Scripps Networks: Bargain Buy Or Stretched Too Thin?

We've said it before and will say it again: media content companies based around pay TV channels are a great business.

There are so many things to like about the business model. First, they have a nice dual revenue stream of carrier affiliate fees and advertising. The former gives these firms a reliable, predictable, and steadily rising stream of cash flows. The latter allows them to capitalize in strong economic climates (which are far more common than recessions where it hurts).

Strong and reliable cash flows give media companies a variety of options to reward shareholders. They can afford to (and do) buy back voluminous amounts of shares. Most pay at least a meaningful dividend yield with room for growth. And the reliability of cash flows give them the flexibility to "lever up" and take out more debt than the average firm to pursue growth acquisitions.

Finally, many of these firms (including the subject of this write-up) own the majority of their content. This is huge as it allows them to monetize regardless of distribution medium. While viewers have moved from over-the-air to pay TV and now into on-demand and Internet-delivered programming, great content is great content and it can be monetized regardless of how it is consumed. That makes content generators almost immune to the ever-shifting changes in distribution.

Weakness in domestic advertising in the first half of 2015 has created several bargains in the space, a number of which have been screened by Magic Formula® Investing (MFI) and the MagicDiligence screens. One I want to focus on today is Scripps Interactive (SNI). Let's take a look.

Home Cooking

You may not have heard of Scripps, but you almost certainly know its networks. About 70% of its revenues are generated through 2 popular pay TV channels: HGTV (36%) and the Food Network (35%). In addition to these, Scripps runs the Travel Channel (12%), DIY Network (6%), the Cooking Channel (5%), and Great American Country (1%). The two major channels reach over 95 million domestic viewers. The company generates close to 70% of its revenues through advertising, with the balance mostly from carrier affiliate fees.

Scripps' networks have some very attractive aspects:

• Both HGTV and Food Network target the female age 25-54 demographic, which accounts for over 75% of all consumer spending. There is no more lucrative demographic for advertisers.
• All of its channels utilize natural product placement opportunities, generating some of the highest "intent to buy" numbers from consumers of any networks on TV.
• Scripps owns practically all of its content (98%). This allows the firm to profit from new distribution channels such as Amazon or Netflix, should the terms be favorable.
• Its shows are low-cost to create, with limited talent and production costs. This leads to gross margins in the low 70% area, substantially higher than competitors such as Discovery (mid-60%) or AMC (mid-50%).

Not a bad roster of advantages there. Let's continue on...

The Next Leg of Growth

Naturally, as investors we also want to know: how can the company continue to grow?

Up until now, Scripps has utilized the tried-and-true media strategy of substantial share buybacks (-4.7% annual share decline over past 5 years) combined with a modest and rising dividend (1.4% yield) and continued distribution and ad growth (7% 5-year annual revenue growth) to reward shareholders.

That has worked well, but growth has slowed down as HGTV and Food Network hit domestic saturation. Last quarter, ad growth was flat while affiliate fees grew just 4%. So where does Scripps go from here? Can it grow?

As it turns out, the answer is: yes, and substantially. First, it could simply increase its ownership in its core assets. Scripps owns only 69% of Food Network (the remainder is owned by Tribune), and 65% of Travel Channel (Cox owns the rest). Should the minority owners be amenable, acquiring full ownership would be a quick way to grow net income.

More importantly, though, Scripps has a near "green field" opportunity internationally, where less than 5% of its revenues come from today.

To this end, Scripps in March announced it would acquire a 52.7% stake in TVN, one of the largest networks in Poland. Just a few weeks ago, this was amended to seeking full ownership of TVN.

Is TVN Worth It?

TVN is kind of like a Polish version of FOX. It has both over-the-air and pay-only general programming channels, "lifestyle" channels (TVN Style, TVN Turbo), a leading 24-hour news channel (TVN24), a business news channel (TVN24 Biznes), a sports channel (nSport), and several others. TVN's market shares in Poland are impressive - 22% viewership share and 33% advertising revenue share. Moreover, Poland is the largest economy in Eastern Europe and is growing ad sales at 6% per annum.

The initial 52.7% stake was to cost a little over $610 million, including assumption of about $950 million in debt. 100% ownership we can only assume would roughly double the purchase price, bringing the total value of the deal to about $2.1 billion. Management stated that TVN's 2014 revenues were $407 million at an operating margin of 30%. That puts the valuation at 5.2 times sales or 17 times pre-tax earnings.

That's a pretty rich price to pay, in my opinion. Scripps itself has traded between 3.3 and 4.5 times sales, or 11-14 times pre-tax earnings, over the past 5 years.

The deal will also really dirty up the balance sheet. Scripps financed the deal with $1.5 billion in senior notes, priced at reasonable rates between 2.8% and 3.95%, due between 2020 and 2025. Assuming another $600 million to complete the 100% stake, we're looking at a company that will carry nearly $4 billion in debt and have negative equity.

Media is a good, reliable business, and interest coverage should still not be a problem, but Scripps will have little safety net if business conditions turn dramatically negative. Long-term, the deal is probably worth it, as it diversifies Scripps internationally and gives it a platform to proliferate its core channels, but short term, it puts the company on shaky financial footing and shines a bright spotlight on execution.

The Bottom Line

For the patient, I believe Scripps is a good buy at current prices around $67. TVN will provide immediate growth, and increased cash flow should allow for debt repayment and continued dividends with moderated share repurchases. However, while in most circumstances this is clearly a "conservative" risk pick, TVN elevates the short-term risk level here. MagicDiligence believes SNI is worth about $84 per share.