QUALIPORT
Capital Radio's Value Mystery

By Maynard Paton (TMFMayn)
December 1, 2003

Watch list favourite Capital Radio (LSE: CAP) is a company with a valuation mystery. During the last few years and the worst bear market for a generation, the radio broadcaster's shares have never traded on a price to earnings (P/E) ratio below 18.

Sure, Capital remains a leading player in a great sector, with good cash flow, no massive debts nor any pension problems. However, dodgy acquisitions and falling profits should surely have produced some real share price gloom. Perhaps the market has been looking beyond simple valuation measures.

History

As noted here, Capital has a bit of a convoluted history, what with its disastrous foray into restaurants and top-of-the-market purchase of Border Television. Following some disposals, Capital has thankfully returned to operating as a pure radio group, but the corporate action has made the financial past a little academic:

Year to September 30th    1999    2000    2001    2002    2003

Turnover (£m)            125.4   134.9   134.6   120.0   115.3
Operating profit (£m)     36.8    41.4    32.7    27.9    22.0
Exceptional items (£m)    (2.6)   (1.7)    7.5    (3.6)      -
Pre-tax profit (£m)       33.5    39.6    40.5    24.4    22.6

Earnings per share*(p)    34.3    39.3    26.3    23.6    19.3
Dividend per share (p)    16.7    18.5    18.5    18.5    18.5

Last month's full-year results revealed lower sales and profits at Capital. In what was a 'difficult' and 'challenging' advertising environment, turnover at Capital's core analogue radio operation fell 4% to £115m, while operating profits tumbled 16% to £26m. The group's fledgling digital business recorded revenues of £691,000 and a £4m loss.

One reason for Capital's deteriorating performance was highlighted in the third-quarter update from RAJAR. The research body's figures reported Capital's 95.8 FM losing its title as London's most popular commercial station to Heart 106.2, owned by Chrysalis (LSE: CHS).

Market share for 95.8 FM in the quarter dived from nearly 9% to 7%, while Heart edged up to 7.2%. Trials of new presenters to replace Chris Tarrant were blamed, though Capital has since confirmed Johnny Vaughan is to host the station's flagship breakfast show from Spring 2004.

Cash flow and balance sheet

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

Year to September 30th    1999    2000    2001    2002    2003

Operating profit (£m)     36.8    41.4    32.7    27.9    22.0
Change in working
         capital (£m)      3.4    (0.4)   (0.2)    1.7     1.8
Depreciation (£m)          4.4     4.4     5.0     4.3     3.0
Net capital
     expenditure (£m)     (5.1)   (5.6)   (3.8)   (2.1)   (3.4)

Over the past five years, Capital has generated a net cash inflow of working capital, while expenditure on tangible fixed assets has on average run below the depreciation charge -- fantastic stuff. The accounts clearly show an asset-light business, which support the prospect of attractive reinvestment returns in the future. Other balance sheet highlights include £28m net debt (interest payments were covered a very comfortable 14 times) and a minor FRS17 pension shortfall of £4m.

Valuation

Now to Capital's valuation mystery. Using the latest figures, Capital's 477p shares sit on a price to earnings ratio of 25 and offer a dividend yield of 3.8%. And adjusting for the share dilution relating to the forthcoming purchase of Choice FM, 16.6p per share of free cash gives a 3.5% free cash yield. Going on all these simple measures, the shares are not obviously cheap. While the forthcoming relaxation of media ownership rules could prompt an aggressive bid, how can shareholders sensibly justify buying at present levels?

Perhaps investors should consider a 'sum of the parts' calculation and separate Capital's main analogue radio business from the embryonic digital radio operations? As noted earlier, the group accounts are presently hampered by digital losses, but these should reduce over time.

Stripping out the £4m digital deficit gives analogue free cash flow per share of 20.1p for the year to September 2003. Demanding a 7.5% free cash flow yield for the analogue business would deem it to be worth 267p. To buy in at today's 477p on the 'sum of the parts' then, the loss-making digital business would have to be worth more than £175m (210p per share). At the moment, many would argue the digital subsidiary carries a negative value.

Then there's the 'recovery valuation' approach. With Capital's strong industry position, proven ability to ride out downturns and talk of an 8% advertising uplift during October, it's fair to say Capital's rating has some sort of revival priced in. Shareholders may therefore have to judge Capital on a recovery basis.

For instance, if 2008 sees Capital...

* Equalling its 2000 peak analogue operating profit of £45m, which produces earnings per share of 35.6p;
* Ensuring its digital division has broken even;
* Trading on a P/E of 20, and;
* Having maintained dividend payments at 18.5p per share.

... then investors could see Capital's shares standing at 712p five years out, having accumulated 92.5p of dividends in the meantime. The total return would be 327.5p per share (712p + 92.5p - 477p), or 11% per annum.

Requiring a greater margin of safety for the inherent risks of projecting such a rebound, say a 15% annual return, needs an entry price of 400p. That buy price is a lot nearer to today's value, suggesting it's the prospect of this type of revival that has supported Capital's apparent high rating.

More:  Why Radio Is Great To Buy And Hold | Background On Capital Radio | How To Value Shares Set For Recovery