Wednesday's Top Upgrades (and Downgrades)

Analyst announces picks and pans for Twenty-First Century Fox, Discovery Communications, and Viacom.

Rich Smith
Rich Smith
Jul 9, 2014 at 1:02PM
Consumer Goods

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we're taking a look at the media sector as analysts at Barclays Capital launch coverage of two stocks, Twenty-First Century Fox (NASDAQ:FOXA) and Discovery Communications (NASDAQ:DISCA), with "overweight" ratings, but rate Viacom (NASDAQ:VIAB) a sell. Let's find out more, beginning with...

Bad news first
Viacom's latest Transformers movie (No. 4) hit $575 million in worldwide box office revenue over the holiday weekend, including $212 million in China -- meaning that country's sales alone were enough to pay for the film's $201 million development budget. The film is expected to top $700 million by the time next Monday rolls around -- and yet, Barclays rates the stock an underperform. Why?

Forbes points out that for all the success of Transformers: Age of Extinction, Viacom itself is something less than a success, ranking sixth (out of six) among major movie studios on revenues this year, and with the fewest movie releases as well. And to hear Barclays tell it, the stock's prospects aren't exactly top-of-the-heap, either. In fact, Barclays thinks that a year from now, Viacom shares will be selling for only $84 apiece -- just under what the stock fetches today. But is that good enough reason to sell it?

Honestly, I don't think so. Priced at 16 times earnings, Viacom shares look fully priced -- maybe even slightly overpriced -- for the 13% long-term earnings growth that Wall Street expects it to produce. But the company produces good free cash flow, roughly equal to reported net income according to data from S&P Capital IQ. It pays a decent 1.5% dividend yield, which helps to bridge the gap in valuation. All in all, while I don't think the stock is cheap, exactly, it's not so obviously overpriced that shareholders must rush for the exits at Barclays' say-so.

Is Twenty-First Century Fox a hit?
That's more than I can say for Twenty-First Century Fox, Barclays' big recommendation of the day. Here we have a stock selling for $35 and change, which Barclays says is headed for $43 -- but I don't see it.

Sure, on one hand most analysts have Fox pegged for faster growth than Viacom -- 16% annualized over the next five years. But Fox bears a price tag to match. Priced at 26 times earnings, it's significantly pricier than Viacom. Meanwhile, Fox is both stingier on the dividends front, paying out only 0.7% annually, and weak in the cash collection department as well.

S&P Capital IQ data show that over the past year, Fox generated positive free cash flow of only $2.3 billion. That's not a bad number, all by itself. And indeed, historically, Fox has done a good job of churning out cash from its business. Nevertheless, $2.3 billion in FCF is far short of the $3.1 billion in "net income" reported on the company's income statement, and this suggests that the stock is pricier than it looks. Barclays says the stock deserves an outperform rating based on its success signing up new subscribers for its network. But from where I sit, the valuation simply doesn't make this one a buy.

 Discovery-ing a bargain?
Subscriber growth is also the thesis behind Barclays' endorsement of Discovery Communications, incidentally. And here, finally, I think the analyst starts making some sense.

At first glance, Discovery actually looks a lot like Fox, selling for about 26 times earnings and growing at about 16%. But there are differences between the stocks, too. For one thing, while Fox costs a little more than 26 times earnings and is expected to grow a little less than 16% annually over the next five years, with Discovery, analysts are calling for the opposite: 16.6% growth on a 25.6 P/E stock.

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Also arguing in Discovery's favor is the fact that the company has the smallest debt load of the three media stocks discussed so far (about $6 billion net of cash on hand), and is the only one generating significantly better cash profits than what shows up on its income statement. Free cash flow for the past year at Discovery came to just under $1.3 billion, and that's 19% more cash profit than the $1.1 billion the company reported for its net income during the same period.

Granted, at 20 times free cash flow and with no dividend payout, the stock still doesn't look cheap enough to buy on growth alone. But it's the closest thing to a bargain in media stocks that Barclays has dug up yet.

Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.