By Paul Rickard

Call it a coincidence, but just as I was addressing a question on Tuesday morning from a Switzer Super Report subscriber about whether the Nine Entertainment Company (ASX Code: NEC) was a “long term buy”, the screen flashed up a Q3 trading update from Nine. I didn’t need to read too far to confirm that the update was bad news.  

In case you missed the update, Nine Entertainment warned that the TV advertising market was subdued and that their ratings were softer than expected. They said that the free-to-air advertising market was likely to experience low single digit decline in FY16, and that Nine’s share is likely to be around 37%.

While they blamed some of the rating loss on the weather impacting the cricket coverage, revenues for Q3 FY16 were going to be down by about 11% compared to the corresponding quarter in FY15.

Not surprisingly, shares in Nine were slammed. Closing yesterday at $1.185, they are a long way short of their December 2013 IPO price of $2.05, which paved the way for the then owners, private equity players Oaktree and Apollo, to exit their holdings.

The subsequent share price performance of Nine (and exit by private equity) is really not that surprising, because Nine is part of an industry facing massive headwinds.

Massive headwinds for free-to-air TV

A bit like newspapers, the digital revolution is eating away at the revenues of fee-to-air TV operators. Despite an increase in channels, total audience numbers are falling as behaviours change.  For example, kids today don’t come home from school or university and as a matter of routine, switch on the TV. Rather, they are in their rooms watching movies or videos, playing games or accessing other content, but doing this through their phones or laptops. 

The advertisers know this. Not only is free-to-air TV losing share of the advertising dollar pool, revenues are actually starting to decline in nominal dollars. As the following chart from data sourced from the industry’s own association (Free TV Australia) shows, there has been no growth over the last 4 years in total advertising revenue, and for regional TV services, it has fallen by 7.3%.

Free TV Advertising Revenue - $m 

It could be getting worse, if Nine’s warning about low single digit decline turns out to be correct, and comes at the same time as 5 subscription video on demand services (Netflix, Presto, Quickflix, Foxtel Play and Stan) wage a war over new customers. While Nine has a 50% interest in Stan, these services could ultimately prove to be a real threat to the viability of free-to-air TV.

While Nine and the other operators have been working hard on their costs, there is still pressure, particularly in regards to high profile content deals. The recent AFL and NRL sporting rights deals attest to the pressure free-to-air TV operators face.

Falling revenue and pressure on costs translates to lower profits. In the first half of FY16, NEC’s Group EBITDA (excluding discontinued businesses) fell by 5.2% to $127.9m, compared to $134.9m in FY 15. 

Potential positives for Nine

There are potential upsides for Nine. It is free of debt (or was until it recently acquired a 9.99% interest in Southern Cross Media for approx. $100m), so it has the capacity to take part in any media industry shakeup. It is also currently undertaking a second on-market buyback of up to $150m.

In March, the Government announced its proposed changes to the media laws. The two major changes, the abolition of the ‘75% reach’ rule and the scrapping of the ’2 out of 3 rule’, mean that Nine could potentially tie up with affiliate WIN or Southern Cross Media under the first change, or merge with Fairfax under the second change. Given a potentially hostile Senate, turning proposals into law may be harder than it looks. However, the market believes that Nine is a winner, and hence wasn’t surprised when Nine fired the first bullet by buying a slice of Southern Cross.

There has also been a suggestion that the Government may in the Budget reduce the licence fees that free-to-air TV operators pay.

The brokers

The brokers see upside with Nine, although their targets have been revised down since the third quarter update. According to FN Arena, the consensus target price is now $1.47. Of the 5 major brokers who have updated their forecasts since the trading update, 3 have buy recommendations, 2 have sells. Deutche Bank is the most bullish with a target price of $1.75, while Ord Minnett is the most bearish with a target price of $1.00. 

Nine is cheap on a multiple basis, trading on forecast multiple of 5.7 times FY16 earnings and 7.3 times FY17 earnings. It is also prospectively yielding over 10% (fully franked), although this may be under pressure if earnings in the second half (traditionally a weaker half) fall right away.

For the punters only

When I previewed the Nine IPO back in late 2013, I headlined the article “Nine is not my ABC”, and concluded with the word ”avoid”. Two and a third years later and with a share price 40% lower, I still can’t see any reason to change this assessment. Why would a long term portfolio investor want to put capital into a business that is fighting such headwinds? 

This doesn’t rule out buying Nine shares as a punt in the short term. If you want to take part in the media merger game, or think that the market may have oversold Nine, then you could mount an argument that Nine shares are cheap. However, “Jack be nimble, Jack be quick”, because Peter Costello (the new Nine Chairman) or not, those headwinds are pretty strong.