Quarterly Commentary 31 December 2016 COMMENTARY wave of initial public offerings (IPOs) are a case in point. IPOs are supposedly engineered to deliver good outcomes for investors and many remember the extreme success of the demutualisations and government sell-downs in the 1980s and 1990s. 2016, however, has been a particularly bad year for these newly-listed companies and the complacent investors who backed them. Not only have newly-listed companies been disproportionately represented in 2016’s corporate collapses, many of those that remain standing have significantly underperformed the broader sharemarket. Dick Smith, Vocation and McAleese were all placed into SIMON MAWHINNEY, CFA administration recently with none of these managing to Managing Director & Chief Investment Officer chalk up their three year anniversary as a listed company. Excluding these corporate failures, seven of the ten worst performing shares in the S&P ASX All Ordinaries Index this It has been a great year for our investors with performance year were newly-listed companies. None of the best bouncing back very strongly after a disappointing 2015. performing ten were newly-listed. Readers may be pleased to know that, despite our recent success, we enter 2017 with the same razor-like focus and Picking on the worst performers is not necessarily investment rigour as we entered 2016. representative of the entire sample of newly-listed companies. Over the past ten years, there have been 141 There is never a good time to be complacent when it comes IPOs of Australian companies with market capitalisations of to investing and we continue to scour the market for great greater than $200m. Table 1 shows how these IPOs have opportunities. Exercising caution is critical and the recent performed relative to the broader sharemarket. Table 1 : IPO performance relative to S&P/ASX 300 Index after one and three years of listing Average Over/(Under) Sample size Number of Number of performance Outperformers Underperformers After 1 year 9% 124 58 66 After 3 years (11%) 74 25 49 Source: FactSet, Allan Gray Australia, Deutsche Bank 2 of 12 Q4 2016 Of the 141 IPOs analysed, 124 have a track record greater shareholders, who know the most about their businesses, than one year (i.e. 17 were listed in the past year). These with fee-gouging investment banks close behind. These companies have, on average, outperformed the sharemarket companies often outperform in their first year as a listed by 9% in their first year of trading. Extending the analysis to company but go on to significantly underperform the broader those with a three-or-more year track record reduces the sharemarket when the cycle turns or their very optimistic sample size to 74. These companies have, on average, projections reflected in the prospectus are not achieved. underperformed the sharemarket by 11%. In both It is for these reasons that we don’t typically participate in categories there are more underperformers than IPOs. Not only do we not have access to the same outperformers. information as the sellers of these businesses, it is usually This should not come as a surprise. IPOs today usually better to wait for less rosy outlooks to prevail, with resulting follow extremely favourable business conditions and are prices which more adequately compensate a buyer of floated when the outlook is extremely optimistic. They are shares for the risks they take on. One such example is Nine usually priced for perfection, with exiting shareholders Entertainment Company which listed in December 2013 eager to extract as high a price as possible. The greatest and today trades at about half its listing price. Tim Hillier beneficiaries are the exiting founders or private equity discusses below. The favourable structure of the TV industry made networks very profitable businesses for many years. TV was the dominant form of home entertainment and consistently attracted large audiences. This enabled the TV industry to win a major share of total advertising revenues – approximately 30%. There were also only three Government-issued licences available, thereby limiting competition for audiences and the corresponding advertising dollars. More recently, external competition for both audiences and advertising dollars has increased. This started with the arrival of subscription TV, but has accelerated with the availability of online content, from internet downloads, to TIM HILLIER, CFA the recent arrival of subscription streaming video-on- demand (SVOD) services, like Netflix. Analyst Like the other networks, Nine has had a colourful ownership Nine Entertainment Company history. The Packer family has owned it twice, having sold it to Alan Bond before repurchasing it at a significantly lower Nine Entertainment Company (Nine) owns one of the three price. More recently, CVC (a large private equity firm) commercial, free-to-air TV networks that broadcast into purchased Nine in a debt-laden acquisition prior to the large Australian cities. Commercial TV networks make global financial crisis. This debt burden ultimately forced money by selling advertising space. The larger their Nine into a restructuring from which lenders Oaktree and audience, the more the network can charge. To attract Apollo emerged as owners of the company in 2012. In these audiences, the networks have to create or buy December 2013 Nine was finally sold to the general public sought-after content (sport, drama, etc.). in an IPO at $2.05 per share. 3 of 12 Q4 2016 Expectations at the time of the IPO In the lead up to Nine’s IPO, TV’s share of national from 35% in 2007 to 38-39% at the time of the IPO. This is advertising expenditure continued to be largely unchanged represented in Graph 1. at 30%. Meanwhile, Nine’s share of audiences had grown Graph 1: Nine’s audience share grew while TV’s share of advertising expenditure remained constant 40 40 35 39 30 38 25 37 20 36 air TV audience in key - to - 15 35 geographies 10 34 % of national advertising % of national advertising expenditure 5 33 % share % share of free 0 32 2006 2007 2008 2009 2010 2011 2012 2013 TV share of advertising expenditure - full years only (LHS) Nine's share of TV audiences (RHS) Source: Nine prospectus, November 2013 The outlook for the TV industry was reasonably positive at The outlook for the TV industry deteriorates the time of the IPO. Many expected TV to retain its share of national advertising expenditure, which itself had grown a Since Nine’s IPO, TV audiences have declined as a range of bit above inflation over time. The more optimistic new platforms and content have become available and been forecasters expected TV to command a greater share of embraced by consumers. Not least of these is Netflix, which national advertising, as a rapidly changing media market launched in Australia in March 2015 and enables users to meant TV remained the only effective way to reach a mass pay a monthly subscription to watch content at a time they audience. However, it turned out that even the less bullish choose with no advertising interruptions. Advertisers also expectations of maintaining national advertising share now have a greater range of platforms upon which to screen were too optimistic. video content (e.g. news websites and social media) where previously TV was the only choice. Nine’s run of ratings (share of audience) improvements also ended, as several of its new shows underperformed and Channel Ten regained lost ground. Graph 2 shows Nine’s 12-month rolling average share of commercial free-to-air audience. 4 of 12 Q4 2016 Graph 2: Nine’s audience share has decreased 40 39 38 37 36 35 34 five capital cities 33 32 Nine's % share of free-to-air TV audience in Nine's % share of free-to-air 2010 2011 2012 2013 2014 2015 2016 Source: Allan Gray Australia, November 2016 Meanwhile, content costs for the industry have continued Warner Bros. This approach will allow Nine to better to grow, most notably as TV companies have outbid each respond to changes in both the advertising cycle and the TV other to win the rights to broadcast sport. With lacklustre industry’s fortunes. Expected reforms to media regulation revenue growth, this has been a recipe for poor returns. in Australia, a response to the rise of online competition, could also result in a substantial reduction in Nine’s c.$35m TV’s deteriorating prospects, the fall in Nine’s audience p.a. annual licence fee costs. Nine also has a strong balance share and concerns about content costs have resulted in sheet, a luxury its fellow broadcasters don’t enjoy – we Nine’s share price underperforming the sharemarket by estimate the company to have net debt of less than $50m. over 50% since its IPO. Pessimism reigns supreme and the outlook for free-to-air TV broadcasters is widely believed to Nine presents an attractive opportunity be dire. But we think the outlook is too pessimistic and Nine’s share price more than adequately compensates Today, Nine’s market capitalisation and net debt total investors for TV’s challenging outlook. around $950m. We expect Nine to generate approximately $140m in operating profits (before tax) in 2017. There is The market has become too pessimistic about Nine’s prospects certainly some risk that earnings fall from here, but at seven times these operating earnings (relative to the broader Advancements in technology will continue to change the sharemarket at 12 times) much of this risk appears to be competitive landscape, with viewers being presented with priced in. more convenient ways to access a broad range of content. The market certainly isn’t pricing in the potential for any However, over the years live TV has remained popular, positive developments, like success in Nine’s SVOD venture.