the borrowing at CBS that will inevitably occur in the interim (e.g. in the past 18 months, CBS tacked on over $1.5 billion in debt to repurchase 50 million shares of stock).

The moral in the nutshell? Cyclical stocks give you misleading P/E ratios, as the stock is most expensive when the P/E ratio seems reasonable and vice versa. This seven year climb in advertising revenues has led some investors to forget how much they shrivel away during recessions. Even though CBS is more diversified than its peers, it still gets almost ⅔ of its income from advertising. The earnings and stock price have risen high now, but don’t extrapolate that growth and capital appreciation into the future. The vulnerability point of a long-term CBS investment is that the debt continues to mount, and the U.S. economy hits a recession in the early 2020s right as the big debt payments come due. Then, the CBS management would have to visit the banks for high-interest loans or hit up Goldman Sachs to underwrite new equity at low prices, both punitive for the long-term common stockholder.