Facebook - Q2 FY14: Squeezing out the returns, but DAU growth slowing

Unparalleled qualitative information on consumers and unmatched reach makes Facebook a must have for both advertisers and NSA alike. For the moment, the group is managing the migration to lower yield mobile and overseas users while sustaining overall yield growth of +41% YoY and +14% QoQ and somewhat surprisingly, an average yield increase on non-mobile DAU that is actually greater than that for mobile! Having convinced the advertisers to spend, Facebook’s low direct cost component is enabling the marginal revenues to drop down substantially through to margins and even more impressively to cash/marketable securities. Indeed, the ability in H1 to increase revenues by almost $1.1bn with accounts receivable expanding by just $81m is truly impressive.   Social media users however are fickle and today’s cool site may not be so appealing should the owners appear to sell-out to commercial and government interests.  Yes, reach is still growing, but at +3% QoQ, not by that much and any reversal could quite quickly see remedial costs thrown at the hole and reverse some of today’s spectacular performances.  

Trading Q2 FY14: Revenues +61%/+$1.097bn to $2.91bn (vs Q1 +72%/+$1.044bn), costs +22%/+$269m to $1.52bn (vs Q1 +32%/+$342m to $1.43bn), EBIT +147%/+$828m to $1.39bn (vs Q1 +188%/+$702m to $1.075bn) and margins +17pts to 48% (vs Q1 +17pts to 43%). Within revenues, advertising (91% of revenues) advanced+67% to $2.68bn (vs Q1 +82% to $2.27bn), including mobile (62% of advertising vs 59% in Q1).  Daily active users (DAUs) meanwhile, increased by +19% YoY to 829m (vs Q1 +21% YoY to 802m), including mobile at +39% to 654m (vs Q1 +43% to 609m).  After -$469m of CapExp (16.1% of revenues (vs Q1 -$363m/14.5%), Q1 FCF was $872m (vs Q1 $922m) while cash and marketable securities ended the period up +$1.32bn to $13.954bn (vs end Q1 of  $12.63bn), albeit not reflected in the P&L with a net interest EXPENSE reported of -$4m (vs Q1 of -$20m)!

 Also to be found here at wyt-i.com

BSkyB & the rising cost of growth

BSkyB:  OK, so what’s the narrative to be?  21st Century Fox (Murdoch) parks some low yielding European payTV assets into a 39% owned subsidiary to raise at least £4.6bn of cash to help fund its (Murdoch’s) $80m Time Warner bid? As long as the market thinks that he will be back for the lot at a later point, with another full bid for BSkyB, once the phone hacking ruckus has died down, then he gets the cash, keeps control and supports the shares; which could always be re-hypothecated for some more funding. 

What about the core business? Last year’s stalled profits can in part be explained by the heavy step up costs for the new Premier League contract and bulls can point to the still healthy advance in revenues of +7% and the prospective rebound in profitability in the coming  year as programming costs stabilise.  The uplift from the revised Premier League contract however was a symptom of the changing distribution landscape and was not the only source of cost inflation to the group. To support all those new services came at a price, with Direct Network costs (+15%), Transmission & Technology (+11%) and Depreciation (+12%) all running well ahead of the +7% revenue growth.  If the above is the problem then, is the decision to buy Sky Italia and at least 57.4% of Sky Deutschland the solution?

Both Sky Deutschland and Sky Italia could be said to offer potential, but this could also be said of them many times over the past decade, while neither of them are particularly cheap on their current trading trajectories. Sky-D subscriber numbers and revenues have been flat-lining for years while the purchase price of €6.75ps values these subscribers  within 10% of BSkyB's on a per subscriber basis, yet with under half the revenue per subscriber generated. For Sky Italia, the growth record is better and the take-out price less onerous, although still struggling to generate much of a return.  Even with the £200m pa of projected savings by end FY17, these would represent less than 1.5% of combined sales and less than an additional 3pps return on the combined gross purchase price. With limited scope for joint rights purchase efficiencies or revenue synergies it seems investors will have to make a leap of faith here.   Having already had access to the best pay TV managers in town (including from BSkyB), it is also unclear what special sauce BSkyB will bring re-invigorate these two assets.

Trading – FY14: Revenues YoY +7% including retail subscriptions +5.1% (o/w ARPU +1.2%/+£7 and  TV subs +2.5%), Wholesale subscriptions +6.6%, Advertising +7.3%, Installation & Hardware -2.3% and Other +7.8% (incl Sky Bet at +18%).  Total paid-for subscriptions increased by +9.9% YoY to 34.775m, including TV at +264k/+2.5% YoY (o/w HD +456k YoY) and Broadband at +341k/+7.0% YoY. Q4 FY14 churn rates edged down slightly (by 20bps QoQ & YoY) to a still modest 10.9% while paid-for products per customer increased to 3.0 (vs 2.8) and with Triple-play now representing 37% of the retail subscription base (flat QoQ and +2pts YoY). FY14 adj EBITDA meanwhile declined by -£25m/-1% to £1,667m; a function of supporting new service introductions (SkyGo, Now etc) as well as higher programming costs (+7%/+£175m), including +£217m YoY increase from the step-up from the new Premier League 3 year contract. Including the benefit from a reduction in share base, the YoY decline in adj EPS was held at the previous year’s 60.0p while the FY 14 DPS was raised by +7% to 32.0p.

The ‘deal’. Excluding associated loan stock buyouts, BSkyB’s  proposed purchase commitments are between £4.97bn and £7.1bn, dependent on the proportion of Sky Deutschland that is tendered; from Fox’s 57.4% to a full 100% that is also being tendered for under German listing rules. To fund this, BSkyB is raising approx. £1.37bn via a placing of 156.1m new BSkyB ordinary shares (9.99% of the enlarged issued capital), with £382m funded from selling Fox BSkyB’s 21% stake in National Geographic and with the remainder funded by debt (possibly up to a max 2.9x debt/EBITDA). To maintain its 39.1% holding in BSkyB meanwhile, Fox will be taking up its entitlement. From Fox’s perspective, the disposal is worth approx. £5.35bn gross (£2.9bn for its 57.4% of Sky Deutschland and £2.45bn for the 100% of Sky Italia. As £382m will be part paid for by BSkyB’s 21% stake in National Geographic and Fox’s share of the placing will cost it around £730m, the net cash receipt for Fox should be approx. £4.24bn.

Pearson H1 FY14 results - cost savings promised, but no growth committment yet

Markets took a little time to appreciate the current cyclical and structural squeeze on profitability, but eventually got the message.  So far, that message is pain today as the group invests to extend is leadership in digital learning through a protracted cyclical downswing in its main markets followed by jam tomorrow as these measures yield returns and their accompanying costs drop away as early as FY15. This time-scale, may or may not be realistic, but having been strung again by missed expectations, markets may first wish to see some tangible evidence of restored organic revenue growth before wishing to reach out and discount the ‘recovery’ in FY15 and beyond. As usual, the lightly weighted H1 provides little hard evidence on progress, with this year’s results incurring a further £14m of restructuring charges, but offset by a slightly more favourable phasing of US educational sales than usual in the period.  Having re-arranged the reporting structure into the somewhat opaque new divisions (including “Growth” and “Core”) meanwhile, transparency into the businesses is not improved (FT is now ‘lost’ and is Brazil really “Growth”?), investors are therefore increasingly dependent on the narrative from management as to whether the current investment will actually deliver. For the moment, the focus seems to be on the cost fall-away into 2015 rather than any particular revenue growth commitment.

Trading H1 FY14: Revenues of £2,047m (+0% organic,+2% Acq,-9% fx) with EBITA of £75m (-40%/-£50m organic, +4% Acq, -9% fx) which was after a -£14m increase in restructuring charges (from -£29m to -£43m); vs WYT estimate of £73m of EBITA on a similar charge and organic revenue growth number.  By division, a heavier phasing of sales into H1 assisted North America to a +2% organic revenue rise with EBITA +24% to £36m notwithstanding a -28% fx drag. The new “Core” division however saw organic sales drop by -8% (weak UK curriculum and phasing) and EBITA by -76% (to  £13m). The new “Growth” segment (emerging market education and FT?) meanwhile is still living up to its moniker and delivered a +4% reported sales increase and +7% organic, albeit with reported EBITA halving from £12m to only £6m.

OUTLOOK:  FY14 expected to remain a transition year with continued cyclical headwinds from US & UK educational markets, but with lower restructuring charges, albeit partially absorbed by additional NPD expenditure and the adverse impact of fx movements.  On a net basis, the group is re-iterating its FY14 adj EPS forecast range of between 62-67p on the 28 Feb fx rate ($1.666 vs the current $1.697).  

Note: Net restructuring charges/benefits for FY14 are forecast at +£136m (v -£135m in FY13) including +£126m from lower restructuring charges, +£60m of incremental cost savings, but a -£50m increase in NPD.  For FY15, the group is targeting a further +£95m of net benefits to drop through to EBITA from +£50m reduced restructuring plus +£45m of additional cost savings, but no additional NPD.   

Murdoch and the art of using other people's money

So you've seen the headlines. First Fox's proposals to consolidate its interests in Sky Italia and Sky Deutschland into BSkyB, described by many as a "tidying up" exercise. Now we are treated to something more substantial to explain the earlier moves; an $80bn (c.$86 ps) plus offer for Time Warner.  The newswires are of course buzzing with analysis of the commercial logic and potential regulatory pitfalls of the proposed deal, along with the inevitable speculation about how much more can be squeezed out of Fox. There is another issue at play here however, that investors need to heed; the growing disconnect between voting control and equity risk.

There is nothing new about cascading shareholding and voting structures being used to exert control over companies.  While these companies perform to their potential, then shareholders usually turn a blind eye to the asymmetric relationship between risk and control. An enlightened despot however may be followed by a less capable one and that unfortunately is when the disenfranchised sheep learn about the equity risk premium.

21st Century Fox has two classes of equity, 2.23bn of the 'A' non-voting ordinaries with a market value of approximately $73.6bn and 0.712bn of the voting 'B' shares currently worth around $24bn.  The Murdoch family controls this c.$98bn of market value with a 39.4% stake of the 'B' voters; in other  words, with under 10% of the risk equity (39.4% x $24bn =$9.5 /$98bn = 9.6%).

This disconnect between risk and control however is not just limited to this top layer of ownership, but cascades down via a series of subsidiary layers which effectively leverage this disparity further with each step down. Take for example Fox's European broadcast interests; 100% of Sky Italia, 57% of Sky Deutschland and 39% of BSkyB. The Murdoch family control all of these assets, although with an effective equity risk exposure of only 9.4% for Sky Italia, 5.4% for Sky Deutschland and 3.7% for BSkyB. But the fun doesn't stop here though. Earlier this year, Fox proposed to fold its stakes in Sky Deutschland and Sky Italia into BSkyB - the purported 'tidying up' exercise. Regardless of the inherent risk that Fox would extract a 'control' premium from BSkyB for these assets, such a move would have further transferred equity risk on these assets to external investors while maintaining control by Murdoch. The effective share of Murdoch's equity risk for his stakes in both Sky Italia and Sky Deutscheland would have dropped to a mere 1.4%. For Fox, this deal would also have released around $11bn of cash with no effective reduction in control on these assets. Even were Fox to consolidate its share of BSkyB's increased debt, this would still add almost $7bn to Fox's funding headroom.

So back again to this Time Warner offer. 40% is in cash with the remainder in shares; not the 'B' voters however, but the 'A' non-voters. If Murdoch senior aims to leave management control to Murdoch juniors, he cannot afford to relinquish control at the top of this chain otherwise it will be game over. If this is his wish, and there is nothing to suggest otherwise, then speculation that he will sweeten the pot for Time Warner with an issue of voting shares seems wide of the mark.