Qualiport

The Qualiport buys a media company. But which one?

Having started with a universe of 121 media companies, we have whittled them down to just two meaningful Qualiport candidates -- Capital Radio and EMAP.

I'm now officially discarding Reuters, primarily because of the uncertainties surrounding their future direction and therefore their future growth rate. This media giant is one of the best brand names in the world, and the decision to ditch them because of my short term concerns may prove to be wrong. They have been a hugely successful company, and probably will continue to be so. But, my fears are enough to feel comfortable in discarding Reuters from Qualiport contention.

You only have to look at the impact that this medium, the Internet, has and could have on a company like Reuters. No longer can companies charge huge premiums for information that is readily available and can be obtained from various different sources. In Reuters' recently published results, they go so far as to identify the Internet as a potential threat to their underlying business. "[The Internet] may increase the availability of commoditised data in cheaper forms and the loss of control over intellectual property. As a new publishing medium, it will also create new outlets for content providers."

The banking sector is in the midst of a huge consolidation phase. This week's mega merger between Citicorp and Travelers Group could intensify corporate activity in the sector even further. One of the main reasons that companies merge, especially banks, is the huge cost cutting potential. This is particularly attractive to the merchant banks, where dealing rooms are shrinking, and a Reuters screen at two banks becomes just one machine in the combined entity. In short, Reuters' customer base is shrinking, and therefore so is their potential revenue base.

A question mark hangs over the management of Reuters. Although you can't argue with their excellent past growth record, because of their size and increased competition, they are now starting to struggle. The grand jury investigation regarding the alleged theft of intellectual property from Bloomberg, whilst denied, could be a sign of desperation at Reuters. The Bloomberg threat is large, and in the City more and more financial institutions are switching to using Bloomberg screens. The switch back the other direction, from Bloomberg to Reuters, is far less common.

So there it is. Bye bye, Reuters. We wish you well, but you won't have our money riding on you. The risks are too great and the future uncertain. The company is fully valued, and with their share price at 650p, are trading at a trailing P/E of 22. If Reuters were trading at a P/E of around 15 (share price 437p), they might be worth considering on valuation. But they're not, so we won't.

Fool Buy

We're plumping for EMAP as our preferred media sector stock. In accordance with the Fool's buying policy, over the next 5 working days (that's between tomorrow Thursday 9th April and next Friday 17th April) we will buy £4,000 worth of EMAP shares. I'll use this opportunity to remind you that this is a real money portfolio. The Fools have been saving hard over these past few months and years, and we will be putting our own money on the line. I'll also remind you that this is the decision of one Fool, and you should not go out and buy shares in EMAP just because we have. I've done my homework, crunched the numbers, learnt as much as I can about the company, and feel comfortable about becoming a part owner in the business. You should do the same before contemplating a purchase of EMAP or any other company.

The Buy Report

EMAP has been listed on the London Stock Exchange since 1947 and was formerly known as East Midlands Allied Press. It started life as a regional newspaper company but has gradually re-engineered itself into an international media business. The last of the low growth, cyclical newspaper businesses went in 1996. They now have five main business divisions: Consumer Magazines UK, Consumer Magazines France, Business Communications, Radio and the small but growing New Technology, New Territory. For a closer look at each entity, here's a link back to the original article.

The thing that impresses me the most about EMAP is the quality of their management. Reading through their annual report, you get the impression that this is a well managed company. I know annual reports have to be read with some caution, as companies can sometimes go over the top in their praise for themselves. However, EMAP also use the opportunity to be realistic about their future prospects. For example the 1997 Interim Report says, "The unique situation of rising revenues and lower raw materials prices cannot, of course, be sustained. The growth in the UK economy will surely start to slow down next year and we must expect, because demand in continental Europe is increasing, that paper prices will harden." This is realism and I much prefer this than unbridled enthusiasm when reading an annual report. Virtually every year, Warren Buffett warns investors in his company not to expect future returns to match those of the past, but they do. Microsoft is continually attempting to lower profit expectations, but continues to beat them anyway. Whilst EMAP are plainly not in the same league as the those companies, who's to say the management may not be?

For me, another sign of a quality company is one that is constantly increasing its profit margins. The advantages of this are twofold. The first and more obvious advantage is that it increases profitability. Sales growth of zero can translate into profit growth by a company increasing its profit margins. The second advantage is more intangible, but will benefit the company in the longer term. A high profit margin usually is a reasonable indicator of a company with a competitive advantage. In that position, the company with the best, most respected product has a lot more flexibility when it comes to pricing and cost control. They call the shots, and it is hard for competitors to break into their markets. Again, Microsoft is the classic example of a company with huge pricing power -- its only real competitor is itself.

We're not buying Microsoft here. We're buying EMAP, and they haven't got the huge protective moat around them to stop competitors encroaching onto their patch. They do, however, have various products that are market leaders. Take FHM, the glossy men's magazine, which has the highest circulation of any monthly magazine in the country. Radio stations are high margin businesses because of the huge barriers to entry. A competitor cannot just decide to start up another Melody FM -- first, there must be a license awarded by the Radio Authority, and even then it is highly unlikely that the RA would allow someone to offer a format similar to one that already exists.

EMAP's operating margin at the Interim Report stage was 17.0%. Their publicly stated objective aim is to increase this to 20% by the year 2000, earlier if possible. That's 17.6% growth in the next 2 years from margins alone. Any significant sales growth will amplify the increase to profits.

Valuation

Let me start by saying that EMAP are not cheap. Many companies are not cheap in this market. However, we have decided that we want to be invested in the stock market, as over the test of time this has proven to be where the best returns are to be achieved. If we were to try and time the market, waiting for a correction or waiting for EMAP's share price to dip below a certain level, we may miss out on being invested in them altogether. We're happy that they are a quality company, and over the very long term we're hoping that this will stand them in good stead.

I do think valuation is important and is not something to be ignored. We are buying EMAP with the intention of holding them for a long time. If, over say a 10-year time period, it looks like we'd have been better to leave our money in the building society, the risk of buying highly valued equities is not worth the reward.

In the last few articles on EMAP, we've calculated some potential 10-year returns. Using the current earnings per share estimates for the year ended March 1998 and projecting them forward for 10 years, we get the following potential return:

Share price (8/4/98)          1150p
1998 EPS (forecast)           45.1p
Compound EPS growth           16%
2008 EPS                      199p
2008 P/E                      20
2008 Share price              3979.1p
10 Year growth                246%
Annualised compounded growth  13.2%

The 16% 10-year growth rate and the 2008 P/E of 20 are subjective and open to debate. However, this is a possible valuation, and a 13.2% annual compounding rate of return is attractive.

The return on equity (ROE) model of a week ago gave EMAP a 2008 market capitalisation of £4.9 billion. That, compared with the current market capitalisation of £2.35 billion, gave EMAP a 10-year compounding rate of return of only 7.6%. This is not much above some of the pre tax rates of return available in a building society, and therefore is a valuation model that implies a lot more risk.

The original ROE valuation was based on EMAP continuing to return 16.5% on equity for the next 10 years. This is equal to their average ROE for the year ended March 1997. This may be conservative. As EMAP were still in the process of moving away from commodity products to higher margin and branded offerings, their historical ROE is arguably low. If they succeed in increasing their margins, then their ROE should follow higher too. A sign of a good company is one that can increase its ROE -- EMAP has the potential to do this. Arguably, Capital Radio and Reuters do not have the same scope. Those two companies have been seeing ROE falling, whereas EMAP has been raising its ROE.

Using a three tier approach, where EMAP achieves a ROE of 16.5% for the next 3 years, then 18.5% for the next 3, followed by 20% for the last 4, this would give EMAP a potential market capitalisation of £6.58 billion and annualised compounding growth of 10.9% per annum.

The last method of valuation I will look at is the discounted cashflow. I won't go into all the details here, but I'm using the same model as that used by Robert Hagstrom in The Warren Buffett Way. Because EMAP is a highly cash generative business and requires few tangible assets to run the company, this is arguably the best way to value them.

The key assumptions I have used are 16% growth in owner's earnings (in the case of EMAP, I've assumed this is the same as net, after tax earnings. This assumption is appropriate for a mature business or one which has low capital expenditure) for the next 3 years, then 12% per annum for the next 7. The discount factor is 10%, the post 2008 growth rate 5% and, therefore, the capitalisation rate of 5%. Don't worry if all this is gobbledy gook -- I'll explain in more depth in the future. The model, based on those assumptions, awards EMAP an intrinsic value of £3.2 billion, a 36% discount to their current market capitalisation. This is the sort of margin of error we should be looking for.

This sort of valuation analysis is interesting, and throws up quite different results. The thing to remember about all these calculations is that you can use assumptions that make the figures say anything you want them to. I have tried to be realistic in my assumptions, whilst realising that some natural bias must have come into it. We have possible 10-year returns of 7.6%, 13.2% and on a cashflow calculation they could be trading at a 36% discount to their intrinsic 10-year value.

I've ignored all dividend calculations in working out potential valuations. The dividend yield is quite low at about 1%, but better than nothing. We're primarily after capital growth here, hence the dividend has been ignored.

Risks

EMAP trade at a 1998 forecast P/E of 25.5. Whilst they have historically traded a premium to the market, this is a high multiple. They are in the publishing business, parts of which are highly competitive. As the company themselves pointed out in their Interim Report, paper prices are at a low point and the economy is buoyant. These market conditions may not be sustainable.

Traditionally, publishing has been seen as a cyclical business. When things are going well, so are publishing companies. Advertisers will advertise, consumers will buy the magazines, and readership will grow. When things are not going so well, consumers are likely to sacrifice luxury items such as their monthly edition of FHM. EMAP are concentrating on building up their brands in the hope that quality and brand leadership will help see them through the bad times. However, on the down side, the reading public can be fickle, and leading publishing titles can easily become also rans if editorial quality is not maintained and continually improved.

A large proportion of EMAP's magazine interests are in France. The economy there, in tune with much of mainland Europe, continues to be depressed. The strength of sterling will weigh on this division's results. The introduction of the Euro will doubtless cause more short-term uncertainty.

Finally

EMAP have the happy knack of beating consensus earnings estimates. In August 1996, they were expected to earn 35.5p per share in fiscal 1997. They achieved 38.9p, beating estimates by 9.6%. I'd obviously like to see 45.1p beaten when EMAP report at the end of May. If they fell short of this estimate, the share price could be in for a real bath. The City doesn't like companies that miss estimates, particularly those that have highly valued shares.

EMAP is a different beast to Rentokil. It hasn't got the great past record of RTO, but then no company has. But, on the upside and unlike Rentokil, EMAP has the ability to surprise. A big acquisition, a move into branded TV, or the rapid recovery of the French market could spark further unforeseen growth. This is where strong management is required, something I believe EMAP possesses.

So there it is. Welcome EMAP to our already market beating Qualiport. Just to reiterate again, this is our decision with our money. Do not go and buy EMAP just because we're going to. We can see the upside, but more importantly know the risks and the potential downside. The shares have risen by about 50% in the last year, so could fall by that amount too. Although it would be ugly, we can live with that prospect. With Rentokil and now EMAP, we believe we are in the process of building a diversified portfolio which, over time, will hopefully be market beating.

Next Week

The hunt for more quality shares to add to the Qualiport continues. However, next Wednesday will be a time to reflect on what we've learnt about share selection from our study of the media sector. Also, I'll have a closer look as to why we didn't choose Capital Radio.

All comments and suggestions, as usual, to the message boards.

Keep Fooling.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

This Week's Numbers          Week Ending 08/04/98

          Change     Bid
          pence       £

RTO        0.05     4.00


Rec'd        #     Stock      Buy      Now  % Change  £ Change

19/12/97   1565  Rentokil     2.55     4.00   56.9%      1.45
19/12/97   1565  Rentokil  4040.63  6260.00   54.9%   2219.37


                    Day        Week       Year      History

Qualiport           1.3%       3.6%       51.5%      54.9%
FTSE 100           -0.6%      -0.1%       17.9%      20.6%