For most of this year, it has been difficult to find stocks that could, in any way, be fairly described as “undervalued.” There have been moments when Tiffany, Hershey, and Diageo have offered a modest discount, which is actually more than any investor deserves given that the earnings quality of those businesses is so high. There have also been moments when Exxon, Chevron, and Royal Dutch Shell have gotten cheap, but the investor community didn’t quite “give away” those stocks at prices that I was hoping for when the price of oil briefly dipped into the $20s. And still others, like Wells Fargo and General Electric, are trading at a pretty fair price in relation to expected dividends and earnings growth over the next decade, but require investors to get passed the mental block of knowing that the returns could have been far superior if they had acted at any time in the past few years to gobble up shares.
But I have been searching for a stock that you can look at and conclude that it is objectively cheap–an investment where you don’t have to include the qualifier “relative to other opportunities in a bull market that has added moderate heat to most large-cap stock prices.”
And the company that I keep coming back to are the B shares of Viacom (VIA.B) which fell 5.38% on Friday as investors have displayed a predictably unfavorable reaction to the uncertainty surrounding Sumner Redstone’s trust that controls 79.3% of the voting power through National Amusements. While I would not describe these board seat proxy wars as inconsequential, I would say that the long-term earnings power of Viacom is not contingent upon whether Shari Redstone succeeds in wielding immediate influence over the board.
The reason why I feel that way is because Viacom operates a largely decentralized business model. It gets almost 80% of its revenues through a collection of network channels that include MTV, MTV2, VH1, Nickelodeon, Comedy Central, TV Land, CMT, BET, and Spike. The rest of its revenues come from Paramount Pictures (film) and Harmonix (video games).
Those subsidiaries have their own management teams that are silo-ed off to act in their own self interest. Even when Sumner Redstone was in his physical prime and applied a micro-managing spirit to his holdings, he wasn’t make individual business decisions–he was firing the managers of his subsidiaries for not meeting his short-term expectations. This isn’t Steve Jobs orchestrating the iPhone; Sumner Redstone did not bring you SpongeBob.
While most Viacom shareholders are understandably paying attention to the public spat over board control, that is not the issue that would keep me up at night if I were a long-term shareholder. Considering that 80% of revenues come from network channels, my predominant focus would be: How many minutes are being delivered per month by the channels we own?
The five year trend has not been good. Netflix is distributing 7x as many minutes to viewers as it did in 2011. This has led to a trend where traditional TV channels have stopped growing–not because middle-aged and older people are cutting the cord or watching fewer programming, but because the millennial generation is not opting into cable bills at a high enough rate to replace those who have died and had TV subscriptions.
Alongside the rise of Netflix, the only network that has seen sizable gains in minutes watched is Discovery (which has over 30% cumulative growth since 2011). But that is more of an indictment of Discovery’s poor programming options in 2011 than a cause of celebration over exceptional performance today.
CBS and 21st Century Fox have held steady from a minutes distributed perspective, but for the rest of the media outlets the results haven’t been pretty: NBC and Disney are down about 15%, Time Warner is down about 20%, and Viacom is down 35%. That is a sizable hit, considering that minutes are extraordinarily important for monetizing content and determine the eventual ad payout revenue that can accrue to shareholders.
These minute declines have been offset by a higher advertising rates over the past fives, as well as a renaissance in buybacks among media companies. The net effect of a 35% minute drop for Viacom over the past five years has only been $200 million in profits; it made $2.2 billion in 2011 and makes $2 billion today. Despite shaky fundamentals, the cash getting pounded out by the media empire hasn’t been impaired all that much (the real risk to Viacom shareholders is that the pace of cord cutting speeds up during a recession when people cut back and advertising revenues shrivel, and then Viacom might conceivably need to borrow money to service its $12 billion debt burden while this is going on.)
At this point, you might be wondering: Given those drawbacks about Viacom, why did I title the article “The Cheapest Blue-Chip Stock”? Because there are three countervailing forces on my mind that make me think the weighting of these factors has been overblown and the stage has been set for Viacom shareholders to do very well over the coming 5-7 years:
Number #1: We’ve had four nasty recessions in the past century. These are illustrative for helping us figure out the durability of a company’s profits during times of deep distress and aid us in quantifying the harm posed by perceived risks. In the case of Viacom, it actually grew profits from $2.38 per share in 2008 to $2.56 per share in 2009. Profits went from $1.4 billion to $1.6 billion even as minutes distributed through the network channels declined by 5%. Advertising rates plummeted, and minutes watched declined by a little bit, and yet the media giant still churned out more cash.
Number #2: Viacom keeps its dividends in the low 30% payout ratio territory so that it can repurchase gobs of stock and boost earnings. It has repurchased 35% of its stock since 2010, taking the share count down from 608 million to 390 million. Viacom is one of the best companies lately when it comes to getting serious about reducing its share count.
Remember when I mentioned earlier that profits have declined $200 million from $2.2 billion to $2.0 billion over the past five years? Well, that also coincides with a significant period of buybacks so that earnings have actually grown from $3.78 per share in 2011 to somewhere in the low $5 range right now. Put another way: Viacom the corporation has seen profits decline by 1.89% per year over the last five years, while Viacom shareholders have seen their profits climb by 6.17% per year over the past five years.
Number #3: The valuation on the stock more than adequately discounts the uncertainty over board control and the trend towards cost-cutting. If Viacom earns $5.25 per share this year, the current price of $42 per share represents a P/E ratio of exactly 8.
For a business that is only semi-cyclical, that’s a tag that encapsulates a margin of safety. The stock has historically traded between 15x earnings and 18x earnings, and the current valuation overshoots the mark. If the concerns about the fundamentals, as well as the more cosmetic concern about board control took the stock’s valuation down to the 13-14x earnings range, I wouldn’t bother writing about it–there are companies with higher earnings quality and growth prospects that I could focus on.
But I consider this current valuation to be a substantial discount; I would consider a valuation of 12x earnings to be the transition point between low end of fair value and the beginning of undervaluation, and the current price tag of 8x earnings counts as a 33% discount to the low end of the fair range. That has caught my attention.
The undervaluation also lets you lock in an attractive yield of 3.81% which is solid for a company that is only paying out a third of its dividends as profits. Assuming 5% dividend growth, reinvestment, and a constant reinvestment rate of 13x earnings, each share bought today will generate $9.60 in total income over the next five years. That means you’ll get almost a quarter of your cash back just from turning the cash sent your way from ongoing operations into a higher ownership count in the firm.
I mean, this is a stock that was trading at $89 per share just two years ago for a valuation of almost 17x earnings. Earnings are only down 2%, and yet the stock is down 52%. Some of it may reflect overvaluation getting burned off as well as a deserved lower valuation from the public drama surrounding board control, but that is the kind of thing that should have taken Viacom from the nearly $90 range to the low $60 range at worst. The fact that it has entered the low $40 range instead makes me regard this as a market overreaction.
In short, the 8x earnings valuation does not adjust for the fact that Viacom can stomach a decent amount of cord-cutting while still maintaining mid single digit earnings growth. When you get a 3.80% dividend that is only a small chunk of profits, a deep discount of 8x earnings at the time you make your investment, a share buyback rate of over 6% per year, and the possibility of cord-cutting that may occur at a slower pace than anticipated, it doesn’t require much to go right for the investment to work out well. That said, I would only own Viacom for a medium-term investing horizon of a few years rather than as a core long-term holding for generations.