QUALIPORT
Eyeing Up ITV

By Maynard Paton (TMFMayn)
June 4, 2001

Rochester, Kent – The media sector is a popular hunting ground for long-term investors in quality companies. Although their organic growth isn't spectacular, the dominance of many media businesses in their particular markets still makes them attractive investments. Having few competitors creates a relatively sustainable competitive advantage and operational predictability. High margins and little capital expenditure are also all typical features of a decent media firm. Such welcome shareholder characteristics can found in Emap (LSE: EMA), Capital Radio (LSE: CAP) and Metal Bulletin (LSE: MTLB), three media companies the Qualiport has recently reviewed.

But one area of the media sector not touched upon by the Qualiport is television. There are five listed companies that allow investors to gain an interest in this field.

Company                      Market Value         Share Price        

British Sky Broadcasting       £13,393m              716.5p
Granada                         £4,706m              170p
Carlton Communications          £2,603m              387.5p
SMG                               £668m              213p
Ulster Television                 £138m              263p

(Just for the record, Capital Radio currently owns the Border Television ITV franchise, although it is due to be sold to Granada (LSE: GAA) within the next three years.)

One of five

Of the five, one company presently stands out: Ulster Television (LSE: UTV). In my opinion, the ITV franchise holder for Northern Ireland is the best of the bunch on the following grounds:

* A lack of any substantial digital investment. British Sky Broadcasting (LSE: BSY) and ONDigital (owned 50:50 by Granada and Carlton Communications (LSE: CCM)) are both shelling out millions to establish digital television gateways, expenditure that will hinder medium-term profits. That said, while Ulster is excused this expense, it will no doubt have to pay one of the digital gatekeepers for broadcasting access when the government finally switches off the analogue spectrum.

* A lack of debt. Unlike most other media companies, Ulster is virtually debt-free. SMG (LSE: SMG), for instance, after its recent acquisition spree, is on course for interest cover of just 4 times during a "challenging" 2001. Indeed, Ulster is noticeably unusual among its acquisitive counterparts by historically returning excess cash to shareholders by way of special dividends.

* The current valuation. Ulster is the only broadcaster on a prospective price to earnings (P/E) ratio of well under 20. Although SMG's forward P/E is 21, the others are well above anything that could be described as reasonable.

* A takeover possibility: Acquisitions are part and parcel of the media sector. Being the smallest, and perhaps the most focused, of ITV franchise operators should make Ulster a likely takeover target. Slightly speculative of course, but investors can't help but to have noticed the ongoing consolidation of ITV and the overall media sector over the years.

Ulster's financials

Year ending 31st December        1996    1997    1998    1999    2000 

Turnover (£m)                    34.5    34.8    37.2    38.3    40.8
Operating profit (£m)             6.9     7.3     8.2    11.8    13.3
Pre-tax profit (£m)               8.1     8.2    10.0    12.6    14.0
Earnings per share (p)           10.1    10.7    12.8    17.0    18.9
Dividend per share (p)            5.1     5.7     6.3     7.5     8.7

Ulster's turnover is virtually all generated from the sale of advertising. Its share of ITV's total advertising revenues has hovered around the 2% mark for the past five years. As could be expected with the advent of new channels, ITV's share of the total television advertising market has been in steady decline. ITV had 59.5% of the £3.3b television advertising spend during 2000, compared to the 69% of the £2.4b spend from five years ago. Overall, Ulster has matched ITV's average compound growth rate of 4% per year since 1996.

While Ulster's top line growth has been steady, if unspectacular, shareholder returns have been driven by margin improvements. Television operating costs have fallen from the £27.5m recorded in 1996 to £25.7m seen in 2000. Operating margins have thus improved from 19.9% to 32.6% over the last five years.

Ulster has provided shareholders with a very attractive incremental return on equity performance. Earnings have increased from the £6.0m achieved in 1996 to the £9.6m of 2000, while shareholders' funds have increased from £13.7m to £19.4m over the same period. The resulting incremental return on equity calculation is a fantastic 63% ((£9.6m – £6.0m)/(£19.4m – 13.7m)). This great accomplishment is undoubtedly helped by a recent special dividend. Excess cash of £18m was returned to shareholders during 1999.

Valuation and Summary

Ulster is an appealing business. Although its market share has been steadily declining, it still attracts, on average, 33% of all Northern Ireland viewers. Over the past ten years, Ulster has consistently been one of the best (if not the best) ITV franchises in terms of local market share. On the face of it, the company has only four direct competitors -- Channels 4 and 5, Sky and to a certain extent, TV3 of the Irish Republic. Of course, the competition will continue to reduce Ulster's monopolistic traits. However, I'd still currently class Ulster, and the other ITV companies for that matter, as "media franchises".

Having said that, there are two clouds beginning to emerge at Ulster.

The first is the current downturn in television advertising. The company's recent AGM statement commented upon an expected 6% fall in advertising revenues for the first half of this year. Coming after last year's dotcom advertising boom, the downturn is not entirely unexpected. But the decline shouldn't extend into the second half of 2001, given that the comparable period of 2000 had already suffered a substantial drop off in dotcom advertising.

However, a much darker cloud is the sudden emergence of corporate activity at Ulster. Previously a company happy sticking to its television knitting, last year saw the £4m acquisition of an ISP, while earlier this year, the 60% purchase of a Cork radio station was made. Worryingly, the £14m used to make the radio investment had been previously earmarked as a special dividend. Unsurprisingly, all the activity began just a few months after the appointment of a new managing director. Needless to say, a new MD trying to prove himself has to be watched carefully!

In terms of valuation, I've estimated free cash flow per share for 2001 to be 17.8p. For the record, the following assumptions were used:

• Television revenues decline by 6% in the first half and remain flat in the second;
• Television costs remain at 2000 levels;
• Internet-related losses reduce from £0.8m to £0.5m, and;
• Radio contributes £1.1m of operating profit.

At 263p, Ulster shares therefore offer a prospective free cash flow yield of 6.8%. 

Overall, Ulster is a solid business for the long term, albeit one suffering from the inevitable increase in competition. However, the company should be able to continue to generate superior returns on shareholders' equity for some time yet.

The main quandary for prospective shareholders is the unproven MD, and his almost immediate move into radio and the Internet. Such activity adds all the investment risks of acquisitions into the equation. An investment in Ulster is all about weighing up the management question marks with a business fundamentally attractive enough for the Qualiport.

More: Ulster discussion board