Tag Archives: Philippines

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

A. Soriano Corporation Shareholder Structure Correction 2/24/2017

There was an error in the shareholder structure table in Anscor initiation.  The total outstanding shares was incorrect.  The corrected table is below.  We also corrected the table in the initial post.

A. Soriano Corporation 2/23/17

A. Soriano Corporation

Bloomberg Ticker:                              ANS:PM

Closing Price (2/23/17):          PHP6.34

6 Month Avg. Daily Vol. (USD mn):    0.017

Market Cap (USD mn):           156

Estimated Annualized Return:            18.0%

February 23, 2017

 

A_Soriano_Corp_Feb_23_2017_Final

 

INVESTMENT THESIS

A. Soriano Corporation (Anscor) is a Filipino investment holding company with investments in many different industries. The company has a healthy balance sheet and consistently generates a return on equity around its discount rate. Despite the healthy balance sheet and the consistency of the company’s ROE, Anscor trades well below its book value currently at 0.56 times book and at 5.46 times cyclically adjusted earnings. There is significant upside to the company’s earnings valuation (110% upside) and asset valuation (77% upside). We are taking a 2.0% starting position as the stock is very illiquid.

 

 

COMPANY DESCRIPTION

 

Anscor was incorporated on February 13, 1930. It is an investment holding company located in the Philippines. Anscor’s largest investments are Phelps Dodge International Philippines, Inc. and Seven Seas Resorts and Leisure, Inc. Other investments include Cirrus Medical Staffing, KSA Realty, Prople Limited, and Enderun College among others.

 

 

Phelps Dodge International Philippines

 

Phelps Dodge International Philippines, Inc. (PDIPI) was incorporated in 1955 and started production in 1957. Its products are primarily copper-based wires and cables including building wires, telecommunication cables, power cables, automotive wires and magnet wires. PDIPI has a technical assistance contract with General Cable Company (GCC), the second largest cable company in the world. GCC was also a shareholder in PDIPI until December 2014 when Anscor acquired GCC’s 60% shareholding for PHP3.0 billion. The Philippine wire and cable industry is comprised of both imported and domestically manufactured products. The four largest manufacturers are Phelps Dodge, American Wire and Cable Co., Inc., Columbia Wire and Cable Corp., and Philflex Cable Corp.

 

Over the past three years, PDIPI’s average return on assets of 16% is well above its discount rate pointing to potential barriers to entry within the industry. Despite the strong returns, the industry is fragmented. There are no supply side barriers to entry as copper cables are a relatively simple product to manufacture and there is no favorable access to raw materials as raw materials are commodities that can be purchased from many suppliers. There are no demand side barriers to entry as purchasing copper cables does not create habit and there are no switching costs, search costs, or network effects.  There may be some economies of scale but with gross margin at only 14%, it seems the cost structure of the business is primarily variable eliminating any real barriers to entry from economies of scale.

 

 

Seven Seas Resorts and Leisure

 

Seven Seas Resorts and Leisure, Inc. (SSRL) was incorporated on August 28, to plan, develop, operate and promote Pamalican Island as a world-class resort. The resort is named Amanpulo and started commercial operations on January 1, 1994. SSRL inventory is 103 rooms with 40 original casitas and 63 rooms in villas. SSRL is a joint venture between Anscor, Palawan Holdings, Inc., and Aboitiz & Co with Anscor owning 62% of the resort.

 

The resort’s services are offered through the worldwide Amanresort marketing group based in Singapore, accredited travel agents, reservation sources/systems, and direct selling. Amanpulo is in competition with all other small 5 star resort companies in other destinations that are generally better known than the Philippines, such as Indonesia, Thailand, and Malaysia.

 

According to reviews on Tripadvisors.com, 90% of Amanpulo’s reviews were excellent, the highest rating. It is rated as the #1 hotel in Palawan Province.

 

Until 2015, SSRL failed to earn a reasonable return on assets. The company also failed to generate any meaningful growth with revenue increasing from PHP517 million in 2011 to PHP645 million in 2016. Similar to PDIPI, there does not seem to be any barriers to entry. There are thousands of luxury resorts around the world illustrating the lack of barriers to entry within the industry. There are no supply side advantages in owning a luxury resort. There are no demand side advantages. If there are economies of scale within the industry, SSRL is a smaller resort, which would be disadvantaged.

 

 

Cirrus Medical Staffing, Inc.

 

Cirrus Medical Staffing (Cirrus) is a US-based nurse and physical therapist staffing business. It places registered nurses on contracts of twelve weeks or longer. In January 2008, Anscor acquired Cirrus. Cirrus has a preferred vendor relationship with the US’s largest home health company. Anscor owns 94% of Cirrus.

 

Similar to SSRL, Cirrus did not generate an acceptable on assets until 2015. Unlike SSRL, Cirrus has been growing its business at a rapid pace. Since 2011, service income growing by 16.7% per annum, gross profit grew by 21.3% per year, and EBITDA grew by 90% per year.

 

The nurse and physical staffing business is very fragmented and there are no supply side advantages. Potentially, there are demand side advantages in the form of switching costs. When using a staffing agency for a large number of employees as long as the staffing agent is doing a good job, the client should continue to use the agent and the agent has a bit of pricing power due to the cost of switching providers. The client can easily offset the staffing agent’s bargaining power by using multiple providers. For small clients, it seems like the potential for a demand side advantage is much smaller as it is easier to find the necessary supply of labor.  Economies of scale do not exist in the industry.

 

 

KSA Realty Corporation

 

Anscor exchanged its old building located at acquired a 11.42% stake in KSA Realty Corporation (KSA) 1990 in exchange for Paseo de Roxas in Makati. KSA develop The Enterprise Center, a two tower, grade A office building located in Makati.

 

In 2015, KSA had an occupancy rate of 96%, generating PHP992 million in revenue, and PHP1,300 million in net income including a PHP517 million revaluation gain. Despite a decrease in the occupancy rate from 2013, KSA was able to increase revenue by 20% over the past two years. KSA’s assets have been revalued twice in the past three years. There are no competitive advantages in the property business.

 

 

Enderun Colleges, Inc.

 

In October 2008, Anscor acquired 20% equity stake in Enderun Colleges, Inc. Enderun was established in 2005 by a group of business leaders, including senior executives from Hyatt Corporation in the U.S., Enderun offers a full range of bachelor’s degree and non-degree courses in hospitality management, culinary arts, and business. Enderun has close to 1,200 full time and certificate students spread almost evenly across the school’s three main degree offerings.

 

Enderun recently launched Enderun Extension, a continuing education unit that is the college’s language training and tutorial business. In 2014, Enderun launched a hotel and management consultancy unit. Several hotels and resorts are under Enderun’s management.

 

Management expects Enderun to deliver double-digit growth in the coming years.

 

Within education, there is a brand advantage at the very elite schools but Enderun does not have that advantages.

 

 

Prople Limited

 

In December 2007, Anscor acquired 20% of Prople for US$800,000. In November 2013 acquired 100% of the non-audit business of US-based Kellogg and Andelson Accountancy Corporation (K&A). Founded in 1939, K&A is a well- established accounting firm that provides tax, general accounting, and consulting services to thousands of small to medium sized companies in California and the Midwest. It operates out of five locations in Los Angeles, Woodland Hills, San Diego, Kansas City and Chennai (India). Following its acquisition of K&A, Prople now employs 373 people serving over 5,500 clients from operations located in six cities worldwide. In 2015, Prople closed K&A’s San Diego office and client attrition in the Midwest. Prior to the acquisition of K&A, Prople’s services included business process outsourcing, knowledge process outsourcing, and content services. K&A tripled the company’s revenue.

 

With the acquisition of K&A, Prople is primarily a tax, accounting, and consulting provider. Professional services, like tax and accounting, have some switching costs as the provider is embedded in the company’s operations becoming an integral part of the team. Despite the switching costs, the industry is fragmented and bargaining power of the provider can be decreased by using multiple suppliers.

 

 

AGP International Holdings Ltd.

 

AGP International (AG&P) is Southeast Asia’s leading modular fabricator of refinery and petrochemical plants, power plants, liquid natural gas facilities, mining processing, offshore platforms, and other infrastructure. AG&P has 110 years of experience serving clients like British Petroleum, Shell and Total.

 

Anscor made its first investment in AG&P in December 2011. In June 2013, Anscor subscribed to 83.9 million series C, voting preferred shares in AG&P. Series B and Series C preferred shares are convertible at the option of the holder, into class A common shares. The subscription increased Anscor’s holdings to 27%.

 

Similar to cable manufacturing there are no barriers to entry within the modular fabrication.

 

Anscor’s businesses do not appear to be competitively advantaged. The lack of barriers to entry makes industry analysis irrelevant.

 

Listed above is the company’s shareholder structure. 50.7% of the shares issued are held by a 100% owned subsidiary. Insiders own another 27.1% of shares issued, affiliates own 3.2% of shares issued, and the public own 19.0% of shares issued.

 

 

VALUATION

 

The lack of barriers to entry within Anscor’s businesses and the management team is deeply entrenched the company’s earnings power is the best method of measuring the company’s value as the earnings generated are likely to continue. Assuming average management and a lack of barriers to entry means the value of the company’s assets should be close to the company’s earnings valuation as excess returns are unlikely and cyclical adjusted earnings should be close to the company’s discount rate.

 

Given the company’s large investments in securities and associates, we use net income as the best measure of the company’s earnings and equity as the best measure of investment capital. Since 2010, Anscor has generated an average net income of PHP1,423 on an average tangible equity of PHP12,106 equating to a roughly 11.8% return on equity.

 

Given the lack of barriers to entry in Anscor’s businesses, growth does not create value and therefore is irrelevant; therefore, assuming a 10% discount rate Anscor should be trading at roughly 1.18 times tangible book value representing a 110% upside.

 

Anscor is trading on a cyclically adjusted PE of 5.46 times meaning in the absence of growth, the company’s expected annualized return in 18.3%.

 

Given the company’s ability to generate a consistent return on equity equal to the company’s discount rate, the reproduction value of the company’s assets should equal the company’s tangible book value. It is difficult to say a collection of assets are impaired if they generate a return equal to the discount rate.

 

Anscor’s fair value is between tangible book (77% upside) and 1.18 times tangible book (110% upside).

 

 

RISKS

 

A company with a dominant shareholder (A. Soriano III) brings potential corporate governance issues. Anscor only material related party transactions are key management remuneration, which averaged 8.8% of net income over the past five years. Key management remuneration is a little high but the absence of any other related party transactions and the cheap valuations means it can be overlooked.

 

Our goal with assessing macro risk is not to forecast the path of macroeconomic indicators but to eliminate risks from a poor macroeconomic position. Anscor’s business is primarily in the Philippines, a country that seems to be in very good financial health. In 2015, the country’s current account was 2.6% of GDP and its structural balance was 0.18% of GDP allowing the country to self-finance all the domestic initiatives as well as decrease the country’s debt load. The country does not have too much credit in the system with domestic credit provided by the financial sector at 59.1% at the end of 2015, which is well below the Emerging Markets average of 97.5% and the High Income countries average of 205%. Gross government debt as a percentage of GDP stood just under 35% with External Debt to GDP at 36%. The one concerning macroeconomic indicator is the level of growth in credit in the Philippines. Over the past five years, the amount of domestic credit provided by the financial sector has increased at a rate 12% per annum. When a country is growing its banking assets at this pace, there is a high probability of an increase in non-performing loans. The country’s banking system has a healthy capital balance with capital to assets at 10.6%.

 

The investment is based on Anscor’s strong financially health. If the company were to leverage its balance sheet, the attractiveness of the investment opportunity would decline.

 

The investment is also based on Anscor’s consistently generating net income around its cost of capital. If earnings in the business were to permanently decline, the investment would become much less attractive.

 

If earnings were to decline making a liquidation value a more appropriate valuation methodology, there is still 30% upside meaning there is significant downside protection.

 

If Anscor were to make expensive acquisitions, it would decrease the returns in the business through the write down of income and equity.

 

Given the nature of Anscor’s businesses, they all lack barriers to entry and therefore are at risk of increased supply depressing profitability.

 

Most of Anscor’s businesses are cyclical in nature and subject to macroeconomic risks.

 

At the end of Q3 2016, 47% of Anscor’s assets were in available for sale securities or fair value through the profit and loss investments making the company exposed to the fluctuations of the Philippines Stock Exchange.

GMA Holdings/GMA Networks 2/1/2017

GMA Holdings/GMA Networks

Ticker:                                                             GMAP:PM/GMA7:PM

Closing Price (1/31/17):                                PHP5.90

6 Month Avg. Daily Vol. (USD mn):             0.56

Market Cap (USD mn):                                 421

Estimated Annualized Return:                    12.5%

Suggested Position Size:                              4.0%

February 1, 2017

GMA_Research_Report_Feb_1_2017

 

FACTOR RATINGS

 

 

 

INVESTMENT THESIS

 

GMA Network is a competitively advantaged firm enjoying economies of scale with customer captivity and regulatory barriers to entry. Unfortunately, management’s operational inefficiency is creating a drag the business’s profitability. Additionally, management pay themselves 20% of operating profit.  The company is trading on a free cash flow yield of 7.5% and should grow at least at 5.0% leading to a minimum expected annualized return of 12.5%.

 

 

COMPANY DESCRIPTION

 

 

Company History

 

GMA Network, Inc. (GMA) is a free-to-air broadcasting company engaged in television and radio broadcasting, the production of programs for domestic and international audiences, and other related businesses. The company derives the majority of its revenues from advertising related to television broadcasting. GMA Network has 47 VHF and 41 UHF TV stations throughout the Philippines with its signal reaching approximately 98% of the country’s Urban TV Households.

 

Robert La Rue Stewart founded GMA in 1950 as Republic Broadcasting System (RBS) with its flagship AM radio station DZBB operating from Escolta, Manila. RBS started broadcasting on Channel 7 in the Greater Manila Area in 1961. In 1975, Felipe L. Gozon, Menardo R. Jimenez, and Gilberto M. Duavit took over management of RBS and renamed it to GMA 7.
The original meaning of the acronym “GMA” was Greater Manila Area, referring to the initial coverage area of the station. The company changed its name to Global Media Arts. Today, its corporate name is GMA Network, Inc.

Apart from its television and radio networks, the company owns many media businesses including film production, record publishing and distribution, program acquisition and syndication, international channel operation, production design, talent development and management, marketing and promotions, audio-visual production and new media.
In addition to its presence in the Philippines, GMA’s content is distributed outside the Philippines through its subscription-based international channels distributed through multiple platforms. Its content is also on many platforms through worldwide syndication sales to broadcasters/companies in China, Southeast Asia, Africa, and Europe.

 

In February 2001, Philippines Long Distance Telephone Company (PLDT) agreed to acquire 75% interest in GMA for PHP 8.5 billion. Regulatory approval for the deal was received in August 2001. In late 2001, the relationship between the parties deteriorated and PLDT pulled out of the deal stating its debt was too much of a burden to complete the deal.

 

GMA went public in 2007. As of September 30, 2016, the company had 3,361,047,000 common shares outstanding and 7,499,507,184 preferred shares outstanding. Common shares have two classes, common shares and Philippine Deposit Receipts (PDRs). Filipinos can only hold common shares, while anyone can hold PDRs. The two are fully fungible for Filipinos. The company’s preferred shares are unlisted and convertible to common shares at a rate of 5 preferred shares to 1 common share. The public float is 24.38%.

 

FLG Management & Development Corp. is an investment vehicle of Felipe L. Gozon, the Chairman of the Board and CEO of GMA Network. Mr. Gozon is an attorney graduating from Yale Law School. Aside from GMA Network, he is a Senior Partner at the Law Firm of Belo Gozon Elma Parel Asuncion & Lucila.

 

M.A. Jimenez Enterprises and Television International Corporation are investment vehicles of Menardo Jimenez was the former President and CEO of the GMA Network. He gave up the position to brother-in-law Felipe Gozon in 2000.

 

The company’s approved dividend policy entitles holders of common shares to receive annual cash dividends equivalent to a minimum of 50% of the prior year’s net income based on the recommendation of the Board of Directors.

 

 

Business Model

 

GMA Network creates and purchases content aggregates the content into channels. Channels are transmitted to audiences directly or over the internet. GMA generates revenue primarily by selling time within programs to advertisers. Advertisers pay based on the size and type of audience. Advertising accounted for roughly 90% of revenues over the past three years. The company also generates revenue from selling content internationally and via its websites.

In 2015, over 90% of the company’s revenue was from television and radio airtime with the remaining revenues coming from content production and others. In the first six months of 2016, Channel 7/RTV accounted for 94% of television and radio airtime revenue while GMA’s news station, GNTV, accounted for 2% of television and radio airtime revenue and radio accounted for 4% of television and radio airtime revenue.

 

The costs of creating content and purchasing local or international content are fixed and are the same regardless of audience size. For GMA, production costs or content creation costs equates the cost of goods sold.

 

The production cost structure is shown above. Talent fees account for roughly half of the company’s total production costs. The next largest expense is rentals and outside services,, which has decreased as a percentage of total production costs indicating the company is slowing moving more production in-house. Overall, the company’s gross margin has averaged 55.0% over the past three years.

 

The general and administrative expenses (GAEX) required to generate revenue averaged 37.9% of revenue over the past three years with personnel costs being the largest expense accounting for 50% of total GAEX. At 12% of GAEX, facilities costs were the next largest cost and only other cost accounting for more than 10% of GAEX.

 

Over the past three years, the total amount of operating expenses were relatively stable over the past three years while revenue fluctuated potentially pointing to the vast majority of operating expenses being fixed.

 

We estimate that roughly 70% of operating expenses are fixed. We assume all production costs are fixed along with 25% of GAEX personnel expenses. The fixed portion of GAEX personnel expenses is sales staff. Additionally, all depreciation and facilities costs are assumed to be fixed. All other expenses under GAEX are assumed to be variable.

 

Since 2007, to generate one peso of revenue, GMA needs to spend 34 centavos on working capital and 40 centavos on fixed capital leading to 74 centavos of total investment. For every peso of revenue, the company generates 24.4 centavos of operating profit leading to an average ROIC of 23.3%.

 

 

INDUSTRY ANALYSIS

 

 

Industry History

 

A predecessor of ABS CBN’s, ABS introduced television to the Philippines in 1953. ABS started broadcasting DZAQ-TV3 on a four-hour-a-day schedule from six to ten in the evening. At the start, programs were American as it was cheaper to purchase international programming than produce programming locally. ABS CBN’s other predecessor CBS started in 1955. The industry continued to grow in popularity with many new television channels broadcasting until 1972 when Ferdinand Marcos placed Philippines under martial rule and took control over the media. The industry was under government control until 1986. ABS-CBN began satellite and international broadcasts in 1989. During the 1990s and 2000s, there was a proliferation of new channels and Filipino programming started to be exported to other countries. In 2009, ABS-CBN started testing digital terrestrial television and SkyCable launched the first HD television channel. In 2010, Philippines adopted the Japanese ISDB-T standard.

 

According to CASBAA, the association for the multi-channel audio-visual content creation and distribution industry across Asia, in 2010 the number of television households in the Philippines was 13.5 million. 1.5 million households subscribed to cable television and another 100,000 subscribed to direct to home (DTH) services. Metro Manila has the highest pay TV penetration rate was Metro Manila at 27% of households.

 

 

Industry Value Chain

 

 

 

Evidence of Barriers to Entry

 

We believe barriers to entry are the most significant force in determining the underlying quality and economics of a business. Barriers to entry stops competition from entering the market allowing a company to sustain excess profitability. The absence of barriers to entry allows competition to enter the market competing away all excess profitability. In practice, excess profitability can persist for a prolonged period without barriers to entry. The institutional imperative can lead to less than optimal decision by some competitors allowing other competitors to take advantage of the poor management and generate excess profits. Also, demand can outpace supply in the short term leading to an ability to take advantage of the disequilibrium through price hikes leading to excess profitability. As supply catches up with demand, usually when demand growth slows, excess profitability will be eliminated.

 

There are indicators that provide evidence of the existence of barriers to entry within an industry. The first is the number of competitors within the industry. Many competitors within an industry means competitors can freely enter the market, while a small number of competitors means entry and survival within the industry is difficult.

 

There are a number of firms competing in the Philippines television industry but the top two firms dominate the industry with almost 80% of the audience share in 2015. Since 2010, the top three firms’ average audience share was 85% pointing very high industry concentration. Over the same period, the industry’s Herfindahl Index averaged 0.30 also pointing to very high industry concentration. Only the audience share of the top three firms were used to calculate the Herfindahl Index as estimating the number and market share of smaller firms does not meaningfully change the industry’s Herfindahl Index. As illustrated by concentration ratios, the Philippines television Industry is extremely concentrated pointing to the existence of barriers to entry.

 

The next indicator we look at to determine whether barriers to entry exist is market share stability. If there are barriers to entry, market share should be stable as potential entrants find it difficult to take share from incumbents. In the absence of barriers to entry, new entrants can use many strategies to take market share from incumbents.

 

As illustrated in the table above, the average absolute share change since 2010 is 1% pointing to share stability and additional evidence that barriers to entry exist. If over a period of at least five years the absolute average share change within an industry is two percentage points or less, barriers to entry exist. If the absolute average share change exceeds five percentage points, it is unlikely that barriers to entry exist.

 

The next and probably the most important test of barriers to entry is sustained excess profits as measured by ROIC minus the cost of capital. If a company is able to generate at least 15% ROIC on a regular basis, it is strong evidence of potential barriers to entry. ROIC cannot be used in isolation as a company can generate excess profits in the short to medium term without the existence of barriers to entry. To calculate ROIC, we attempt to separate any operating performance from capital allocation decisions leading to only using net operating assets to calculate the amount of invested capital (net working capital + PP&E + other operating assets).

 

Since 2007, GMA’s ROIC averaged 23.3%, well above the 15% threshold, with the lowest ROIC of 10% in 2014. The strength of GMA’s profitability points to barriers to entry.

 

The final test to see if barriers to entry exist is looking at potential pricing power. We assess pricing power by looking at company’s gross margin. If a company has pricing power, it should be able to raise prices to cover its raw material costs leading to a stable to increasing gross margin.

 

GMA’s gross margin has declined from 61.2% in 2007 to 57.4% in 2015. Although the company’s gross margin is high, there is very little stability with a step change in 2011 with gross margin declining by 7.0%. The lack of gross margin stability points to no pricing power and a lack of barriers to entry.

 

Overall, the evidence of barriers to entry existing is strong with three of the four tests pointing to barriers to entry existing.

 

 

Barriers to Entry

 

Given the evidence pointing to the existence of barriers to entry, the next question is what are those barriers to entry? We believe there are four barriers to entry; supply advantages, demand advantages, economies of scale with some form of customer captivity, and/or government regulation.

 

Within the Philippines and globally, the Television Industry’s barriers to entry take the form of economies of scale with customer captivity, and regulatory barriers.

 

Economies of scale comes from high fixed costs associated with producing and purchasing content as viewership of content is not known at the time of producing the program. Production costs represented 41.9% of sales. The fixed cost nature of content production/purchasing allows larger companies to produce/purchase higher quality content as they can outspend competitors. There is a wide gap in audience share from the two largest competitors, ABS CBN and GMA, and all other peers allowing ABS CBN and GMA to outspend peers by a noticeably amount. In the nine months ending 2016, ABS CBN had a 44% audience share, GMA had a 34% audience share, and third place TV5 had a 7% audience share. Assuming audience share and market share equate, TV5 would have to be twice its current size to spend as much on production costs and be break even at a gross margin level. This does not account for fixed costs below the gross margin line including depreciation and amortization, facilities, and personnel related to sales of advertising space. We estimated non-production fixed costs represented an additional 13.0% of GMA’s sales.

 

Customer captivity comes from continuous programming such as news and long running television shows, such as soap operas and sitcoms. Consumers tend to watch the same news station and get addicted to television shows. Continuous programming also requires fixed infrastructure leading to the previously mentioned economies of scale.

 

Like many countries, the Philippines restricts ownership of media assets. According to Article 16, Section 11 of the Philippine Constitution   “The ownership and management of mass media shall be limited to citizens of the Philippines…”

 

Economies of scale combined with customer captivity and regulatory restrictions are very difficult barriers to entry to overcome. Audience share is stable and the industry is becoming more concentrated pointing to a stable to expanding barriers to entry while the declining ROIC points to deteriorating barriers to entry.

 

A good way of understanding the competitive advantage is determining the length of time it would take a new entrant to replicate GMA competitive position. To replicate GMA’s competitive position, any new entrant would first have to obtain regulatory licenses associated with owning and operating mass media. This requirement is restricted to Filipinos A new entrant would have to spend over PHP5.5 billion annual in content production. This content then needs to be packaged and distributed. Advertising slots also need to be sold via building a sales force. GMA’s audience share and time in the business has created relationships that are difficult to replicate. Additionally, a new entrant would need to acquire all the expertise associated with running the business. The company would also need to advertise heavily in an attempt to attract customers from rivals. Despite, the heavy spending the share stability in the industry points an inability to attract an audience. If we assume 1% share can be acquired every year, equal to the average absolute share change over the past five years, it would take 34 years to reach GMA’s current position. Assuming all share gains are taken from GMA, despite evidence of industry concentration increasing, it would take 17 years to reach GMA’s position.

 

Given the barriers to entry, it seems GMA’s competitive position within the Filipino Television industry will remain very strong. A more likely scenario is over the top takes hold or some other technology disrupts the importance of television. Overall, GMA’s barriers to entry seem to be very difficult to overcome and should be sustained for a long period.

 

 

GROWTH

 

Ad spending is linked to GDP. The table below shows ad spending as a percentage of GDP for a number of different countries at a number of stages of development.

 

For most countries ad spend as a percentage of GDP has remained relatively stable. There is little correlation between ad spend to GDP and GDP per capita so growth in ad spend to GDP should not necessarily increase as GDP per capita increases.

 

The scatter plot graph above shows the relationship across countries and years. A linear trend only has an R squared of 0.2599, while a power trend has the highest R squared of 0.4492 illustrating while there is relationship it is not strong.

 

Looking at the United States as it has the most data, ad spend as a percentage of GDP has been consistently between 1-2% over the past 100 years, as illustrated by the chart from Bloomberg Businessweek. The consistency and lack of growth in ad spend relative to GDP supports the argument that ad spend as a percentage of GDP does not increase with development.

 

Since 2007, the Philippines ad spend to GDP has remained between 0.57% and 0.75% but seemingly on an upward trend.

 

Given the evidence, it seems appropriate to assume a stable ad spend as a percentage to GDP meaning the overall advertising market will grow with GDP growth.

 

The table above shows the growth of Philippines GDP in current local currency terms over various periods along with IMF forecasts through 2021. IMF is forecasting 6.8% growth per year until 2021.

 

Given it seems ad spend will growth with GDP, the question now becomes how will the ad spend be divided among different types of media. Television accounted for 75% of total ad spend in the Philippines in 2006, 74% in 2010, 77% in 2011, 78% in 2013, and 71% in 2015. As illustrated, television has long been the dominant form of advertising in the Philippines. Outside of the Philippines, TV is far less dominant as shown in the graphic below.

 

While television is far less dominant outside of the Philippines, it still holds a leading share of ad spend as it is the easiest and most cost effective way to reach the masses. Internet advertising is growing the fastest and taking a larger piece of the pie. Television continues to gain share increasing its slice of the advertising pie from 36.8% in 2005 to 40.2% in 2013. The growth of the internet and television’s share of ad spend is coming at the expense of everything else with newspapers and magazines being the biggest losers. The resilience of television means it continues to play an important role for advertisers in reaching a mass-market audience. The internet has not been able to take the role of reaching mass markets as audiences on the internet are much more fragmented. The internet is now doing the jobs for audiences that newspapers and magazines used to do therefore is taking their share of the advertising budgets. This makes sense as newspapers and magazines audience is much more fragmented with magazines catering to niche interests while newspaper catered to local interests therefore could never garner the national audience that major television stations.

 

While internet advertising should continue to grow, the importance of television within the Philippines will allow it to maintain a large portion of the advertising market. TV may not be the best for targeting a specific audience, but it provides an opportunity to reach an audience that other media cannot reach making it a perfect venue to educate the masses about your product.

 

Within TV, GMA and ABS CBN’s maintaining roughly 80% audience share with an increasing audience share concentration in the industry have been stable with barriers to entry allowing the companies to maintain their share of TV’s advertising.

 

Overall, ad spend should remain stable as a percentage of GDP. IMF forecasts GDP growth of 6.8% until 2021. TV currently accounts for 71% of advertising within the Philippines and has oscillated in the 70-80% region over the past decade. It should continue to maintain a strong position among other mediums particularly when digital and internet advertising is taking share from other media rather than TV. Within TV, GMA and ABS CBN’s position will be difficult to overcome and could potentially further consolidate.

 

 

MANAGEMENT

 

To judge the strength of a management team we assess management’s incentives and its ability in operations, strategy, capital allocation, and corporate governance.

 

 

Incentives

 

The current chairman of the board and CEO, Felipe Gozon owns 25.3% of the company via FLG Management & Development Corp. GMA’s management team incentives seem to be aligned with minority shareholders as members of the board and management team are the largest shareholders in the company.

 

 

Operational Efficiency

 

Regardless of the existence of barriers to entry, operational efficiency is crucial. In an industry with barriers to entry, a firm can fully exploit its advantage. Without barriers to entry, operationally inefficient firms would be forced out of the industry due to persistent losses.

 

The metrics listed above are averages over the last five years in a millions of Philippine pesos per percentage point of audience share. ABS CBN is a media conglomerate with many unrelated business segments. Its most comparable business segment is its TV and Studio segment, which releases partial accounts. ABS CBN generates much higher revenue per percentage point of audience share but also spends more on the production of content leading to a slightly higher gross margin than GMA. ABS CBN’s audience share advantage was already mentioned but it also dominates the top 10 most watched programs over the past five years, with GMA only getting a Manny Pacquiao fight in 2012 and another in 2014 into the top 10 most watched programs. The audience share and domination of the top 10 programs points to superior content of ABS CBN and ability to charge higher prices than GMA.

 

Operationally, GMA’s operational expenses are much lower than ABS CBN’s on both a per percentage point of audience share and as a percentage of sales. GMA’s operating expenses per percentage of audience share are less than half of ABS CBN’s and 7.6% less as a percentage of sales.

 

GMA’s has much higher capital efficiency with net operating asset turnover of 1.35 times compared to 0.84 times for ABS CBN. The operating efficiency and capital efficiency allows GMA to be much more profitable with a return on net operating assets of 24.3% compared to 10.7%. GMA is far more operationally efficient than ABS CBN allowing it to exploit the barriers to entry within the industry.

 

The table above illustrates the key value drivers of a number of television broadcasters around the world. ABS CBN’s figures are different from the previous discussion as this is the whole company rather than just the TV and Studio business.

 

GMA outperforms on gross margin relative to its peers with only Surya Citra Media, Media Nusantara, and Television Broadcasts having a higher gross margin meaning the company is spending less than peers on content, which could be efficiency or under spending. The company has the highest spending on GAEX relative to its peers. The company could be shifting costs from gross margin to operating expenses or it could be inefficient relative to peers. The company has the second lowest operating margin of all peers, ahead of only ABS CBN.

 

The company is middle of the pack in capital efficiency with four peers being more efficient at turning over invested capital and four peers being worse at turnover invested capital.

 

Overall, GMA has the second lowest ROIC of all peers ahead of only ABS CBN. Despite performing poorly relative to peers, GMA still generates an ROIC well above the benchmark rate of 15%. It is interesting that the two Filipino companies performed so poorly on profitability as the country has one of the most favorable market structures with essentially a duopoly. GMA has a strong gross margin pointing to an ability to extract more value from its content than peers. The key driver to GMA’s profitability weakness is administrative expenses as the company pointing to weaker operational efficiency than global peers. It is also not a capital efficiency issue as the company is also middle of the pack in invested capital turnover.

 

 

Strategy

 

Evidence points to the existence of barriers to entry within the industry with GMA being a competitively advantaged firm within the industry. The company’s management team has been in place since they took ownership in 1975. During that time, they have built and maintained their competitive position, which deserves praise.

 

The current barriers to entry are economies of scale and customer captivity. Strategy should be to strengthen those barriers to entry. The company currently spends a roughly 45% of sales on production costs. The largest competitor outside of ABS CBN, TV5, has an audience share of 7% roughly 1/5th of GMA’s 34% audience share. Assuming market share and audience share are equal, TV5 needs to increase its audience share by 217% before it was able to produce the same amount and quality and reach break-even at the gross margin level. The company is spending the necessary amount on fixed costs to ensure its smaller competition has a difficult time gaining share.

 

Despite the company’s size advantage over smaller peers, GMA is competitively disadvantaged to ABS CBN. ABS CBN dominating the top 10 programs with GMA having the odd showing when it broadcasts a Manny Pacquiao fight illustrates GMA’s lack of quality programming and inability to match ABS CBN in production costs due to its smaller size. The poor quality programming impacts customer captivity, as customers are less likely to create habit with poorer quality programming.

 

 

Capital Allocation

 

We start our discussion on capital allocation by looking at the company’s financial health. If management takes on too much debt, it is taking a significant risk for minimal reward. At the end of September 2016, GMA had a net cash position of PHP1,596 million.

 

At the end of 2015, GMA Network’s short-term loans amounted to PHP1,152.97 million. 100% of debt was in USD at an interest rate of 1.73%. At the end of 2014, GMA Network had PHP1,922.96 million in USD debt at an interest rate of 1.68% and PHP300 million in PHP debts at an interest rate of 1.90%. Foreign currency debt adds risk without any additional reward, particularly when there is a marginal difference in interest rates in USD debt and PHP debt. The unnecessary risk is nothing more than currency speculation. GMA Network has sufficient cash to buffer an increase in USD relative to PHP so other than poor judgment by management the company’s FX debt is not a major concern.

 

Next, we look at the company’s balance sheet to estimate the amount of operating assets and non-operating assets. We would like to see all assets as operating assets as the non-operating assets are not part of the company’s core business and should be returned to shareholders. Since 2011, 83% of assets have been operating assets, the best of the peer group.

 

The company has not made any expensive acquisitions in the recent past. It also was willing to sell itself in 2001 to PLDT at PHP12.5 billion or 10 times EBITDA. The 2001 valuation is roughly 75% of the company’s current enterprise value.

 

The company’s approved dividend policy entitles holders of common shares to receive annual cash dividends equivalent to a minimum of 50% of the prior year’s net income based on the recommendation of the Board of Directors.

 

Other than the excess non-operating assets on the company’s balance sheet, it is doing a good job of allocating capital to fixed costs that are crucial to the company’s size advantage. The company is also doing a good job of not straying from its core competency in a quest for growth.

 

 

Corporate Governance/Value extraction

 

With most emerging market small cap companies run by owner operators, the board and management is dominated by the owner operator making benevolence crucial.

 

To assess corporate governance we start by looking at the company’s related party transactions.

 

The majority of related party transactions are legal, consulting, and retainers’ fees paid to Belo, Gozon, Elma Law, the Chairman and CEO’s law firm. These transactions are less than 1% of operating profit and seem to be reasonable. All other related party transactions are much smaller advances to associates and joint ventures. Overall, related party transactions do not point to any corporate governance issues or excess value extraction by management.

 

After related party transactions, the compensation to key management personnel is assessed to determine if wages are excessive.

 

Compensation to key management personnel averaged 20% of operating profit and 3.2% of sales, which is very high. Typically, we would want to see salaries at less than 5% of operating profit. This is a big negative as key management is already significant shareholders meaning the excessive salaries are just extracting value from minority shareholders. Management are no way creating the value extracted from salaries as the barriers to entry in the industry are so strong that pretty much anyone can run the company and generate the level of profitability the company is generating. The massive value extraction in the form of salaries is a big negative and significantly decreases the quality of the company.

 

VALUATION

 

We start by valuing GMA at its liquidation value. Liquidation value is the most appropriate valuation method for a company that is no longer viable therefore should be liquidated. Given GMA’s competitively advantaged position in a viable industry, liquidation value is not too relevant. We estimated GMA’s liquidation value to be PHP1.32 per share representing 79% downside.

 

Using a more conservative net current asset value per share, GMA’s liquidation value is PHP0.99 per share leading to a liquidation value of roughly PHP0.99 to PHP1.32 per share.

 

Next, GMA is valued at its reproduction value. Reproduction is the appropriate valuation method in an industry lacking any barriers to entry, which eliminates excess profitability leading any investment not creating any additional value. The value of any asset under this condition is the cost to recreate the assets.

 

To calculate GMA’s reproduction value, we assess what assets would need to be reproduced to reach GMA’s competitive position. We start by looking at the company’s balance sheet. The vast majority of balance sheet values are assumed a fair representation of the cost to reproduce the asset. Trade and other receivables come with bad debt that would need to be incurred to reproduce the company’s level of receivables. GMA’s bad debt provision is 7% of the company’s trade and other receivables account. We assume a new entrant would need to match the company’s level of bad debt. Additionally, a few expenses need to be recreated. Advertising and marketing are assumed to educate the population about the company’s programming therefore in the process of recreating the company’s position advertising and marketing is necessary to reach the company’s audience share. Many television programs run for more than one year forcing a new entrant to spend a multiple of GMA’s advertising and marketing expense as advertising and marketing may create value beyond one year, but to be conservative we assumed only one year of advertising would need to be recreated. Similarly, research and surveys create knowledge that is an asset to the business and not reflected on the balance sheet. This knowledge would probably take years to replicate but we assume that two years of research and survey expense would do a good job at replicating the asset. It also costs to hire personnel and talent. We assume that any new entrant would have to spend 20% of one year’s personnel expense on agent’s fees, recruiter’s fee, and building the infrastructure to hire.

 

We also assume the non-interest bearing liabilities of trade payable and other current liabilities as well as current portion of obligation for program and other rights are spontaneously created decreasing the amount of funds required to invest in the business. Overall, we estimate GMA’s reproduction value to be PHP3.79 per share or 39% downside.

 

Given the barriers to entry in the industry and GMA’s competitively advantage position, valuing the company based off its earnings is the most appropriate valuation methodology. We value GMA using a variety of earnings based valuations. The first earnings based valuation is simply FCF yield plus growth. The Philippines advertising industry is very cyclical with political advertising distorting revenue generated by firms in some years. To eliminate this cyclicality associated with political advertisements, we average GMA’s FCF over the past five years leading to a FCF yield of 7.5%. Given FCF takes into account working capital and fixed capital investment, any potential growth can be added to estimate a company’s FCF yield to estimate its total return. It seems growth of industry will mirror the GDP growth rate as ad spend as a percentage of GDP tends to be relatively stable. Television’s share of ad spend is increasing and the share within the industry is relatively stable. All evidence points to a growth rate equal to GDP or higher. The IMF forecasts that the Philippines will grow at a rate of 6.8% through 2021. If we use a growth rate of 5.0%, to add a bit of conservatism, GMA should return 12.5% per annum over the next five years.

 

The next earnings based valuation method assumes various competitive scenarios by changing key value driver assumptions used in a residual income/DCF with the output being a range of valuations. The key value driver assumptions we use for every residual income/DCF valuation is cost of capital, sales growth, operating margin, tax rate, working capital turnover, and fixed capital turnover. With our residual income/DCF valuation, we have a five-year forecast period followed by a fade to a terminal value in year 10.

 

The key value drivers that remain stable are discount rate, tax rate, working capital turnover and fixed capital turnover at the values listed above.

 

Sales growth and operating margin are the key variables that change under different scenarios. We use three states of sales growth 0%, 2.5%, and 5% into perpetuity. There are four scenarios for operating margin: 2007-2015 trough = 12.0%, current = 21.9%, 2007-2015 average = 24.0%, and 2007-2015 peak = 32.8%.

The average 2017 target price is PHP7.42 or 19% upside, while the average 2020 target price is PHP9.74 or 56% upside. The maximum downside over the next five years is 41% under the no growth and trough operating margin scenario. This scenario points to a deterioration of the competitive environment where barriers to entry are eliminated and television share of ad spend is succeeded to the internet. The maximum upside is 228% under the 5% growth and peak operating margin scenario. This scenario points television maintaining its share of total ad spend and more benign competitive environment allowing for stronger profitability. The more likely of the two scenarios is the most optimistic scenario as this was the norm prior to 2011. Our base case scenario is 2.5% perpetuity growth with average operating margins leading to 55% upside over the next five years.

 

In summary, earning base valuation is the most appropriate valuation methodology for GMA as its industry has barriers to entry and the company is competitively advantaged. FCF yield and average of all the earnings scenarios lead to 10-12.5% annualized return.

 

 

RISKS

 

We classify the risks to an investment into four main categories: financial risk, business risk, macro risk, and valuation risk. Financial risk is the risk of permanent loss of capital due to an inability to pay its debts. Business risk is the risk a permanent loss of capital due to an impairment of a company’s earning power from competition, poor management, a disruptive technology, or government regulation. Macro risk is the risk of permanent loss of capital due to macroeconomic troubles of a country. Valuation risk is the risk of permanent loss of capital from paying too much for a company.

 

 

Financial risk

 

GMA is very conservatively financed with a net cash position of PHP1,596 million and has a competitively advantaged position making the probability bankruptcy very low. The company does finance itself with USD debt rather than PHP debt making the company susceptible to any significant moves in the USDPHP exchange rate. It is not a concern as the company has sustainable earnings stream and a net cash position.

 

 

Business Risk

 

Given GMA benefits from its competitively advantaged position, the biggest risk to the company’s business is if those barriers to entry were to weaken allowing competitively disadvantaged peers to catch up with GMA. GMA’s strongest barrier to entry is economies of scale due to the large fixed costs associated with production costs. If the company’s relative size advantage were to deteriorate, the competitive environment would be come much tougher. If fixed costs were to turn variable or not be crucial to creating value, it would also weaken GMA’s competitive position.

 

The Philippines has a regulation stating that only Filipinos can own mass media companies. If this law were to change, the number of broadcasters could increase leading to a potential pricing war via declining ad rates.

 

GMA’s content seems to lower quality than ABS CBN as illustrated by ABS CBN dominating the top 10 most viewed shows in Philippines for a number of years and ABS CBN’s high revenue per percentage of audience share. If the relative weakness in content production and sourcing continues, GMA may relinquish share.

 

Cable may increase its penetration providing more options for viewers and fragmenting audience share leading to a fragmentation of advertising revenue. At the end of 2015, cable TV penetration stood at 17% of all homes with televisions up from 15% in 2012 and 11% in 2010. Cable TV penetration is well below international standards with pay TV in Asia at 54% so there is potential for increased penetration if cable operators can improve their offering.

 

The internet is changing distribution in many industries including television. The biggest threat to television broadcasters is content producers going direct to consumers or over the top (OTT). If the OTT offering is more attractive, audiences will shift their viewing habits to providers of content via the internet. We are seeing content aggregators such as Netflix and Hulu make significant inroads in the developed world. Content aggregators acquire content from content producers and sell subscriptions. These are more of a threat to cable as they are essentially performing the same job of bundling niche content and selling it to the consumer for a subscription fee. Internet penetration in the Philippines is at 43.5%. While GMA and ABS CBN are at risk, these two produce their own local content. If the content aggregators are able to disrupt the distribution part of GMA’s and ABS CBN’s business, there will always be value in their local content. These aggregators have started producing content but not niche language content.

 

The internet is taking over traditional roles that the television used to perform. News, which is continuous content that creates customer captivity, is being consumed via the internet rather than the traditional television in many parts of the world. An increasing shift of audience towards the internet will severely affect GMA’s profitability.

 

The production of content leads to a high level of fixed costs creating operating leverage. Operating leverage is a double edge sword as growth leads to greater profitability while decline in profitability leads to a greater fall in profits. If TV broadcasting as matured and is in the decline phase of its lifecycle it may not take long before profitability is eliminated.

 

 

Macro Risk

 

Our goal with assessing macro risk is not to forecast the path of macroeconomic indicators but to eliminate risks from a poor macroeconomic position.

 

GMA Network business is primarily in the Philippines, a country that seems to be in very good financial health. In 2015, the country’s current account was 2.6% of GDP and its structural balance was 0.18% of GDP allowing the country to self-finance all the domestic initiatives as well as decrease the country’s debt load. The country does not have too much credit in the system with domestic credit provided by the financial sector at 59.1% at the end of 2015, which is well below the Emerging Markets average of 97.5% and the High Income countries average of 205%. Gross government debt as a percentage of GDP stood just under 35% with External Debt to GDP at 36%. The one concerning macroeconomic indicator is the level of growth in credit in the Philippines. Over the past five years, the amount of domestic credit provided by the financial sector has increased at a rate 12% per annum. When a country is growing its banking assets at this pace, there is a high probability of an increase in non-performing loans. The country’s banking system has a healthy capital balance with capital to assets at 10.6%.

 

 

Valuation Risk

 

The key valuation risk is the assumptions used in our scenario analysis are too optimistic. We looked at GMA’s operating history back to 2007. If we reviewed 2011 to 2015 rather than 2007 to 2015, there would be a difference in valuations. Using 2011 to 2015, the average operating margin would decrease from the current 24.0% to 18.3%. The peak operating margin would decline to the current operating margin of 21.0%. We used the operating history since 2007 as the company’s profitability in the trailing twelve months ending in September 2016 returned to levels not seen before 2011.

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

WEEKLY COMMENTARY November 21, 2016 – November 27, 2016

 position-summary-table

 

 

COMPANY NEWS

 

PC Jeweller

 

PC Jeweller reported FQ2 2017 results on November 23, 2016. During the quarter, the company opened five stores including a franchised showroom bringing the total number of showrooms to 68. The company also introduced the Inayat wedding jewelry collection and the Azva festive and wedding season collection, which is selling in 15 independent retailers.

 

Year on year, the company’s revenues grew by 30.2%, gross profit declined by 0.9%, and operating profit declined by 5.3%. Gross margin declined from 16.3% in FQ2 2016 to 12.4% in FQ2 2017. To review the company’s business, the mix between exports and domestic sales and the mix between diamond and gold jewelry sold drive gross margin.

pc-jeweller-business-model

The expected sales mix between domestic sales and export sales is roughly 67 % to 33% with domestic sales having an estimated gross margin of 16-17% while export sales have a gross margin of 6-8%. Gold jewelry sales is expected to represent 70-75% of domestic sales with a gross margin of roughly 10%, while diamond jewelry sales is expected to represent 25-30% of domestic sales with a gross margin of roughly 25-30%.

pc-jeweller-sales-mix-and-gross-margin

The table above illustrates the actual figures on a quarterly basis dating back to the quarter ending December 2012. Since FQ3 2013, domestic sales averaged 72.3% of sales while gold sales averaged 70.5% of domestic sales. Domestic sales averaged a gross margin of 16.4%, export sales averaged a gross margin of 10.6%, and the overall gross margin averaged 14.4%. Using expected figures, gross margins should range from 12.7% to 14.0%. Operating expense averaged 3.8% of sales leading to an expected operating margin range of 8.9% to 10.2%.

 

Regarding demonetization, 32% of sales are cash sales so the company expects short-term impact from demonetization.

 

Overall, the company is operating in an industry without barriers to entry as illustrated by the thousands of competitors, but management has been able to consistent excess profits when peers other than Titan have struggled to generate any excess profits. Given the ability generate excess profits during industry distress and when peers cannot gives us confidence that valuing the company on earnings is appropriate.

 

Under our pessimist case scenario, which assumes a 12.5% discount rate, no growth into perpetuity and profitability fading to the discount rate in year 10, PC Jeweller has 4.3% annualized downside over the next five years. Under our base case scenario, PC Jeweller grows at 10% for a five-year forecast period (store openings) before fading to 0% in the terminal value in year 10. Current excess profits remain over the forecast period before halving in the terminal. Excess profits persist in our base case because of the strength of management and evidence that the company can generate excess profits when competitors cannot. Under the base case, PC Jeweller’s estimated annualized return is 9.1% over the next five years. Under the optimistic case, there is no change to profitability with growth increasing to 15.0% over the forecast period and 2.5% growth in the terminal value leading to an annualized return of 16.0% over the next five years.

 

The table below illustrates our assumptions under each scenario as well as historical averages for each key value driver.

pc-jeweller-scenario-assumptions

 

The company’s management is very strong and continues to generate excess returns in a fragmented industry where competitors struggle to generate excess profits. We will maintain our 4.0% position size.

 

 

PRE-RESEARCH REPORT

 

Executive Summary

 

ABS-CBN is a Filipino media conglomerate with three business segments: TV and Studios, Pay TV Networks, and New Business. The TV and Studios business generates 73.6% of revenue and 92.1% of EBITDA. Economies of scale exist in the form of content creation and distribution creating an advantage for the largest competitors. ABS-CBN is the largest. Unfortunately, the company is operationally inefficient generating an average of roughly 10% return on net operating assets over the past three years. The company’s Pay TV Network business only generates an average return on net operating asset of 2.3% over the past three years despite having a 45% cable market share in the Philippines. New businesses are a disparate group of organizations with no strategic connection pointing to extremely poor capital allocation. The average NOPAT margin of new businesses over the past three years is -253.4%.

 

Given the inability of the company to generate a reasonable return on a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would potentially warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business. To reach an acceptable buy price, the company’s share price would need to fall to PHP15.00 per share.

 

 

Company Description

 

ABS-CBN Corporation is the Philippines’ leading media and entertainment organization. Primarily involved in television and radio, the company has expanded owning the leading cinema and music production/distribution companies in the country as well as operating the largest cable TV service provider.

 

ABS-CBN has business interests in merchandising, licensing, mobile and online multimedia services, publishing, video and audio postproduction, overseas telecommunication services, money remittance, cargo forwarding, TV shopping services, food and restaurant services, theme park development and management, and property management.

 

 

History

 

ABS-CBN Corporation traces its roots from Bolinao Electronics Corporation (BEC), an assembler of radio transmitting equipment, established in 1946. In 1952, BEC adopted the business name Alto Broadcasting System (ABS) and began setting up the country’s first television broadcast by 1953. On September 24, 1956, Chronicle Broadcasting Network (CBN), owned by Don Eugenio Lopez Sr. of the Lopez family, was organized primarily for radio broadcasting. In 1957, Don Eugenio Lopez Sr. acquired ABS and on February 1, 1967, the operations of ABS and CBN were integrated and BEC changed its corporate name to ABS-CBN Broadcasting Corporation. On August 16, 2010, the Philippine Securities and Exchange Commission approved the change of the corporate name to ABS-CBN Corporation reflecting the company’s diversified businesses in existing and new industries. ABS-CBN achieved many firsts since it started the television industry in the country in 1953. However, with the imposition of martial law in September 1972, ABS-CBN ceased operations as the government forcibly took control. ABS-CBN resumed commercial operations in 1986 after the People Power or EDSA revolution. Despite being shut for 14 years, ABS-CBN recaptured leadership in the Philippine television and radio industries by 1988. During the 1990s and the early part of the new millennium, the company expanded and ventured into complementary businesses in cable TV, international distribution, mobile services, and magazine publishing among others.

 

 

Shareholder Structure

 

The top 20 shareholders own 98.57% of the business.

abs-cbn-shareholder-structure

 

Lopez Inc. is the largest shareholder at 55.15%. Lopez Inc. is a Filipino business conglomerate owned by the López family of Iloilo. Oscar M. López is the Chairman Emeritus and his brother Manuel M. López is the current Chairman and Chief Executive Officer of the López Group. It was first established by Eugenio Lopez, Sr. in 1928. It has holdings in many industries including media, power, energy, real estate, infrastructure, and manufacturing.

 

PCD Nominee Corporation is a wholly owned subsidiary of Philippine Central Depository. Shares are held at PCD Nominee Corporation for other shareholders.

 

 

Current Business

In 2015, ABS-CBN’s generated PHP38,278 million with 73.6% of revenue from the TV and Studio business, 21.1% from Pay TV Networks and 5.2% from new businesses.

abs-cbn-revenue-by-segment

 

In 2015, ABS-CBN generated PHP8,083 million in EBITDA. The TV and Studio business generated 92.1% of EBITDA, Pay TV Networks generated 20.7%, and new businesses generated -12.8%.

abs-cbn-ebitda-by-segment

 

As illustrated above, ABS-CBN has three business segments: TV and Studio, Pay TV Networks, and new businesses.

 

TV and Studio

 

The TV and studio segment is comprised of broadcast, global operations, film and music production, cable channels and publishing. This consists of local and global content creation and distribution through television and radio broadcasting.

 

abs-cbn-tv-and-studio-revenue

 

In 2015, free to air TV accounted for 63.4% of revenue, global operations accounted for 19.2% of revenue, with films and music, narrowcast, and others accounting for the remaining 17.4% of revenue.

 

The Free to air TV business includes content creation and distribution mainly through free TV and radio with Channel 2 and DZMM as its flagship platforms. The content created is predominantly in Filipino and is aimed at the mass Filipino audience. The company’s leading position in the Philippine television broadcasting industry is largely due to the popularity of its entertainment programs, while the news and public affairs programs have developed a reputation for the quality of news coverage that includes national, local and international events.

php-ratings-and-audience-share

 

In 2015, ABS-CBN 41.5% audience share in all of Philippines. There is significant barrier to entry in the form of economies of scale with content creation being a large fixed cost required to acquire an audience. The industry is very concentrated pointing to the existence of a barrier to entry. The top two players ABS-CBN and GMA Network have roughly an 80% market share.

 

The global business pioneered the international content distribution through Direct to Home, cable, Internet Protocol Television, mobile and online through The Filipino Channel. It is available in all territories where there is a significant market of overseas Filipinos such as the Unites States, Middle East, Europe, Australia, Canada and Asia Pacific. Other activities include international film distribution, remittance, retail, sponsorships and events. Similar to free to air, there are economies of scale in the form of content creation with much of the content created for the free to air business can be used in global operations. Distribution is another fixed cost in the global segment intensifying economies of scale. Efficient scale also comes into play, as the global market for Filipino content is not that large therefore the market cannot support many players. GMA Network also produces content for the international market.

 

The films and music business is composed of movie production, film distribution, audio recording and distribution and video and audio postproduction. Films and music needs are generally produced through ABS-CBN Film Productions Inc. (AFPI), more popularly known as Star Cinema. Other movies are co-produced with other local or international producers or are simply distributed by AFPI. Music needs are also managed by AFPI to complement the recording needs of the company’s multi-talented artists and handle music publishing and composing requirements, respectively.

 

The Narrowcast and sports business caters to the needs of specific or targeted audiences or markets not normally addressed by the broadcast business. Included in this line of business are cable programming and channel offerings such as Filipino movie channel, music channel, animé, upscale male sports content and upscale female lifestyle content. It also covers print, sports, and other niched programming via its UHF (Ultra High Frequency) channel. Narrowcast includes the following subsidiaries: Creative Programs, Inc., ABS-CBN Publishing, Inc., and Studio 23, Inc. As part of the company’s goal to elevate boxing as a sport in the country, it entered into a joint venture agreement with ALA Sports Promotions, Inc., a world class boxing organization and promotional company.

 

In the whole TV and Studio segment, economies of scale as content creation or acquiring content is a significant upfront fixed cost. Being the market leader in free to air TV with a 41.5% audience share illustrate the strong competitive position of ABS-CBN.

tv-studio-key-drivers

 

Despite the existence of economies of scale and market share leadership, ABS-CBN’s is only able to generate an average return on net operating assets of 9.9% over the past three years point to operational inefficiency.

 

 

Pay TV Networks

 

ABS-CBN owns 59.4% of Sky Cable Corporation. Sky Cable provides cable television services in Metro Manila and in certain provincial areas in the Philippines. As of December 2015, Sky Cable held a 45% market share in the Philippines. Sky Cable’s main competitor in the pay TV business is Cignal. The company also competes with other small local operators in certain cities it operates in, but no other operator has the same scale and geographic reach as Sky Cable. Given the fixed cost associated with infrastructure needed for cable coverage, size is a key competitive factor. Size also helps with bargaining power.

 

The company also provides broadband internet services through Sky Broadband. PLDT dominates the broadband industry with 65% market share.

pay-tv-network-key-value-drivers 

 

Cable television requires infrastructure, which is an upfront fixed expense. Despite its size advantage, Sky Cable is unable to generate a reasonable return pointing to operational inefficiency.

 

 

New Business

 

ABS-CBN’s new businesses include wireless telecommunications business, digital terrestrial television, theme parks and home shopping.

 

ABS-CBN mobile’s network sharing agreement with Globe Telecom enables the company to deliver content in addition to traditional telecommunication services on mobile devices. Through the network-sharing agreement, Globe provides capacity and coverage on its existing cellular mobile telephony network to ABS-CBN Convergence, Inc. (ABS-C) on a nationwide basis. The parties may also share assets such as servers, towers, and switches.

 

In February 2015, ABS-CBN commercially launched the digital terrestrial television (DTT). The company continues to invest in DTT equipment to improve clarity of signal in certain areas of Mega Manila and Central Luzon with a belief that the transition from analogue to digital will result in an increase in its audience share.

 

ABS-CBN invested in a theme park more popularly known as KidZania Manila. KidZania provides children and their parents a safe, unique, and very realistic educational environment that allows kids between the ages of four to twelve to do what comes naturally to them: role-playing by mimicking traditionally adult activities. As in the real world, children perform “jobs” and are either paid for their work (as a fireman, doctor, police officer, journalist, shopkeeper, etc.) or pay to shop or to be entertained. The indoor theme park is a city built to scale for children, complete with buildings, paved streets, vehicles, a functioning economy, and recognizable destinations in the form of “establishments” sponsored and branded by leading multinational and local brands.

 

Launced in October 2013, A CJ O Shopping Corporation is a joint venture between ABS-CBN and CJ O Shopping Corporation of Korea to provide TV home shopping in the Philippines.

new-business-key-value-drivers

 

ABS-CBN’s new businesses generate significant losses and there seems to be no strategic logic when allocating capital. New businesses are from a variety of industries where the company does not have any particular competitive advantage, which leads to the losses. The poor capital allocation will affect the ability of the company to grow its intrinsic value. Capital allocation is unlikely to change with the current management and ownership.

 

 

Valuation

 

Given the inability of the company to generate a reasonable return in a competitively advantaged business and the weak capital allocation, the company is unlikely to be considered for investment unless it trade well below book value (<0.5) or at a very cheap earnings multiple (<7 preferably <5). A change in ownership or evidence of the company improving its operational efficiency and/or capital allocation would warrant a change to the view. The company currently trades at over 2 times invested capital and 16.5 times NOPAT well above its fair value based on the returns generated by the business.

 

 

INTERESTING LINKS

 

A Dozen Things Warren Buffett and Charlie Munger Learned From See’s Candies (25iq)

A discussion about the lesson from See’s Candies (link)

 

Mental Model: Price Incentives (Greenwood Investors)

An good article by Greenwood Investors discussing discounting and brands (link)

 

Two Powerful Mental Models: Network Effects and Critical Mass (A16Z)

The title speaks for itself, an excellent essay on network effects and critical mass. (link)

 

The Reason We Underperform – Markets Have Evolved Faster Than Humans (Acquirer’s Multiple)

An article discussing potential behavioral reasons for the underperformance of fund management. (link)

 

Anatomy of a Failed Investment (Tom Macpherson- Gurufocus)

A great reminder to never be too confident of one’s views as there is only so much that one can prove to be absolute truth. Understand the counter to your argument and always remember looking for evidence confirming either side. (link)

 

Frozen Accidents: Why the Future Is So Unpredictable (Farnam Street)

The must read blog Farnam Street discusses how complexity and randomness make prediction a difficult if not impossible task. (link) We agree with the difficulty associated with forecasting and attempt to make as few forecasts as possible. Instead, we wait until the key value drivers being priced into by the market are so pessimist that there is little downside.