A Bull's Take On 3 Media Stocks: 1 to Buy, 2 to Avoid

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although media faces an unpredictable market (movie goers and music listeners can be very fickle), there are, in my view, clear winners and losers in the sector. Firms that are well exposed to diverse mediums and are not overly reliant on one, no matter how "next-generation" it is, are ideal for investments. In this article, I compare 1 company that I believe is fundamentally weak to 2 companies that I find to be viable in the long-term. Of these 2 companies, I only recommend investing in one for right now.

Why Pandora's (NYSE: P) Future Is Bleak

Pandora, the internet radio, has lost two-fifths of its value since it IPO'd in mid-2011. This erosion of shareholder value has been driven by poor quarterly results, and increasing recognition that the business model is fundamentally weak--it is, after all, run on an ephemeral website. But, as a column in the Wall Street Journal rightfully noted, Pandora is challenged by rising content royalties that are format-blind to the fact that mobile ads are no more than half the price of PC ads. In short, "the more it sells, the more it loses." The bulls have pointed to studios scoffing at Apple's insistence upon a lower royalty expense rate as a sign that Pandora has a better economic moat than recognized. However, it's only a matter of time before Apple secures more lucrative contract--all it has to do is leverage its leading customer base.

Though Pandora boasts an impressive 62.4 million active listeners last month, Spotify has caught up fast and now has 20 million users and 5 million paid subscribers. Moreover, Spotify's early-mover advantage in international markets outside the United States also throws a wrench into the bull's claim that Pandora "just needs to go abroad." In the third quarter, Pandora's management blamed weak fourth quarter guidance partly on the fiscal cliff, which is causing advertiser caution. If you are not saying "what?" to this claim then I don't know what piques your curiosity. Regardless of how opposed you are to the tax hikes and spending cuts that will result from the fiscal cliff, it's hard to determine how much of an impact that this will have on the long-term fundamentals. Mobile ad revenue per thousand listener hours (RPM) is less than half of its PC ad RPM, and it continues to become an increasingly large part of the business. In a sense, the company is eating itself to death.

Perhaps most disappointingly, the company has blamed poor mobile ad RPM on removing the 40 hour listening cap. In my view, this sounds a bit "Netflixy." It is as if the company is afraid of making its customers happy and giving them what they want, because if they do, the company won't make money. Unfortunately, sometimes you need to give in to your customers to have a bright long-term future. But in Pandora's case it's a lose-lose either way, because the business simply faces too much competition irrespective of the 40-hour listening cap. The decision to increase headcount by 38% y-o-y as a way to boost mobile monetization also makes me wonder. Brainstorming is good, but it's not a cure for poor fundamentals.

Viacom (NASDAQ: VIAB) Vs. Dreamworks Animation (NASDAQ: DWA)

As much as investors like to move towards the next big thing, Pandora provides an important exercise in not moving too fast. Viacom and Dreamworks are experts in the media business, and they have sustainable business models. 

Viacom trades at only a respective 12.3x and 9.8x past and forward earnings even after rising 30.2% format the 52-week low. Analysts forecast 14.6% annual EPS growth over the next 5 years--around 120 bps below the rate experienced during the last half decade. Assuming expectations are met, 2016 EPS will come out to $8.18. At a multiple of 15x, this translates to a future stock value of $122.70. Discounting backwards by 10% yields a present value of $76.19. This indicates hat the company is more than 40% undervalued. Multiples simply can't stay this low for long. A 8.6% free cash flow yield should be used to implement an aggressive share repurchase program that communicates to the market how undervalued the stock is. But what about Dreamworks?

You have almost surely seen the letters "SKG" on a film and wondered what it stood for. This acronym humbly conceals the identity of Dreamwork's fundamentals: Steven Spielberg, Jeffrey Katzenberg, and David Geffen. Each one of these executives are the top of the top in the business--having created multi-billion dollar fortunes through their own respective media ventures. And if you didn't make out the letters "SKG," you certainly recognize that image of a boy fishing from a three quarter moon. In any event, Katzenberg controls the company after converting his Class B stock to Class A stock for 61% of the comapny's voting rights.

In any event, the stock has fallen by an unreasonable 18.7% over the last month--largely as a result of a poor North American response to Rise of the Guardians. In the domestic box office, the movie brought in only $30 million--well below the $50 million expected and the motion picture studio's third-worst opener ever. It cost $145 million just to produce the movie and now needs $230 million abroad to enter the black. It should be noted that the company can't blame this disaster on poor Thanksgiving business, which featured strong performance from Twilight and overall cinema ticket revenue of $290 million, a record. Stifel Nicolaus downgraded the stock to a "sell" as a result, but I believe the worst has been factored into the stock. Even still, challenges in financing films--evidenced by the licensing of international distribution rights--is a long-term headwind that will prevent value creation. Accordingly, I recommend avoiding the stock for now.


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