Qualiport

Bruce takes a deeper look at this media company

For those new to the Qualiport, it's worth reiterating what we are attempting to do here. We are trying to build a portfolio that is made up of some of the best British companies that we can lay our hands upon. A "quality" company is difficult to define and is ultimately a subjective decision. We like well managed companies, backed up by an excellent past growth record. The past is the only thing certain in stock analysis -- future industry trends and growth rates are no way to judge whether a company is well managed. If a company has a good growth record in the past, it is often a good sign that they have management who can adapt to the changing business environment ahead.

On Wednesday we took our first in depth look at EMAP, one of the 3 media companies left in our short list. We looked at their business, what they do, and briefly at their profitability. Today, we delve a little further, looking in particular at the numbers that make up the accounts of EMAP.

Sales, Margins & Profits

These three are inextricably entwined. A company must have sales to make a profit. It must have positive net margins to make a profit. Profits are what ultimately drive a company's share price forward. Sounds simple doesn't it?

Regular Qualiport readers will know I'm a great fan of companies with high and increasing profit margins. A good example of their power was illustrated in yesterday's Daily Fool where we looked at the past growth phase of retailer Next. Here's a simple example:

                     1980     1985

Sales                 100      100
Profit                 10       20
Profit Margin          10%      20%

5 Yr Sales Growth       0%
5 Yr Profit Growth    100%

This company has managed to double its profits in 5 years. That's a compounded rate of almost 15% per annum. Few companies can consistently achieve this level of return. Many are cyclical, such as house builders or construction companies. They may have bonanza growth periods in the good times but big losses in the bad times. Profitability is the ultimate driver of share prices. Sure, loss making companies can still have appreciating share prices (e.g. Orange, COLT and Verity), but if the companies are never profitable or don't live up to the lofty expectations that the share market has bequeathed them, they will never be long term winners.

The above example, as well as highlighting the power of increasing margins, shows how a company with zero sales growth can actually increase its profits. Just imagine what would have happened to the above theoretical company if they'd also increased their sales by 100% over the 5-year period. (For those totally dependent on a calculator, like me, the answer is that profits would have increased to 40, a 300% appreciation)

Margins are not the be all and end all of stock analysis. There is usually only so far that you can stretch them. Competitors may start a price war, forcing you to follow suit. Prices of raw materials may rise due to influences out of your control, such as a strong pound. Or you may decide to finally upgrade the computers of your staff from the old 286s to some second hand but really fast 486s. (This company is not the most computer literate in the world -- they'll love the speed of their 486s.) Ultimately, a company needs sales growth if it is to keep growing at a sustainable rate. Which brings us conveniently back to EMAP. Let's see what they're up to as regards sales, margins and profits. Remember their year end is March 31st.

                         1997       1996
                          £m         £m

Sales                   768.2      705.0
Operating Profit        125.8       95.6
Operating Margin         16.4%      13.6%

Sales growth was relatively small at 9%, but operating profits grew by almost 32%. Note the increase in the operating margin. Much of the profit growth was driven by the increased margin.

As we saw on Wednesday, EMAP is a business that has undergone some big changes in the last few years. Out went the regional newspaper business, in came magazine titles and new media that management hopes will drive the company's growth forward in the future. In 1996, the above numbers contained a full years sales and profits (£110.8m sales, £9.6m profit, margin 11%) for the now disposed of regional newspapers business. By comparison, 1997 shows only two months worth of comparable results for that division. Sales from continuing businesses rose 23%, a much better sign of EMAP's underlying growth.

The latest numbers we have from the company are for the half year ending 30th September 1997 (oh so long ago -- wouldn't we love quarterly reporting for UK companies?).

                         1997        1996
                          £m          £m

Sales                   376.1       388.3
Operating Profit         64.0        55.3
Operating Margin         17.0%       14.2%

On the surface, these figures provide us with both good and bad news. On the downside, sales have actually fallen, hardly an encouraging sign. However, again, 1996's numbers have some of the turnover and profit from the discontinued newspaper business included in them. Strip them out and underlying sales growth was 4%. The big culprit was the French Consumer Magazines business, where sales fell by 14%. As we have commented earlier, the French economy is a long way behind the UK's in terms of recovery. The strength of sterling also played a large part in the sales drop. However, the profit for this division actually rose substantially, due to a massive 47% increase in the operating margin.

The margin increase of the whole business was impressive, to say the least. A 20% jump goes a very long way towards making up for the lack of significant sales growth. The bottom line result for EMAP was a 28% increase in normalised earnings per share -- not bad considering sales from continuing businesses rose by only 4%.

Before leaving margins, it is worth pointing out that EMAP publicly state that their objective is to achieve 20% operating margins by the year 2000 -- earlier, if possible. Considering they are at 17% at the moment, that's a further 17.6% growth from margins alone.

Cashflow & Debt

One of the first things I turn to when looking at an annual report is the cashflow statement. All the accounting profit in the world can mean nothing if it is not ultimately being turned into cash. There are many ways accountants can legitimately fiddle the numbers, but bank statements have a nasty habit of being a bit more difficult to manipulate.

EMAP's corporate activity had been intense in the period leading up to the 1997 published accounts, especially in the French market. In June 1994, they splashed out £108m on Editions Mondiales and its 28 titles. March 1996 saw £142m being shelled out on Telestar S.A. These acquisitions, along with many smaller ones as well, saw EMAP's debt levels rise significantly, so much so that it stood at £350m on 31st March 1996. Then, with stated shareholder's funds of just £112m, gearing was a whopping 212%. Here at the Fool, we prefer to look at debt as a proportion of sales rather than gearing when assessing a company's level of borrowings. Shareholder's funds are often distorted by the goodwill reserve, and debt to sales gives an objective ratio that is hard to argue with. In 1996, EMAP's debt to sales ratio was 50%. This was on the high side, but not unmanageable. After its takeover of BET, Rentokil Initial had a debt to sales ratio of 31% in 1996, and the acquisitive Stagecoach's ratio was 79%.

Financial year 1997 significantly changed all that. The sale of EMAP's regional newspaper businesses brought in £220m. Acquisitions totalled only £95m. Another year of successful trading brought in £76m cash, after tax and dividends. Suddenly, debt was down to £89m. Using the traditional gearing calculation, this was 36% of shareholder's funds and the debt to sales ratio was down to 11%. Quite a transformation.

Interest cover is EMAP's principal determinant of debt capacity. Their current objective is to ensure operating profits cover the net interest expense by at least 5 times. In 1996, interest cover was calculated by the company at 7 times, and in 1997 it was 15 times as debt fell. As far as being able to manage their borrowings, EMAP felt free to hit the acquisition trail again.

EMAP uses operating cashflow after expenditure on tangible fixed assets, expressed as a percentage of operating profits as its key cash management measure. Their long term aim is to achieve a conversion ratio of at least 95%. This is quite a demanding target, and highlights the importance the company places on cash generation. Over the last 5 years the ratio achieved has been 98%, and in 1997 is was 100%. A net cash generator usually has more money to spend on enhancing shareholder value, either through increased dividends, share buy backs, or acquisitions.

The EMAP Snapshot

Recent Share Price: 1110p

Fiscal 1997 Sales: £768.2m
Fiscal 1997 EPS: 38.9p

1998 EPS Estimates: 45.0p
1999 EPS Estimates: 50.8p

Market Capitalisation: £2,320m
Market Capitalisation to Sales: 3.0
Current P/E: 28.5
Forward P/E: 24.7 on 1998 estimates, 21.8 on 1999 estimates.

Long Term Expected Growth Rate: 15%
Yield: 1.1%

Conclusion and Next Step

EMAP has undergone some big changes since incorporation in 1947, but none bigger than those made in the past few years. In re-inventing itself, the company obviously hopes for future benefit. Its strategy is to focus on brands and market leadership, believing that this represents the potential for high margins, high cashflow, and a high return for shareholders.

After a period of consolidation, primarily to reduce debt, EMAP have recently embarked on the acquisition trail again. The French magazine business is a concern as the economy in that country, like the rest of mainland Europe, continues to splutter. Sterling keeps going from strength to strength, which is good for the Calais day trippers, but not so good for EMAP when converting its franc sales into pounds. Their results for the year ended 31st March 1998 will be released at the end of May.

Next Wednesday, we will look at the valuations of both EMAP and Capital Radio. It is all well and good identifying a quality company, but we must also work out whether it is fairly valued. If over 10 years you find that you would get an equal or better return by leaving your money in the building society, why risk it by buying an over-valued share?

I'm parking Reuters to one side for the moment. EMAP and Capital Radio have at least some similarities, and therefore some comparisons can be made. We will look at the media giant next Friday.

Please post all comments, opinions and thoughts to the message boards. Alternatively, if you're feeling a bit shy, please don't hesitate to email me.

Have a great weekend, Fools.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

This Week's Numbers          Week Ending 25/03/98

          Change     Bid
          pence       £

RTO        0.17      3.50


Rec'd        #     Stock      Buy      Now  % Change  £ Change

19/12/97   1565  Rentokil     2.55     3.50   37.3%      0.95
19/12/97   1565  Rentokil  4040.63  5477.50   35.6%   1436.87


                    Week          Year          History

Qualiport           5.1%         32.6%            35.6%
FTSE 100            1.1%         16.2%            18.9%
FTSE All Share      1.3%         16.0%            18.4%