Keep An Eye On GCap

At first glance, GCap Media (LSE: GCAP) looks grossly overvalued. In today's results, GCap said it generated adjusted earnings of 7.8p a share last year, which puts the company on a hefty price/earnings ratio of 32. Wow!

GCap needs to grow pretty fast to justify that kind of rating.

But GCap might just manage it. That's because radio is an industry with high operational gearing. In other words, revenue can rise significantly without a correspondingly high rise in costs.

A look at margins illustrates the point nicely. Back in 2000 -- before GWR and Capital merged to form GCap -- GWR's pre-tax margin was a tasty 17%. Yet in today's results, GCap's pre-tax margin was just 10%.

So could GCap's margins head back towards 17%?

Possibly. For starters, merger upheavals should now be over. That will enable management to concentrate on running the business.

What's more, the Xfm network looks promising. Xfm is aimed at young men, a hard-to-reach and attractive market for advertisers. The network already has a million listeners and I expect that figure to rise.

Classic FM is another big plus for the business. It has an audience of 5.7 million people, most of whom are affluent. Modest revenue growth here should deliver a nice boost to profits.

And finally, there's digital radio which is now beginning to take off. GCap has a strong position here and its Planet Rock digital station is performing especially well with almost 500,000 listeners.

But it's not all good news for GCap. Perhaps its biggest problem is the BBC. The Beeb now has a 55.4% market share in radio, its largest share since 1992.

Another worry is declining audiences at Capital Radio, GCap's main station in London. GCap's solution is to cut the number of ads per hour and hopefully boost ratings as a result. That's a sensible approach but it does make it harder for GCap to get margins back to 17%.

What's more, with the threat of rising interest rates, the economy may not be that strong in the next couple of years which could reduce revenue.

It's hard to be sure, but I'm not that confident that GCap is going to dramatically increase margins in the next couple of years. Further out, though, things could be different.

And there's lots of recovery already in the price. I've done some "back of an envelope" calculations on what might happen if revenue increased by 20%, while margins rose to 15%. I reckon that would take earnings to 14p a share. So even then -- at 248p -- GCap is hardly a bargain.

I'll keep watching, because I know how fast profits could rise. But I won't be tempted to buy until either the share price falls to 220p or there are firm signs of a recovery.

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