STV Group — Update 20 December 2015

STV is Scotland’s leading TV broadcaster, producer and media brand. It is the Channel 3 licence holder for Scotland (STV), reaching a fairly stable 3.6 million viewers each month, making it the largest commercial TV channel in Scotland by a considerable margin. This accounts for around 86% of EBIT and provides a fairly steady, highly cash-generative earnings stream. With TV viewing becoming increasingly non-linear, management is working towards leveraging its strong brand and content assets to increase its share of non-broadcast earnings and drive growth. It has made good progress in the last couple of years in developing a portfolio of media assets, at relatively little expense. ‘Off-network’ initiatives in its Consumer division are focused on its digital channels through its STV Player and stv.tv and, more recently, on developing targeting capabilities via its local City TV channels and by leveraging its large and growing bank of first-party customer data. It is also investing in expanding its Production division, which we expect to start to deliver in 2016, and has announced plans to launch an enhanced digital news service in February 2016.

Management has provided a transparent road map of KPIs and is making good progress delivering on these targets. STV peak-time audiences remain ahead of the ITV Network and the ‘off-network’ initiatives continue to gain traction; the STV player added a further 100k users around the Rugby World Cup, and it is now experimenting with commercialising the first-party data it holds on one-third of the adult population in Scotland. The Production division has been slower to develop than hoped, acting as a drag on group revenues. However, we expect overall revenue growth again next year: the investment made in drama and factual over the last 18 months should start to deliver, we see scope for margin improvement from the faster-growing digital initiatives, the city channels are moving towards break-even and earnings will also benefit from the falling debt position.

Using our more conservative basis for calculating EV (adjusted for the pension deficit funding) at 9.9x FY16e EV/EBITDA, the shares are in line with the broader sector, although at a 20% discount to the closest peer, ITV. On an 10.4x FY16e P/E, its discount to peers is very marked against both ITV (14.9x) and the sector average of 17.9x; the market does not yet seem to be reflecting the earnings leverage that STV is deriving from its falling financial gearing. The business is strongly cash generative and historic issues regarding high debt levels are firmly in the past. This is reflected in management’s reinstatement of a progressive dividend policy; 10p per share for the full year (+25% on 2014) and 12p per share planned for 2016, despite a higher pension funding requirement. Year to date the shares are up 20%, although they have been weak since the interims on 27 August. This pause for breath is a good time to look at STV again ahead of a forecast return to top-line growth next year and potential enhancements to earnings from favourable changes to the UK’s TV regulatory regime.

Both Ofcom and the DCMS, recognising the challenges that PSB broadcasters may face in the coming years as viewing becomes increasingly on demand, have launched a review into a number of initiatives that could result in changes in the obligations and the monetisation possibilities for PSBs. The outcome is unclear and we have not attempted to capture it in forecasts. In parallel, the BBC Charter Review could alter the competitive landscape for commercial TV companies. We expect the outcome of these reviews to be broadly favourable to STV, although there is limited visibility and this cannot be guaranteed. With the majority of revenues from advertising, results may also be affected by the strength of the economy and advertising trends.

STV reports across two divisions: STV Consumer, which houses its family of advertising-funded broadcast channels and digital services and STV Productions. Founded in 1957 (as Scottish Television), STV is headquartered in Glasgow, with additional studios and offices in Edinburgh, Aberdeen, Inverness, Dundee and London. It has approximately 400 employees, plus about 600 freelancers per year for its production business.

In 2015, we forecast Consumer will generate 93% of revenues and 98% of EBIT. The UK accounts for 99% of STV’s sales, with any overseas sales generated by its productions.

STV Consumer’s largest component (81% FY15e revenues) is STV, Scotland’s largest commercial TV service. Consumer also includes STV’s digital initiatives; STV Player, its on demand catch-up service; its growing portfolio of City TV channels (currently in Glasgow and Edinburgh with three more Scottish cities due to launch in 2016); City Apps (for Scotland’s four largest cities); and the STV website, www.stv.tv.

STV Productions is Scotland’s largest commercial television production business, producing c 100 hours of programming a year. It creates and produces programmes for broadcasters in the UK and overseas, including the BBC, ITV and Channel 5. Popular recurring series include the Antiques Road Trip and Catchphrase. It also works in partnership with Red Arrow Entertainment and GroupM, to license and develop new formats.

Since March 2012 STV has been an affiliate of the Channel 3 network, which also comprises ITV in England and UTV in Northern Ireland (recently bought by ITV plc). As a network affiliate, STV makes its own regional programmes and sells its regional airtime, while ITV plc is responsible for network programming and national airtime sales.

The Channel 3 franchise provides a fairly stable stream of cash of around £20m a year (after network programming and transmission costs), growing at 2-3%, which management is using to pay down debt and underpin its progressive dividend policy. Given national airtime sales account for a large chunk of revenues (71% FY15e revenues) and network programming accounts for c 40% of its cost base, management has limited control over the performance of its Channel 3 franchise. Management aims to exceed network audience share through its regional programming and news (which it does consistently).

With 34% of audience share, it also generates mass TV audiences far in excess of any other media in Scotland, providing a strong platform to launch, cross-promote and fund its off-network initiatives to exploit its strong brand in Scotland.

These off-network initiatives underpin management’s target to grow its non-broadcast share of earnings to one-third of its earnings base by 2015 and to deliver a 10% CAGR in adjusted EPS over the period 2014-17. To measure its progress it has set 11 clear KPI financial and operational targets (summarised in Exhibit 3). So far in 2015, it is tracking ahead for most of its KPIs bar production revenues, and with the recent strength in the TV advertising market, broadcast EBIT will remain higher than one-third of total EBIT this year (a nice problem to have).

STV is creating a strong brand of family services that enable it to operate at a national (Channel 3 franchise), regional (four micro regions in Scotland) and city level (City TV and City Apps). Its integrated offering, combined with a growing bank of customer data, enables it to offer advertisers unique access to both mass and targeted TV and digital audiences. Its strategy seems to be gaining traction as it finds an increasing number of ways to use its strong brand and IP. 92% of Scots use its products each month and 75% use two or more.

STV holds the two Channel 3 licences for Scotland (northern and central), which were renewed by Ofcom in January 2014 (at a nominal cost) and run for 10 years, to December 2024. STV reaches 92% of Scottish viewers, generating an average monthly audience of 3.6 million and an average peak-time audience approximately three times larger than Channel 4, four times larger than Channel 5 and 20 times larger than Sky 1.

As a public service broadcaster (PSB), STV’s licences, which guarantee it spectrum and prominence on the electronic programming guide (EPG), require it to deliver a minimum of four hours a week of news (including separate regional bulletins) and 78 hours of regulated, non-content news a year, including 29 hours of current affairs. In practice, it always exceeds this.

Under the network affiliate arrangement (NAA), ITV plc is responsible for acquiring programme rights and devising the network schedule. STV pays a set fee for the network schedule, which it combines with its own original Scottish programming. This means it broadcasts a channel with a network programme budget of more than £750m (significantly more than that of its commercial rivals) at a cost to itself of only c £40m. While the NAA means that STV has limited control over network programming decisions, it materially de-risks the group by linking the fee to national airtime sales, effectively locking in margin and smoothing cash flows (the fee is paid on a monthly basis). Management targets ‘outperforming’ the network (which it has consistently done) through its regional input.

ITV plc currently handles the sale of STV’s national airtime. Given ITV’s dominant position in airtime sales, Ofcom (the UK media regulator) has loosely pegged the price of advertising to audience share via a formula known as the Contract Rights Renewal. STV’s sales contract with ITV plc expires at the end of 2016. As the current terms were agreed more than 10 years ago, STV is evaluating other options, which could include self-representation or an alliance with another sales house (eg Channel 4 or Sky). STV has a legal entitlement to at least similar terms as the ones it receives currently, so there is no downside to exploring its options. We estimate that STV is paying c 10% of its national airtime revenues which, given the low marginal cost of provision to ITV, may leave scope for improvement.

Contrasting with the ongoing declines in newspaper circulations, TV advertising has been relatively unscathed in the move to online and, over the last few years, ITV’s audience and advertising has also been fairly stable (Exhibits 5 and 6). However, the way consumers access TV is evolving rapidly. According to Ofcom, 60% of adults in Scotland have a smartphone and 50% a tablet. Half of Scots now use catch-up services and 21% use standalone OTT services (up 12 percentage points on the year before). For younger demographics, the change in viewing habits is even more marked, with only half of TV viewing done live via broadcast.

STV’s off-network initiatives are geared towards these evolving TV viewing habits. Its strategy is to provide its content free to viewers anywhere, at any time. Along with its home-grown content, it has full digital rights to all the Channel 3 content in Scotland and delivers this, plus its own content, to online, mobile and connected devices. Against management targets for use and engagement, its initiatives to leverage its brand are performing strongly, with viewing and engagement steadily increasing towards management’s 2016 targets (Exhibits 7 and 8).

STV Player offers 30 days VOD which, as the programme costs are sunk, is very high margin. It is available on all the main OTT and mobile platforms. Approximately 1.2m videos are streamed by 0.6m users each month, with a very high average engagement of 50 minutes, ahead of both target and the TV channel. For technical reasons, the player is currently not yet available on satellite or cable – any change to this could also provide a boost to viewing.

The website (stv.tv) is Scotland’s largest online commercial destination with 4.8 million unique users in H115. While registered users are numerous, usage is fairly low (three minutes a day) and STV is experimenting with ways to drive engagement. It has had some success with its social media strategy, which increased traffic to stv.tv news by 44% in H1 this year. Management also recently announced that in February 2016 it plans to launch a potentially disruptive new service, dubbed project Metropolis, which would merge its regulatory news service with its city franchises to provide a service including sport, news, weather and entertainment, much akin to the online news services provided by the BBC and other newspaper groups.

Localisation is a key part of STV’s strategy to engage the consumer and compete with other media. STV has been awarded five 12-year licences to launch City TV channels in Scotland. Glasgow TV was launched in July 2014, Edinburgh TV in January 2015 and STV plans to launch Aberdeen, Ayr and Dundee in 2016. Together these channels cover 80% of Scotland’s population. The channels are produced in association with local universities, which gives a unique flavour and reach into the local community. STV has developed a low-cost TV package for local advertisers where the cost of producing an advert is bundled into the advertising sales agreement. In doing so, it is enabling many local SMEs to advertise on TV for the first time. The channels are also feeding the wider STV network with talent, content and cross-marketing opportunities; for instance, after the launch of STV Glasgow, use of its City App increased by 80%.

Looking ahead to 2016, along with the launch of the remaining three City TV channels, management is in discussions with Ofcom to try to secure PSB prominence of the City TV channels. The city channels currently occupy slot 23 on the Freeview EPG. With the probability of BBC Three moving off air, slot 8 opens up and as the only other PSB channel in Scotland, there is a good chance of City TV getting it, which should provide a boost to viewing. Further out, management is exploring ways in which the five city services could be linked more closely to drive viewing.

STV’s digital platforms allow for much greater data mining. Customers have to register to use STV Player and City TV Apps and STV now holds data (typically four data points including name, post code, gender, age) on 1.6m Scots (approximately one-third of the Scottish adult population) and targets 2.4 million by 2016. This information, enriched with data from Experian, provides high-quality, first-party data, which enables STV to provide a more tailored experience to the consumer and a more targeted audience for advertisers.

It is early days in STV’s data strategy, but initial results are promising. One of its first projects was in partnership with the Scottish Rugby Union (SRU) for a targeted email campaign to drive registration on STV Player around the Rugby World Cup – this was broadcast on Channel 3 this September and saw registrations increase by c 100k. It is also working with around 20 local advertisers in the north-east of Scotland who are trialling location-based VOD advertising. It is early days, but targeting is a nice complement for TV brand advertisers that might otherwise look elsewhere for more targeted campaigns.

STV Productions is Scotland’s largest TV production business, producing 138 hours of content in 2014. Its largest customer is ITV, although it also produces content for the BBC (One, Two and Three), Sky and TV3 in Ireland.

STV Productions has a strong franchise in factual and entertainment content, with recurring commissions Catchphrase (ITV, ITV2 - evening), Antiques Road Trip and Celebrity Antiques Road Trip (BBC One and BBC Two - evening), The Link (BBC One - daytime), The Lie (TV3 Ireland, S4C and STV - evening) and a promising new game show format Safeword (ITV2 - evening). It is also developing a good reputation in serious documentaries. However, to drive margins and growth towards targeted levels, STV needs to have greater success with higher-margin recurring drama and formats that have greater library and international potential.

It has a number of drama initiatives underway, but has not yet found a ‘breaking’ format, and production revenues and EBIT margins are running behind the group’s targets. After a disappointing 2015, there are a number of reasons why 2016 and beyond should be significantly stronger:

Drama: in 2014, STV recruited a new head of drama, Sarah Brown (ex-BBC Drama). The lead time between development and commercialisation of a project is 18-24 months, and we understand there are a number of promising projects that could contribute in 2016, notably a three-part drama based on the high-profile novels by Elizabeth Gilbert and a separate eight-part, high-end drama series. High-end drama can sell for more than £750k an episode; consequently, if either one of these projects is commissioned, there would be a significant uplift to production revenues.

Entertainment and factual: during 2015 STV appointed Dan Korn (ex-Discovery) as creative director for factual entertainment. The lead time to commercialisation of factual tends to be shorter than drama. Also, there are 12 hours of new programmes in development. The recommissioning of Catchphrase in 2016 will also be supportive to overall growth (for timing reasons, two seasons fell into 2014, and none into 2015).

New partnerships: during 2015, STV announced a strategic relationship with GroupM entertainment, the world’s largest media investment group, which deepens and formalises the group’s existing collaboration.

Independent status: management plans to relaunch its campaign to be classified as an independent producer in the UK, which would enable it to benefit from the quotas that require UK broadcasters to commission content from the independent sector and far improved terms of trade.

While STV’s target of £23m of production revenues by 2016 is looking rather ambitious, we believe the momentum is building, and 2016 should be a considerably stronger year than 2015.

Public service broadcast channels hold a privileged place in the TV landscape. PSBs are ‘gifted’ dedicated terrestrial spectrum and guaranteed prominence on the EPG (electronic programming guide), in return for fulfilling certain commitments that are deemed to be in the public interest, but which might not make commercial sense if left to the free market. However, many of these obligations were constructed in an analogue environment of little competition. In the digital era, PSBs face considerable competition and in its December 2014 review of PSBs, Ofcom recognised the challenges PSBs may face in the coming years as the market internationalises and consolidates, and as viewing becomes increasingly on demand.

The DCMS and Ofcom have launched a review into a number of initiatives that could result in changes to the obligations and the monetisation possibilities for PSBs. The review is far reaching, and there seems to be an overall thrust for a more lenient environment for PSBs. The most significant proposal relates to the notion of retransmission fees and the must offer/must carry obligations.

The government is proposing to repeal section 73 and is reviewing the need for must offer/must carry on pay platforms, given that 98% of UK homes can now access digital Freeview or Freesat (both of which would carry the PSB channels). The outcome of this review should on the whole be positive for PSBs. To put it into context, most pay TV platforms pay their other premium channels (such as Disney) on a subscriber basis, whereas ITV is currently paying cable and satellite companies for the technical cost of transmission and playout. If these provisions are updated, PSBs would have more negotiating power with respect to the pay platforms (Sky, Virgin etc) and could be in a position to demand compensation for ad skipping in the form of a retransmission fee. In the US these fees account for c $1.2bn in revenues for channels annually.

Given the public service aspect of the channels, determining the value of any change is not simple and we are wary of placing too much weight on straight comparisons with other markets and channels. Ofcom has warned that “with this extra revenue would come additional responsibilities in terms of investing in public service content…it is concerned how a new system would ensure that the resulting funds would be invested in public service content rather than simply passed on to shareholders”. We would hope that at the very least, retransmission fees cover the additional direct costs the PSBs carry for making their content available on the pay TV platforms (this would equate to £1m annually for STV). In a purely free market environment, it could be significantly more; if we assume 50p per subscriber per month for instance, this would equate to £86m for Channel 3, of which c 7% would flow to STV (£6m). On the whole, we expect positive change when the DCMS reaches a conclusion expected in H116.

STV has an extremely experienced management team (see biographies on page 16 and at www.stvplc.tv). Before joining STV in 2007, CEO Rob Woodward was commercial director of Channel 4 television and on the main board. CFO George Watt joined the company as financial controller in 1998 and was appointed to the board in 2001. Chairman is Margaret Ford (Baroness Ford of Cunninghame) has more than 20 years’ experience as a non-executive director of companies and was a member of the Olympic board between 2009 and 2012.

The director of channels, Bobby Hain, is responsible for STV’s consumer services on all platforms, having previously been responsible for STV’s two Channel 3 licences between 2003 and 2010. Peter Reilly is responsible for advertising and STV Creative, having formerly worked for ITV, while Alan Clements is the director of content at STV Productions.

We believe that management’s target of 10% CAGR in adjusted EPS over the 2014-17 period seems achievable. Although there is still work to be done to scale the production business, this is a small part of group earnings, and its higher-margin digital and city initiatives are performing well, providing a boost to a stable base of earnings from its Channel 3 franchise and a falling interest charge as debt continues to reduce. Furthermore, there is a favourable regulatory tailwind that may provide a booster to revenues in a number of areas, none of which is explicitly forecast.

We are reducing our estimate for STV Productions this year, but maintain our strong forecast growth rate for production into FY16. This results in a slight reduction to EPS (2% in FY15 and 3% next year). We also introduce FY17 estimates. Overall, we are forecasting 10% CAGR in EPS to FY17, in line with management’s targets.1

Key assumptions underlying our forecasts include:

STV operates two defined benefit pension schemes. A full actuarial valuation of the scheme was carried out as at 1 January 2012, resulting in an actuarial deficit of £83m as of March 2014. This is significantly more than the balance sheet value of the deficit (£6m at H115) as the actuarial valuation uses a discount rate based on gilts rather than the corporate bond-based discount rate of 3.7% used for the IAS 19 balance sheet valuation. A recovery plan was agreed over 11 years with funding of £7-7.8m pa for the period 2015-25. The actuarial valuation is refreshed every three years, and the outcome of the valuation as at January 2015 is expected to be completed in Q116. There are many inputs to the valuation, but one of the key determinants is interest rates and, with gilt rates currently broadly similar to those used in the last triennial valuation, we are assuming the annual funding requirement does not change.

The business is strongly cash generative and excessive net debt, historically an issue for the group, is firmly in the past. This is reflected in management’s reinstatement of a progressive dividend policy: 10p per share for the full year (+25% on FY14) and 12p per share planned for 2016, despite the higher pension funding requirement. In 2014, STV refreshed its facilities and equipment, following the licence renewals and we expect capex to now return to a maintenance level of approximately £2.5m a year. Overall, we forecast FY15 net debt to reduce by £5m this year to £24.3m (debt/EBITDA ratio of c 1.0x), falling to £16.2m by the end of 2017.

STV’s closest peer in the UK is ITV plc, and UTV in Ireland – both Channel 3 franchise owners. UTV recently announced the sale of its TV assets to ITV. Adjusting for our estimated NPV of the IAS 19 deficit, the deal was completed on 3x 2014 revenues and 20x 2014 EBIT, with the premium reflecting the significant synergies that will be generated in absorbing UTV into ITV plc. STV is now the only remaining Channel 3 licence holder that has not been consolidated into the ITV plc group. While we do not think its acquisition is currently on the agenda, the synergies from consolidation would be significant and the logic of a deal is inescapable. Along with the progressive dividend policy, this should provide a solid support to the shares and should be considered as part of the longer-term investment case. UK commercial TV assets are also sought after internationally; Liberty Global recently increased its stake in ITV to 9.9% and in 2014 Viacom acquired Channel 5 for £450m (Channel 5 generates advertising revenues roughly 2.5x those of STV).

The UK commercial TV companies all have fairly substantial pension deficits. When looking at EV multiples, we adjust net debt to include our estimated NPV of the actuarial pension funding requirements (£45m for STV and £156m for ITV) to treat the companies consistently. As part of our peer comparison, we also make reference to other European commercial broadcasters.

Year to date, the shares are up 20%, although they have been weak since the interims on 27 August. Using our more conservative basis for calculating EV on an FY16e EV/EBITDA, the shares on 9.9x are in line with the broader sector, although at a 20% discount to the closest peer, ITV. On a 10.4x FY16e P/E its discount to peers is very marked against both ITV (14.9x) and the sector average of 17.9x; the market does not yet seem to be reflecting the earnings leverage that STV is deriving from its falling financial gearing.

Using a WACC of 11%, our DCF, which assumes our forecast to 2017 followed by 3% revenue growth to 2025 and a 2% perpetuity growth rate, returns a value of 492p.