Unfair weakness offers buying opportunity at ITV

ITV’s shares have slumped in the wake of the challenges. Down nearly a third in the past 12 months, the group now trades on a forward price/earnings (PE) ratio of nine times, while its enterprise value is just eight times forecast adjusted cash profits. That’s well below the UK broadcasting sector average. But we don’t think it's a fair reflection of the potential at ITV, especially as the group is becoming less reliant on the advertising industry.

In 2017, 56 per cent of its revenues came from non-advertising sources, although about a quarter of that £2bn in sales represented internal payments for ITV to broadcast of programmes made by its own studios business. Aside from £1.6bn of studio sales, other non-advertising revenue sources include ITV's online and pay-TV offerings. Importantly, growth from non-advertising sources is good.

Last year, ITV’s studios business produced over 8,400 hours of programming (up 8 per cent on the prior year) and secured 239 new commissions. Of note was the 33 per cent increase in revenues in the US studios business, where ITV is now being employed by Netflix and Amazon – the two pioneers of digital TV. In the UK, too, its original content offering is strengthening thanks in part to its acquisition of a majority stake in World Productions, producer of Line of Duty, and a 50 per cent increase in its investment in drama programmes to £243m.

Prospects are also looking up in the broadcasting business, which principally represents advertising income, but also encompasses the online and pay TV operation. Shore Cap forecasts roughly 2 per cent revenue growth in each of the next three years – a relief following two years of declines.

Driving that uptick is ITV’s online offering. Its ITV Hub now has 21m registered users, including 75 per cent of the UK’s 16- to 24-year-olds – a notoriously difficult demographic for traditional broadcasters to target. In the short term, advertising is expected to be boosted by the upcoming 2018 Fifa World Cup and over the longer term it is hoped TV advertising will stabilise. Encouragingly, advertising revenue is expected to be up 1 per cent in the first quarter, too. Meanwhile, management is planning to increase spending on programming in a bid to entice more viewers and advertisers. Scheduling costs are expected to rise from £1.06bn this year to £1.1bn in 2019.

That expenditure may have forced analysts to taper their profit forecasts, but should stand ITV in good stead for the long term. What’s more, original content is becoming increasingly valuable as the dynamics of the global TV market shift. As demonstrated by the complex takeover saga unfolding around Sky (SKY) and attempted merger between AT&T and Time Warner, entertainment companies are willing to dig deep to get their hands on quality programmes. ITV’s strong portfolio of content could therefore make it a takeover target.

Financially, the group remains in good shape. It is cash generative and in 2017, made £793m of cash from operations, equivalent to 94 per cent of adjusted operating profit before amortisation. That leaves plenty of headroom for investment, including further acquisitions. New chief executive Carolyn McCall – who joined ITV earlier this year following a successful seven years at easyJet – recently announced a “strategic refresh”, which will include £15m-£20m of investment in property, online and data.

The group also pays a generous dividend, which currently yields 5.5 per cent and is covered 1.9 times by forecast earnings. Investors may have been disappointed that ITV failed to produce a special dividend in 2017 – for the first time in five years – but that seems a sensible decision considering the forecast expenditure in 2018 and the fact net debt has risen to one times adjusted cash profits.