Invest in Food & Shelter TV

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Food Network and Home & Garden Television, which consistently rank among the top 15 in audience ratings for all U.S.cable networks, are the only U.S.cable franchises that devote their entire programming to lifestyle subjects.  They are the flagship channels owned by Scripps Networks Interactive, Inc. (NYSE: SNI) and together they contribute more than 70% of revenue for the company which has developed a very profitable and high cash generating niche in what analysts call the food and shelter television programming segment.  In addition to Food Network and Home & Garden Television, Scripps owns all or a portion of the Travel Channel, DIY Network, Cooking Channel, and the Great American Country channel.  The smallest business segment is SN Digital which is the interactive segment of the company.  In 2011, Food Network and HGTV each accounted for about 36% of operating revenue, while Travel Channel accounted for about 13%.  The remaining 15% of revenue was from the other 3 channels and SN Digital.

By concentrating their programming in these lifestyle areas, Scripps has connected with affluent viewers whose significant disposable income attracts advertising dollars.  And the consistently high audience ratings produces a steady stream of monthly fees from affiliates in addition to the advertising revenue.

Since fiscal 2005, Scripps has been able to leverage annual revenue growth of about 13% into net income growth of about 38% and operating cash flow growth of about 29% by maintaining its gross margin at about 52% and improving operating margin from about 36.8% in 2005 to about 42.8% in fiscal 2011.  By controlling expenses while simultaneously growing revenue, Scripps' management has been able to increase the amount of operating cash flow for every dollar increase in revenue.  In 2005 the company had an operating cash flow to revenue ratio of about 20.2% and this was improved to about 35.2% in 2011.

So while these past results are impressive and tell a very good story about company management and its ability to control operations and allocate capital, future results are dependent on several factors.  The company should reap higher affiliate fees due to 1) renewals of old underpriced contracts and 2) the entry of telecom companies into the television services marketplace which should lead to contested bidding for Scripps' content.  A fairly new internet innovation called Over The Top streaming ("OTT") is not yet proving to be a direct substitute for pay TV subscriptions which is Scripps' dominant delivery model. The company has planned a step-up in investments for new programming with Travel Channel, HGTV, and Food Network accounting for the bulk of the investment, and to a lesser extent, international expansion into Canada, Europe, Asia and South Africa including a new UKTV joint venture with BBC and purchase of Travel Channel International. The company is developing streaming video on demand, or SVOD, which is a new distribution platform for streaming stale content that Scripps no longer monetizes on its own channels.  The potential plan is to deliver SVOD via Netflix (NASDAQ: NFLX) and/or Amazon (NASDAQ: AMZN).  Share buybacks are ongoing under a $1 billion plan of which about $500 million remains to be executed.  Scripps will also be rolling out new distribution platforms, including high definition television channels, mobile phones and video-on-demand.

Success in achieving these ambitions and coping with the changing entertainment landscape will come from management exploiting and maintaining its current competitive advantages and looking for new ones. Scripps' niche programming to affluent viewers allows it pricing power with advertisers while consistently high ratings allows pricing power with affiliates which is important because about 30% of sales are from these fees.  Another way that Scripps has a competitive advantage is that its content is cheap to produce compared to other types of television entertainment like sitcoms or sports.  In addition to creating a low cost structure, these relatively inexpensive shows often create strong brands developed from their shows' personalities. This aspect of Scripps' programming acts as a barrier to entry that discourages other, larger content providers such as Disney (NYSE: DIS) or CBS (NYSE: CBS) from using their scale to successfully replicate these types of inexpensive of shows.

Scripps' success has not gone unnoticed with shares increasing by more than 14% since being spun off from E.W. Scripps in June 2008, handily beating the 3.6% rise in the S&P 500 index during that time.  And investors expect continued gains with the forward price to earnings ratio at about 15.7x at a recent price of about $49 per share.  This forward P/E is higher than both Disney at 14.5x and CBS at 14.0x.  Investors are also willing to pay more for Scripps' growth with the price to earnings to growth ratio at 1.8x for 2012 compared to only 0.9x for Disney and 0.7x for CBS.  However, looking at 2013, Scripps' growth brings the price to earnings to growth ratio down to 0.9x which is in line with Disney and CBS at 0.8x each.  I am comfortable paying a premium for Scripps compared to its competitors because I am more confident that it will reach its estimated growth rate.  This is because Scripps' estimated future growth is lower than both its past growth rate and the future growth rates estimated for both Disney and CBS.  Although I do agree that Scripps' growth rate will slow over time as it increases its size, with a market cap of only $7.7 billion compared to $ 79.2 billion for Disney and $21.6 billion for CBS, I have serious doubts that the growth rate will fall below these industry giants for any length of time.

An analysis of discounted cash flow indicates an intrinsic value of about $55 to $60 per share assuming forward growth in free cash flow of 10% and no reduction in share count  despite the buyback program currently in place.  I used a 10% growth rate which is significantly less than the approximate 30% growth rate since 2005 because the company plans to escalate its investment in programming which will mean increased capital expenses.  If operating cash flow continues to grow at the same historic rate, free cash flow growth will be reduced by higher capital expenditures.

I think that management capability, as demonstrated by the company's past success, and its competitive advantages make future earnings and cash flow growth highly probable and I look at this gap between it and its competitors as a chance to buy shares with a tremendous upside up to about $55 or $60 per share over the next two years.  Any further pullback in shares due to broad market weakness presents an opportunity for investors to buy Scripps.

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