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The Demise of ESPN Could Benefit This Stock

The Demise of ESPN Could Benefit This Stock

ESPN has gone from one of the crown jewel of Disney’s empire to one of its biggest problems.

ESPN, according to many analysts, pays too much for content and costs too much for consumers. For years, this didn’t matter. The cable industry “bundled” channels and customers were forced to pay for it even if they never watched it. Now, as the cable bundle slowly disintegrates, it matters a lot.

Consumers have realized that cable is expensive as alternatives like Netflix popped up. ESPN is one of the reasons cable is expensive. The network charges over $7 a month per subscriber. When you throw in the rest of the ESPN channels, that number approaches $10.

That money allowed the network to pay high prices for content — $1.9 billion a year for one NFL game a week; a 12-year, $7.3 billion contract for the rights to the college football playoffs; $1.4 billion a year to the NBA; Big Ten sports for $2.64 billion over six years. Its annual content costs more than $7 billion.

Cable customers who don’t watch sports, and many who do, have chosen to abandon bundles that include ESPN. This has created problems for cable companies.

Winners Always Replace Struggling Companies

New reports indicate a non-sports skinny bundle is about to become a reality. Discovery, Viacom, AMC, A+E, and Scripp Networks are teaming up to offer an entertainment-focused streaming service that will be void of sports programming.

The Wall Street Journal reported the news about the skinny bundle and said that the new service will have a soft launch in the upcoming weeks with subscriptions priced at less than $20 a month. The lineup of channels featured in the bundle aren’t all drawn out, but WSJ says that the media companies are expecting all their core channels to be part of it. This includes Discovery’s ID, TLC and Animal Planet; Scripps’ HGTV and Food Network; and Viacom’s roster that includes Nickelodeon, MTV, Comedy Central and BET. AMC and A+E’s will be featured as well.

This could benefit the stocks of companies that offer non-sports programming.

AMC Networks (Nasdaq: AMCX) owns and operates entertainment businesses through two operating segments. National Networks includes programming networks, such as AMC, WE tv, BBC AMERICA, IFC, and SundanceTV in the U.S. and AMC, IFC and Sundance Channel in Canada.

The International and Other segment includes AMC Networks International (AMCNI), the company’s international programming businesses, IFC Films, the company’s independent film distribution business, and AMCNI-DMC, the broadcast solutions unit of certain networks of AMCNI and third party networks.

AMCX Offers Value

AMC Networks Inc.’s earnings have increased from $5.80 to an estimated $6.45 over the past 5 quarters. Earnings have also been accelerating in quarterly growth rates when adjusted for the volatility of earnings, according to Ford Equity Research.

This indicates an improvement in future earnings growth may occur. Ford notes “nearly 40 years of research have shown that the change in the growth of earnings per share is an important factor that drives stock price performance.”

The analysts also note, “Earnings forecasts for AMC Networks Inc. have been increasing which indicates an improvement in future earnings growth. The company has also reported higher earnings than those predicted in earlier estimates. This indicates an ability to exceed analysts’ expectations and the potential for improving earnings growth in the future.”

This favorable outlook is not reflected in the company’s stock price. The chart below shows the stock’s price to earnings (P/E) ratio since the stock began trading in 2011. For the past year, the stock’s P/E ratio has consistently been near 10, well below the market average.

A below average P/E ratio is justified if the company’s earnings are declining. That is not the case for AMCX where earnings are rising.

In fact, the projected earnings growth of AMCX of 11.2% a year is slightly above average. The stock’s growth places it in the 52nd percentile, with expected growth that is faster than the growth expected of 48% of the companies with earnings estimates.

The stock’s current P/E ratio of about 12.2 places it in the bottom 20% of all stocks with P/E ratio. Many value investors consider this to be the area where they find stocks that are attractive. Over the past five years, AMCX has traded with an average P/E ratio of 17.8, slightly above the market average.

This year, analysts expect AMCX to report earnings per share (EPS) of $6.67. To develop a price target, we can use the current P/E ratio and the average ratio over the past five years. This will provide an expected range for the stock.

The earnings history, shown in the next chart, indicates AMCX is likely to maintain its current earnings.

This indicates earnings can be used to estimate the value of the stock. With a P/E ratio of 12.2 and this year’s expected earnings, the minimum price target for AMCX is about $81. With the higher P/E ratio of 17.8, the target is about $118.

One reason the stock is undervalued is because of concerns about cord cutting. ESPN’s high cost created a problem for the entire cable and satellite television industry. Many consumers cut the cord as they realized a few subscription services could deliver the content they wanted at a lower cost.

AMC is now addressing that problem. AMC also has a library of hit programs including Mad Men, Breaking Bad and The Walking Dead. The networks hits make it a network viewers are willing to pay for and should allow the company to continue growing its earnings.

A Specific Trading Strategy

To benefit from potential gains in AMCX, an investor could buy shares of the company. This requires a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. Although the risk is limited, it is equal to 100% of the amount paid for the option.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. Potential risks and rewards of this strategy are shown in the diagram below.

Source: The Options Industry Council

This strategy is designed to profit from a gain in the underlying stock’s price but has the added benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership.

Both the potential profit and loss for the bull call spread are very limited and very well defined. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

For AMCX, the October 20 options can be used. The October 20 $60 call option can be bought for about $2 and the October 20 $65 call could be sold for about $0.55. The difference between the two prices indicates the trade would result in a debit of $1.45. Since each contract covers 100 shares, this trade would cost about $145 to open.

That is the maximum potential loss on the trade.

The potential gain is equal to the difference in the option exercise prices minus the premium paid to open the trade. In this case that is $5 ($65 – $60) less the $1.45 premium, or $3.55. The potential gain of $355 on the trade is equal to about 145% of the amount of capital risked, a favorable reward to risk ratio for many traders.