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Pay TV, which has a long history in the US and Europe, had been considered somewhat recession proof. However, in Australia the industry is still in its infancy after only coming to life in the mid-1990s. Given this was after the last recession the recession proof theory had never been tested in Australia. Now it has.

Foxtel reported record subscribers, revenue and profits for the year to June, with EBITDA up 16% to $406 million.

EBITDA at Austar rose 13% to $115 million in the half year to June 2009.

Whilst the spotlight has been on Foxtel, Austar should be on investors’ radars as a well managed company with an equally strong market position.

The company

Established in 1995, Austar United Communications Limited’s (ASX:AUN) television business is the company’s core operation. Since its establishment, the television subscriber base has grown to over 729,000 (at June 30, 2009), which makes Austar far and away the largest subscription television operator in regional and rural Australia. Austar provides subscription television services in a service area of approximately 2.4 million homes, which is one-third of Australia’s total homes.

Austar’s digital television service includes over 120 premier channels, a near video-on-demand service and increased levels of interactivity, such as Box Office, Sports Active and Sky News Active. In February 2008, Austar launched MyStar, its personal digital recorder. With live pause, live rewind and recording functionality for two programs while reviewing a third, MyStar also provides viewers with the opportunity to record entire series as they’re aired, at the touch of a button.

Austar also has a 50% stake in XYZ networks (a 50/50 joint venture with FOXTEL). XYZ is the exclusive owner and/or distributor of 11 key programming channels.

The Industry

The industry in Australia is clearly dominated by two players, Foxtel and Austar. Both essentially act as regional monopolies, with Foxtel servicing the major centres and Austar servicing regional and rural Australia.

The market position and the monopolistic nature of these businesses have made them very desirable assets. Their performance through the recent downturn has further reinforced the attractive nature of these businesses.

Foxtel has been under the spotlight recently with Kerry Stokes seeking to gain exposure to it through buying into Consolidated Media Holdings Limited (ASX:CMJ). Consolidated Media own 25% of Foxtel with the other shareholders being Telstra Corporation Limited (ASX:TLS) at 50% and News Corporation (ASX:NWS) at 25%. In defence, Consolidated Media sold off its other assets and initiated a buyback. After Stokes realised he was not going to be able to overtake James Packer on the register, (the buyback was designed to get Packer over 50%) he sought a truce and had two representatives added to the board. Now, Consolidated Media is cashed up and potentially looking for acquisitions.

There is uncertainty around one of Foxtel’s other shareholders, Telstra. Following the government’s regulatory review and the strong possibility that Telstra will structurally separate, it is possible that Telstra will look to sell its stake. If it did choose to sell, Consolidated Media would be a natural buyer. However, we believe it is unlikely Telstra would choose to sell off Foxtel. So Consolidated Media would need to look elsewhere to deploy its cash. Could Austar be a target? Definitely, it shares almost identical attributes to Foxtel and the two companies would be a very natural fit.

Austar has been under takeover speculation in the past. In 2007, Foxtel approached Austar about a merger. Given the similarity of the two companies and the potential synergies available we believe the merger would make sense. Therefore if Consolidated Media isn’t interested in buying Austar outright we believe the merger with Foxtel may come back to the table.

Figure 1 – Valuation: Difficult with negative equity


 

In valuing Austar the first thing we notice is that the company has negative equity. This makes it difficult to value on a Return on Equity (ROE) basis. Normally, having negative equity would be a black flag for a company, however we believe this case is different. It is different because the company we are evaluating is consistently profitable. As can be seen it has made a profit in four of the last five years. The loss in FY08 was due to the non-cash accounting charges associated with hedges in place on their debt.

As we can’t use our tried and true ROE method to value the company we must find another way. We believe a discounted cash flow model (DCF) to be the most appropriate way. By estimating future free cash over coming years, defined as EBITDA less capital expenditure, working capital and tax, and discounting this back to the present we believe we can accurately value the company.

Undertaking a DCF we get a value of $1.15 for Austar. This is based on revenue growth of 5% and EBITDA growth of 7.5% over the next 10 years. Revenue growth is achieved in two ways – through subscriber growth and through fee increases. EBITDA growth should exceed revenue growth as the marginal cost of each additional subscriber decreases. Figure 2 below shows the sensitivity to both EBITDA growth over the next 10 years and the beta of the company. We have assumed a beta of 0.9 given the defensive nature of the earnings stream.

Figure 2

Our assumption of 7.5% EBITDA growth appears quite conservative when compared to the growth in recent years.

Figure 3


 
Source: Austar Results Presentation

The growth in EBITDA is a result of two key drivers:
1)    Average Revenue per User (ARPU); and
2)    Growth in total subscribers.

Firstly, ARPU:

Figure 4  

Source: Austar Results Presentation

This measure has increased steadily over the last few years. This has been driven by more subscribers migrating onto the higher fee MyStar platform. We believe this migration will continue over the next few years and continue to grow EBITDA growth.

The second key driver is the total subscribers:

Figure 5


 
Source: Austar Results Presentation

Subscribers have risen steadily on the back of new subscribers coming on board and decreasing churn:

Figure 6

Source: Austar Results Presentation

Clearly the business is being well managed and is performing well. The recent results suggest that our long term EBITDA growth assumption is conservative. From the sensitivity table we can see that just a 0.5% increase in EBITDA growth to 8% can have a $0.12 increase in the price.

Conclusion

Austar is a well-managed company with a strong market position. It is of a defensive nature as witnessed by recent results. There is potential for corporate activity building and we believe there would be a number of interested buyers. Valuations do not appear stretched at current prices and we see good value at $1.15 or below.

Guy Carson uses StockVal. Exclusively for The Bull subscribers, StockVal is offering a free two-week test drive. Click here

 

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