Thanks for the response!
You're not really breaking anything to me to say that you're working on assumptions (as i am) - using assumptions to value securities is the very essence of investing. The fundamental point of the exercise for us all, in my mind, is to test our assumptions for reasonableness based on what is known.
So, for example, i personally find your assumption that licencing fees are peremptorily cut from their existing 3.4% to 1.5% a little unreasonable, in the absence of some justification. I find it a little unreasonable because the cut from 4.5% to 3.4% (i.e. a 25% cut in licensing fee) was legislated only 6 months ago, and that cut was achieved after three years of concerted lobbying efforts by the FTA television groups (the big cut from 9% to 4.5% was made in early 2013). So, to my mind, it's a little brave to assume that there's an immediate additional 55% cut in licensing fees which is coming down the pipe any time soon (although of course it's possible).
Can i ask what an "overall cost decrease of 5%" means? I think you have to be rather careful here, because there's really two sets of costs for a broadcaster - its cost of sales (i.e. the programming it buys), and its operating costs (employees, rent, marketing, admin and so on).
Operating costs
PRT basically has two P&L line items of operating costs - its broadcasting expenses, and its admin/marketing expense. However, as we know, the broadcasting expense line item comprises two items: 1) the government licence fee (which was cut from 9% to 4.5% in early 2013, and further cut to 3.4% late last year), and 2) other broadcasting costs. PRT doesn't have any ability to control (1) as that's a government-mandated cost, but it can control (2) to an extent.
We can take a look at how PRT has managed to control these costs over the last 3.5 years (seven operating halves) as set out below:
|
Column 1 |
Column 2 |
Column 3 |
Column 4 |
Column 5 |
Column 6 |
Column 7 |
Column 8 |
Column 9 |
| 1 |
|
2014 |
2015 |
2016 |
2017 |
|
|
|
|
| 2 |
|
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
| 3 |
Revenue |
$135.55 |
$124.73 |
$135.27 |
$123.55 |
$124.54 |
$114.28 |
$130.68 |
|
| 4 |
4.5% licence fee |
$6.10 |
$5.61 |
$6.09 |
$5.56 |
$5.60 |
$5.14 |
$5.88 |
|
| 5 |
Implied variable broadcast expense |
$15.13 |
$14.81 |
$13.07 |
$12.84 |
$12.68 |
$14.03 |
$12.52 |
|
| 6 |
Admin/marketing |
$7.47 |
$7.35 |
$7.45 |
$7.15 |
$7.08 |
$6.42 |
$6.78 |
|
| 7 |
Total variable operating costs |
$22.59 |
$22.16 |
$20.52 |
$20.00 |
$19.76 |
$20.46 |
$19.30 |
|
| 8 |
Variable operating costs % revenue |
16.67% |
17.76% |
15.17% |
16.19% |
15.87% |
17.90% |
14.77% |
|
The bit that stands out like a sort thumb to me is how consistent the variable operating costs of PRT are - since 1HFY15, every single half, PRT has spent between $19.3m and $20.5m on its variable operating costs (i.e. non-licence broadcasting expense, and admin/marketing).
So, when i look at that, i query the reasonableness of your assumption that "overall costs to decline 5%". It seems to me that the variable operating cost base of PRT, having last been hacked to the bone in FY14, is now very much stuck at about $40m per year.
Cost of sales
In addition to its operating costs, of course PRT has to buy programming which it broadcasts to its viewers. Its programming is bought primarily from Channel 7 in an agreement that commenced in June 2013 and runs until June 2019. While the terms of this syndication agreement are not made public, it's generally been accepted that the key mechanics are that C7 charges PRT a fixed percentage of PRT's advertising revenues (somewhere between 35-40%) in return for it providing the programming to PRT.
Assuming C7 charges PRT 40% of its advertising revenues (which is what media speculation was at the time - indeed, there was speculation that C7 ramped up that charge from <35% to ~40% in the new agreement effective June 2013), what we can do is split out PRT's cost of sales into two categories, being payments to Channel 7 under the syndication agreement, and non-Channel 7 cost of sales:
|
Column 1 |
Column 2 |
Column 3 |
Column 4 |
Column 5 |
Column 6 |
Column 7 |
Column 8 |
Column 9 |
| 1 |
|
2014 |
2015 |
2016 |
2017 |
|
|
|
|
| 2 |
|
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
| 3 |
Revenue |
$135.55 |
$124.73 |
$135.27 |
$123.55 |
$124.54 |
$114.28 |
$130.68 |
|
| 4 |
Channel 7 payment at 40% |
$54.22 |
$49.89 |
$54.11 |
$49.42 |
$49.82 |
$45.71 |
$52.27 |
|
| 5 |
Total cost of sales |
$71.06 |
$66.85 |
$72.04 |
$66.62 |
$69.37 |
$61.84 |
$74.12 |
|
| 6 |
Non C7 cost of sales |
$16.85 |
$16.96 |
$17.93 |
$17.21 |
$19.55 |
$16.13 |
$21.84 |
|
| 7 |
Non-C7 cost of sales % of revenue |
12.43% |
13.60% |
13.26% |
13.93% |
15.70% |
14.11% |
16.72% |
|
The really worrying part of the above table as far as PRT is concerned, is the last row - that is, the cost of PRT's programming that isn't paid to Channel 7 is going up and up, while revenues are going down and down. That has to do with the changing media landscape - content providers/producers have more avenues than ever before through which to sell their content (i.e. internet) so the price is going up, so PRT has to pay more and more for the non-C7 content that it buys, but its revenues are shrinking.
That, i believe, is why we are seeing the below gross margin performance in PRT (see the last row of below table):
|
Column 1 |
Column 2 |
Column 3 |
Column 4 |
Column 5 |
Column 6 |
Column 7 |
Column 8 |
Column 9 |
| 1 |
|
2014 |
2015 |
2016 |
2017 |
|
|
|
|
| 2 |
|
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
H1 |
H2 |
| 3 |
Revenue |
135.546 |
124.731 |
135.266 |
123.547 |
124.543 |
114.275 |
130.681 |
|
| 4 |
COS |
-71.064 |
-66.854 |
-72.041 |
-66.624 |
-69.367 |
-61.839 |
-74.117 |
|
| 5 |
GP |
64.482 |
57.877 |
63.225 |
56.923 |
55.176 |
52.436 |
56.564 |
|
| 6 |
GP margin |
47.57% |
46.40% |
46.74% |
46.07% |
44.30% |
45.89% |
43.28% |
|
So, given this seemingly inexorable trend of PRT paying more and more for non-Channel 7 programming, while having less and less viewers (and therefore revenue) from which to pay for the programming, i believe it follows that we should continue to expect PRT's gross margin to compress further and further, at least until June 2019 when they have the opportunity to renegotiate their syndication agreement with Channel 7.
What might happen in 2019?
When C7 and PRT last renegotiated the syndication agreement in 2013, it was rumored that C7 turned the screws on PRT and ratcheted up its take of advertising revenue from about 35% to around 40%. While this is unconfirmed, what we do know as fact is that PRT's gross margin peaked around 51% in FY12 and has since been going backwards every year, so i think it's reasonable to assume that C7 did negotiate for themselves a more favorable syndication agreement with PRT in mid 2013.
The payments PRT makes to C7 show up in C7's P&L as a revenue item called "affiliate fees and other". What i think is really interesting is that these affiliate payments in C7's accounts actually
increased from FY15 to FY16 - it went from $115m to $119m - while all other categories of TV revenue decreased. On my assumption that PRT pays to C7 40% of its revenues, it's fair to assume that the lion's share of C7's reported affiliate fees revenue comes from PRT.
This raises some interesting questions:
1) Why is C7 apparently getting
more from PRT, when PRT's revenues are declining? It is generally accepted that PRT pays a % of its revenues to C7, so we should be seeing C7's affiliate fees revenues decline.
2) What might a desperate C7 do to PRT in the next round of negotiations in FY19? If i'm C7 and all my other categories of revenue are declining, i might be inclined to squeeze a few more drops of blood out of my affiliates by ratcheting up that fee even further (as was the case in June 2013). Indeed, i think last year's musical chairs with C9 & C10, and WIN and Southern Cross, gives some good insight into where PRT might end up in 2019. The nub of that musical chairs is Nine ditched WIN after 30 years and went for Southern Cross instead, and SC pays Nine 50% of its revenue to syndicate; the reason WIN is now affiliated with C10 instead of C9 is because WIN wanted the cheaper deal (lower syndication fee), but that invites problems of its own because its known that C10's programming is the worst of the three major Australian networks (so the syndication costs less, but advertising revenue is lower).
Conclusion and implication
So, given my belief as above that: 1) controllable (non-licence) operating costs are stuck at around $40m per year, and 2) gross margin will continue to compress until at least 2019 when PRT can renegotiate with C7, it becomes a mere question of how severe one wants to be in determining where PRT might be by the end of FY19. In any event, i believe it is facile and misleading to think about this business in terms of FY17 multiples, because the earnings are very clearly headed down.
And, while government may change policy, there's no guarantee on that. Indeed, a continuation of business-as-usual is still the most likely outcome here. And i believe PRT faces a very uncertain future in FY19 when its existing syndication agreement with C7 expires - given syndication fees are trending up (as desperate networks suck the last drops of blood out of their affiliates), i would personally be inclined to place a higher-than-normal discount rate on PRT's terminal value beyond FY19 because its future is very uncertain and, in my view, weighted heavily to the downside.
