QUALIPORT
Producing A Return On Capital

By Maynard Paton (TMFMayn)
April 10, 2003

Apart from a suspect boardroom, Capital Radio (LSE: CAP) has all the hallmarks of a quality company. It's a market leader in a sector renowned for great accounts, high visibility and decent competitive moats. While the management appears to have overpaid for recent acquisitions, Capital's attractive industry position could appeal to large, foreign rival. The company joins the Qualiport watch list with immediate effect.

Background

Formed in 1973 and floated in 1987, Capital Radio is the country' s largest commercial radio broadcaster. As explained here, radio is a great sector for buy and hold investors. Competition is restricted in two ways: 1) broadcasters require a license, of which numbers are limited, and; 2) new licenses involve 'broadening listener choice', which limits copycat rivals. All in all, it's good news for the incumbent, mainstream players such as Capital. Read more.

Although starting out life in London, Capital has gradually bought its way into other areas of England, notably through the purchase of Midlands Radio in 1993 and Southern Radio in 1994. Turnover growth has also been aided by the increasing popularity of radio among advertisers. Radio's share of total UK advertising has doubled to over 6% during the past ten years and the industry predicts an 8% share by 2010.

Capital 95.8 FM is the leading commercial radio station in London, with a near 9% market share and around 3m listeners. Other leading commercial stations in the Capital stable include 96.5 BRMB (Birmingham, 11.5% market share), FOX FM (Oxfordshire, 16.1%), Invicta FM (Kent, 16.5%), 103.2 Power FM (Hampshire, 11.1%), Southern FM (Sussex, 16.8%) and Red Dragon FM (South Wales, 15.5%). Figures from RAJAR can keep investors up to date with the ratings and competition. At the moment, Capital has around 8m listeners in total and a corporate target of 10m.

Five-year review

The table below shows Capital's five-year performance:

Year to Sept 30th         1998    1999    2000    2001    2002

Turnover (£m)            120.7   125.4   134.9   134.6   120.0
Operating profit (£m)     35.8    36.8    41.4    32.7    27.9
Exceptional items (£m)    (0.7)   (2.6)   (1.7)    7.5    (3.6)
Pre-tax profit (£m)       35.6    33.5    39.6    40.5    24.4

Earnings per share*(p)    35.0    34.3    39.3    26.3    23.6
Dividend per share (p)    15.3    16.7    18.5    18.5    18.5

(* adjusted for exceptional items and goodwill)

With plenty of now discontinued non-radio interests to account for, Capital's financial record is not the easiest to interpret. The company made a disastrous foray into restaurants in the mid-1990s (under a previous management regime), from which it has only recently extricated itself. In 2000, Capital bought Border Television and operated an ITV franchise for a year before selling it on to Granada (LSE: GAA). 

The next table strips out all the discontinued businesses and shows how the group's analogue radio stations (by far the major contributor to profits) have performed:

Year to Sept 30th         1998    1999    2000    2001    2002

Turnover (£m)             93.0   105.2   123.9   122.2   118.8
Pre-tax profit (£m)       35.6    39.7    45.4    36.5    33.3

Acquisitions such as Cardiff Broadcasting (£18m), XFM (£11m), Century Radio (via Border Television, a net £109m) and Beat 106 (£24m) have helped radio revenues improve over the past few years. However, similar to the media industry as a whole, Capital has suffered from declining advertising sales over the past two years. Nevertheless, analogue operating margins for fiscal 2002 were a very healthy 28%, albeit down from the 37% peak registered two years prior.

Cash flow and balance sheet

In keeping with most radio companies, Capital has a great cash flow profile:

Year to Sept 30th         1998    1999    2000    2001    2002

Operating profit (£m)     35.8    36.8    41.4    32.7    27.9

Change in working
         capital (£m)      0.3     3.4    (0.4)   (0.2)    1.3

Depreciation (£m)          4.1     4.4     4.4     5.0     4.3
Net capital
     expenditure (£m)    (6.7)    (5.1)   (5.6)   (3.8)   (2.1)

There are no problems in the working capital department; over the past five years, Capital has generated a net cash inflow. In addition, expenditure on tangible fixed assets has run just 5% ahead of the depreciation charge since 1998. Capital's reliance on precious intangible assets is emphasised by the fact that operating profits of £28m in 2002 were generated from tangible assets of only £17m.

Capital does not have burdensome debts. At September 2002, net borrowings of £29m were recorded. Interest payments were covered a comfortable 15 times in the last financial year.

Gauging Capital's incremental return on equity performance is fraught with difficulty. For starters, 2002 'adjusted' earnings were lower than those recorded in 1998, which leaves the Qualiport's traditional five-year calculation redundant. On a ten-year basis though, the incremental return comes to an estimated 11-12%, though with all the corporate activity over that time, that calculation has plenty of scope for error.

Under-performing slugs of goodwill don't help. For instance, the £109m spent on Century Radio valued the loss-making regional station on a price to sales ratio of 10. It's unclear how profitable (or not) Century is at the moment, but it'll undoubtedly take Capital a fair few years before it ever sees a worthwhile return.

Still, the accounts show an asset-light business and, with a revival in the radio advertising market, Capital should be able to produce attractive reinvestment returns in the future. During the go-go years of the 1990s, Capital was recording incremental returns in the 30% bracket.

On the FRS 17 pension front, Capital revealed a shortfall of £4m at the September 2002 year-end. With underlying earnings of £20m, the deficit is not a major problem.

Valuation and summary

Good business, shame about the management. That summarises Capital Radio and, it has to be said, numerous other media groups. Chunky investments made around the peak of the economic cycle won't have pleased long-standing Capital shareholders, but for prospective investors like the Qualiport, it's the future that counts.

At the moment, the acquisitive nature of the radio industry is a double-edged sword. With the forthcoming Communications Bill set to relax media ownership rules, Capital could embark on another round of consolidation with all the inherent risks that entails. On the other hand, Capital itself could be on the end of a bid. Clear Channel Communications (NYSE: CCU), for instance, is one of many US firms touted as a possible predator. Currently valued at £350m, Capital would certainly make a digestible purchase. In general, the risks for and against tend to balance each other out.

Whatever happens, there's no denying Capital has an enticing competitive position backed up by regulatory hurdles, coupled with some appealing accounts. At 415p, Capital shares offer a historic free cash flow yield of 5.7% if reported earnings are taken as a genuine proxy for free cash. Demanding a 7.5% free cash flow yield would require a 313p share price.

More: Why Radio Is Great For Buy and Hold | Capital Radio discussion board