BSkyB - look beyond the lynch mob

So the lynch mob is out and led by such political worthies as Keith Vaz. How can David Cameron do anything else but embrace the 'popular' frenzy that has been whipped up by Murdoch's media rivals and fickle Westminster toadies.  The BSkyB bid is of course now dead, or so we are reliably informed by Roland Rat's creator and as MPs exercise some political posturing by voting against the deal (albeit legally meaningless), prior to jetting off on vacation to exotic locations on taxpayer funded junkets or courtesy of some dodgy billionaire sponsor.

Naturally Murdoch will be suitably humbled and slink off to the US, never to grace these shores again. Dream on!

As Murdoch's shares free-fall, what are the options for BSkyB's share and how should investors position themselves. 

Option 1: Murdoch/News Corp is not deemed fit and proper to own a UK broadcaster. While an unlikely verdict by OFCOM, it could precipitate either Murdoch withdrawing from News Corp's management or a sale of their current 39% holding in BSkyB (as this already represents a controlling interest).  Both outcomes could be positive by either reviving the bid or forcing News Corp to divest. To seek the best possible price for shareholders, News Corp would undoubtedly use its controlling stake to put BSkyB into play to secure a control premium for its shares.

Option 2: Status Quo - Murdoch/News Corp remain fit to own BSkyB, but are scared off from pursuing the bid or are blocked by a spurious 'public interest' test (which could be appealed) and sit still with their existing stake until the storm passes. Without the immediate bid premium, the shares settle down to a fundamental valuation, although as highlighted by my FCF/Growth rating analysis, as margins ratchet up, this may not be materially below were they are at the moment.

Option 3: Murdoch fights back - Today's fight-back from the Sun and Times suggest that there may be life in the old dog and that he's not going to give up his bone just yet. The general assumption that top management is implicated in illegal activities has yet to be proved. While the concession to having the bid referred to the competition authority (by withdrawing the earlier concession to divest Sky News) will kick the deal into touch for a good six months, it would provide Murdoch more time to resolve some News Intl management issues as well as get his PR response to these accusations better sorted.

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BSkyB valuation trade off between growth and margins

Rebekah Brooks may have described the News of the World as being toxic, although one might well ask under whose watch this originated. Murdoch's desperate attempts to distance himself and News Corps bid for BSkyB from the phone tapping (and worse) scandal by discarding the offending title, but retaining her however risks all of this. Not only has it failed to end the media feeding frenzy, but it has also scared the government into delaying a decision on the bid and even resulted in dark mutterings from OFCOM about reviewing News Corps fitness to own Sky at all. 

With a delay and possible challenge to the bid, the BSkyB shares dropped to only 750p on Friday, a level halfway between the original 700p per share offer and the >800p that the independent directors indicated would be the minimum necessary to secure their support. Having sacrificed the UK's largest paid circulation title (and > 200 staff) to stay in with a chance at Sky, will Murdoch's sense of personal loyalty to Rebekah be allowed to stand in the way of this, particularly if she's off David Cameron's Christmas card list? BSkyB's short term share price performance may therefore be inversely proportional to the length of her continued tenure, which may not be long.

Beyond the hysteria, markets will need to keep an eye on what Sky may be worth. Still in investment mode, the group has traded margins for growth, which naturally makes the stock look expensive on near term metrics. However, the group is past an investment inflection point and leveraging its dominant market position, control of content and rising subscriber and revenue base this is changing rapidly. Current EBITA margins are sub 20%, but these are capable of rising to the mid-twenties while still supporting near market average growth rates. Looking at the valuation in terms of a low-twenties normalised margin and even sub market growth rates of +3.5-4.5% CAGR could comfortably support a valuation of between 800-900p per share on my growth model.  Squeeze the margins up a little to mid-twenties and the growth rating to a still sub-market growth rate of +5% and one can quickly see how some major shareholders have been arguing for a price of around £11 per share. 

BSkyB - valuation trade off between growth and margins

Although a >+5% CAGR growth rating may be an ambitious expectation on current consensus revenue growth forecasts beyond 2013, the group has sustained a growth rating in excess of this in all but two years, 2005 and 2006, when I estimate it fell to +3.6% and +2.8% respectively.

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News of the World - Will amputation save the patient (bid)

"Murdoch shutters the venerable 'News of the Screws'" Was this an act of contrition for the phone tapping scandal or an act of desperation to secure regulatory (read political) approval for News Corporations bid for the outstanding shares in BSkyB? If so, will it work when the editor of the NoW at the time of these infractions remains in place at the top of the corporate pole, yet the rest are sacrificed?

As an attempt to draw a line under the phone hacking scandal, this rather radical action is unlikely to satisfy the 'liberal' media. Much of their real gripe had less to do with their sense of moral indignation of phone tapping, than their concern about Murdoch's bid for the rest of BSkyB. However, this action tells us a lot about Murdoch's determination to secure his real prize of BSkyB and this is unlikely to be missed by markets. Existing BSkyB shareholders meanwhile will no doubt have their resolve harden to hold out for a knockout price.

When Murdoch waves goodbye to the News of the World and 200 staff, will he really abandon its 7.5m readers, 2.6m of weekly sales and annual revenues approaching £200m (including approx £110m from copy sales)?   Rumours had already been circulating that News Intl was looking to move to a 7 days a week operation to offset the structural decay in readership and revenues.  In this case, keeping the captain while throwing the crew overboard makes a lot of sense.

If News Intl is really going to abandon the Sunday market, the main beneficiary would be Trinity Mirror, with its two ailing titles, the Sunday Mirror and People.  However, I suspect that the bounce in its share price on this expectation may be fairly muted as markets see through the ruse. In a sense, Murdoch may be trying to kill two birds with one stone here. Lance a story that was threatening his bid for BSkyB while accelerating a cost reduction plan for his newspapers.  200 angry journalists and hardened price expectations by BSkyB shareholders however might provide an offsetting price to pay.