As one of the largest media companies in the world, Viacom’s (VIAB) distribution and reach puts the company in a very strong competitive position.
Size matters in the media business as much or more than almost any other sector.
Nevertheless, the market greatly undervalues the cash flows of the company. To be specific, the current value of the stock (~$50/share) implies the company’s after-tax cash flow (NOPAT) will permanently decline by nearly 25%.
In other words, the market is predicting that Viacom’s cash flows will take a major dive and never recover. Figure 1 plots a comparison of the stock to its economic book value, which is currently $66/share. This is the value of the stock if Viacom’s NOPAT never grows beyond its 2012 level.
Figure 1: Impressive Margin of Safety
Bears will point to the company’s recent disappointment in fourth quarter revenues. Total revenue of $3,363 million in 4Q2012 dropped 17% versus 2012. That is a big drop to be sure, but earnings still rose by over 14% over the same period.
Rising earnings despite a rather large drop in revenues suggests the company is focusing its business more on the profitable segments (affiliates) than the unprofitable segments (movies). By focusing more on scaling their existing brands into new markets as well as investing more in digital content and distribution, Viacom’s future cash flow prospects look great to me.
The merits of this strategy are proven by the rising trend in the company’s return on invested capital (ROIC). This impressive trend shows the company is becoming more profitable not less profitable as the market suggests. Figure 2 plots VIAB’s ROIC versus its weighted average cost of capital (WACC) over the past seven fiscal years.
VIAB’s 2012 ROIC was 14% compared to just 2% for Time Warner, Inc. (TWX) and 10% for Disney (DIS). Neither TWX nor DIS have achieved as strong or consistent an ROIC as VIAB over the last several years. And both of those stocks are much more expensive than VIAB.
Figure 2: Business Is Growing Stronger
If one looks only at the reported earnings of the company in 2012, one sees a decline in earnings. On the other hand, assessment of the company’s economic earnings shows an increase. Figure 3 compares the company’s 2012 GAAP earnings to is economic earnings.
Figure 3: Economic Earnings: Diligence Matters