QUALIPORT
Capital Radio: Time to Tune In?

By Maynard Paton (TMFMayn)
March 26, 2001

Carburton Street, London -- On Thursday, Capital Radio (LSE: CAP) warned that profits for its full year could be at least 10% lower than that achieved in the previous twelve months. Although analysts had been expecting a forthcoming earnings dip, the scale of the possible downturn took shareholders by surprise. Capital's shares plunged 24% on the day. 

There are three reasons why this news has tweaked the interest of the Qualiport.

* Capital's business, commercial radio broadcasting, has traditionally generated above average long-term returns to shareholders. Capital's "underlying" operating margin of 40%-plus suggests a media franchise.

* Capital is a direct competitor of Emap's (LSE: EMA) local radio business. It's always worthwhile to keep tabs on your portfolio rivals, and to strengthen your circle of competence.

* The sharp markdown in Capital's shares may have left a bargain.

Business

Capital is the country's largest quoted commercial radio operator. As well as its successful London station, the company holds a whole raft of other regional licences. Most cover major metropolitan areas, such as Manchester, Glasgow, Cardiff and Birmingham.

For an established mainstream player like Capital, radio is a great business to be in. Firstly, any potential competitor needs a to get hold of one of a limited number of licences to broadcast. Secondly, additional licences tend to be given to minority stations with niche audiences. And thirdly, there's little in the way of ongoing capital expenditure to maintain your station. It's all good news for Capital's shareholders, as growing advertising revenues increasingly fall to the bottom line.

Financials

Unfortunately, while the business of radio is simple to grasp, Capital's finances are not. A disastrous diversification into restaurants during 1996 has plagued Capital's accounts ever since. Here's the group's full five-year record.

(to September 30th)        1996   1997   1998   1999   2000

Turnover (£m)              77.8  113.6  120.6  125.4  134.9    
Operating Profit (£m)      30.6   36.9   26.4   17.1   32.8
Earnings per share (p)     29.4   32.1   19.0    5.7   26.3

...and here's the record excluding the (now disposed of) restaurant business, all exceptional items and the amortisation of goodwill. Or in other words, the "underlying" performance of the radio operation.

(to September 30th)        1996   1997   1998   1999   2000

Turnover (£m)              77.8   86.1   94.0  105.8  130.1
Operating Profit (£m)      27.9   31.0   34.8   38.4   41.4
Earnings per share (p)     29.4   30.7   33.0   35.2   39.3
Dividend per share (p)     12.5   13.8   15.3   16.7   18.5

Group radio revenues have increased 68% over the past five years. Although acquisitions have played a part, a buoyant advertising market has underpinned most of the growth. Internet aside, the past few years has seen radio become the fastest-growing medium for advertisers. Its advertising market has grown by 13% or more every year since 1997. Having said that, Capital's like-for-like sales growth has slightly, but consistently, undershot the market's growth over that time.

However, Capital's profit warning referred to a "slowdown in the UK advertising market" and the group stated that ongoing revenue growth this year could be just 2%. The slowdown coincides with Capital's expenditure on a national digital radio network and increased investment in "strategic marketing", hence the imminent profit decline. Nevertheless, Capital's history of 30-40% operating margins is very attractive.

Return on Equity

Trying to get a handle on Capital's incremental return on equity is very difficult. The £50m purchase of the restaurant company My Kinda Town in late 1996 quickly decimated Capital's balance sheet, with a flurry of exceptional write-offs and divisional losses occurring in subsequent years. Thankfully, the last of the "Capital Cafes" were sold off last year. After a quick look through the accounts, my best guess is that Capital lost the whole £50m purchase price (and probably more) through the misadventure.

Not only does the restaurant activities distort the balance sheet, the recent acquisition of Border Television and Beat 106, part way through the previous financial year, makes matters even more complex. And just to confuse things further, Capital is due to sell off Border's television interests to Granada (LSE: GAA) for £50m within the next three years!

Overall, any return on capital type calculation is fraught with problems. Writing back goodwill relating to the restaurant venture and annualising the performance from the latest acquisitions, my estimate for a five-year incremental return on equity figure is 10.7%. This is based on pre-exceptional earnings having risen from £21.5m to £31.0m between 1996 and 2000, and shareholders' funds (adjusted for goodwill) having swelled from £98.1m to £186.7m over the same time (( 31.0 - 21.5 ) / ( 186.7 - 98.1 ) = 10.7%). All in all, not an inspiring performance.

Indeed, there are two concerns with the Border deal. Firstly, after stripping out the television side, Capital paid £109m cash for £10m of annual sales for Border's profit-less radio stations. A very high price, especially if the radio advertising market continues its slowdown. And secondly, Capital is now saddled with net debt of £101m. Until Granada buys Border's television operation, Capital's interest cover will be a rather thin five times.

Valuation and summary

At 670p, Capital shares stand on a prospective price to earnings (P/E) ratio of 23.5, based on the two forecasts issued since the profit warning. The shares also offer a dividend yield of 3%. No obvious bargain, especially when you consider the prospect of falling profits and the cloudy financial history.

Although I like Capital's core business, I'm unimpressed with its acquisition history. While the restaurant business was an unmitigated disaster, there's also a whiff of desperation with the Border deal. After trumping the original bid from Scottish Radio (LSE: SRH), Capital has effectively paid ten times sales immediately prior to an industry slowdown. And the very fact that forthcoming Capital profits are expected to fall, even though the full contribution of Border is still to come, speaks volumes. At the present valuation, the signs are ominous for current Capital shareholders.

All things being equal, I'd begin to contemplate Capital for Qualiport status if the shares fell to the 400p, a level that would result in a forward p/e of 17 and a dividend yield of 5%. But even then, I'm not entirely sure whether that price would adequately cover the risks of the management team, who seem hell bent on diluting a fundamentally great business with poor acquisition decisions.

More: Media Mayhem (Comment, 22nd March)