Tips for the CFA Research Challenge

Participating in the CFA Research Challenge? Or just want an example of a research report + financial model? Look no further.

I competed in the Local Finals for the CFA Research Challenge this year and would have loved a resource like this. I searched for previous contestants’ experiences online before starting but got very little in terms of online help. So, I’m hoping this will at least be useful for one contestant. I’ll start by giving my advice for the CFA Research Challenge. Then I’ll list our report below. Or you can go straight to our pretty PDF report and contact me for the excel model.

GET STARTED EARLY

Oh boy how time creeps up. We got started with this competition so early. Yet we still submitted 2 minutes before the midnight deadline. I’d want to be finished at least 2 weeks before submission. Because you’ll be ‘finished’. But then a minor change to your assumptions will be needed. And then another one. It never ends. The last thing you want to be doing leading up to submission is still adding content and information. That should have been added weeks ago. I’d argue good time management really sets the winners apart. Everyone’s juggling other assignments and life too. But those might have to take a back seat if you want to win. Divide the work. As much as you think you can, you can’t do it alone. So get everyone on board and start dishing out tasks.

MAKE USE OF YOUR INDUSTRY MENTOR

Now this one is a bit of luck of the draw. We lucked out and got an amazing mentor. He was young but he was super keen and interested in seeing us do well. He had participated before so knew the ins and outs of what was expected. Any question we’d have he would walk us through and extremely patient with us noobs. We used our maximal hours 

I did hear other stories about mentors being away on business or holiday (but still helping out mind you, just couldn’t do face to face meetings). Either way you just have to make it work for you. 100% recommend using all your allotted hours with your industry mentor though. 

DON’T REINVENT THE WHEEL

The CFA Institute gives plenty of examples of reports and presentations on their website. You’re going to want to make use of this. Especially if you are new to all this like I was. They give a great base of what’s expected and how to layout your reports. Only problem is I feel the quality of reports submitted is rising exponentially. If you look back on reports further than a few years, I don’t think those types will get you very far. The quality of work just seems to jump so much from year to year. But if ever in doubt, maybe look to previous examples or ask your mentor. Don’t be a hero.

USE RESOURCES EFFECTIVELY

We were lucky as our Business school had Bloomberg Terminals to take advantage of. Your school might have access to Thomson Reuters or Morningstar. Use it. We found it useful for growth assumptions and supplementary data. 

I recommend setting up a Google Drive that all group members have access to. Then upload all annual reports, resources and drafts of work there.

Also, if you don’t already know, you’re going to have to learn how to model. Financial modelling obviously. I recommend A Simple Model (free) or Wall St Prep (Paid).

CFA RESEARCH CHALLENGE SUMMARY

So feel free to take a look at our PDF Research report. I’ll include the text below but I encourage you to look at our pretty report with corresponding graphs etc. You can find below the text from our report submitted for the CFA Research Challenge if that suits you instead. Obviously this was a group effort and not all my work so I’m not trying to claim credit here. Just wanting to put out there to help and for feedback. Any comments and thoughts is greatly appreciated.

RESEARCH REPORT

SXL: SOUND PLAYER IN TOUGH INDUSTRY

INITIATING WITH A SELL

We issue a SELL recommendation on the SXL shares based on an estimated price of $0.91, presenting a 22.37% downside. In our team’s view, Southern Cross Media Group is troubled by: 1) Deteriorating Earnings, 2) Weak Market, 3) Valuation and 4) Weak Growth Strategy. 

1) Deteriorating Earnings

SCA’s earnings growth is anticipated to deteriorate due to weak revenue growth attributed to difficult market conditions, along with contracting margins trying to keep market share.

2) Weak Market:

Based on the analysis of the Australian Radio and TV broadcasting industry, online advertising platforms are forecasted to grow, diluting radio and TV advertising market share. Demand for advertisement on traditional platforms such as Radio and TV is also expected to decrease. Thus increasing pressure in contemporary radio advertising market

3) Valuation

Utilising a blend of DCF analysis and Multiples valuation to provide a current intrinsic value of $0.91 for SCA shares.

4) Weak Growth Strategy

With the boom of online advertising (48% of the market), TV and radio advertising market are expected to decline with the TV advertising market contracting at a much faster rate. Since SXL’s main advertising revenue comes from its audio assets (70% of FY20F revenue), it is expected to be cost intensive going forward in order to maintain current revenues.

BUSINESS DESCRIPTION

Southern Cross Media Group Pty Ltd. was established in July 2011 as a merger between Southern Cross Media Group and Austereo Group. Since the merger, it has grown into one of the largest players in the free-to-air commercial radio industry as well as some market share in the television industry and online media platforms across Australia. SXL has 2 main line of business; Audio and Television.

Audio

  • Segments: Operates in metro and regional radio as well as podcasting.
    • Two main radio brands: Hit and Triple M networks with over 7.5 million listeners daily.
    • SCA operates PodcastOne Australia – the largest podcast service in Australia. Expected to become cash flow neutral after 2020.
  • SCA’s largest revenue stream.
  • Leader in Australian radio broadcasting with 25% market share.
    • The industry generates $4.4 billion dollars annually.

Television

  • Segment: Solely operates in regional TV broadcasting.
    • Only affiliate of Channel 9 and Channel 7 in regional Australia.
  • SCA’s second main revenue stream.
  • Not a leading player in the Australian TV industry.

INDUSTRY OVERVIEW

Radio Broadcasting

The radio broadcasting industry is capitalised at $1.70 billion with an annualised growth of 0.2% 2019-2024F. There’s a positive correlation between the current 0.9% decline in the industry and consumer sentiment. Increasing demand from media buying agencies, radio resilient in the advertising market and increased use of motor vehicles are forcing radio broadcasters to consider radical innovation strategies within the industry.

Free-To-Air TV Broadcasting

The industry is capitalised at $4.40 billion with an expected decline in annual growth of 2.8% 2019-2024F.  The shift in Australians watching free-to-air TV has limited the for advertising time-slots thus decreasing revenue streams from media buying agencies.

Domestic Outlook: Radio Broadcasting Industry

Increasing Disruption Forcing Creative Innovation

Increased Demand From Media Buying Agencies

Radio broadcasting industry revenue is largely owed to media buying agencies paying for advertising time slots on radio programs. The annualised growth of 2.60 % 2019-2024F implies a resilient market despite the robust demand across digital media. Higher revenue is expected from increased competition as media buyers are anticipated to develop innovative strategies to penetrate emerging markets.

Radio Resilient in the Advertising Market

Radio represents the 4th largest (8%) while FTA TV represents the 2nd largest (21.6%) in the advertising market. Since the boom of online advertising (5Y CAGR: 7.9%), the FTA TV has been dropping at (5Y CAGR: -5.9%) while radio has been declining at a much slower rate (5Y CAGR: -2.3%). This shows that the radio industry is still able to attract demand for advertisers despite the boom of online advertising.

Increase In Motor Vehicles

Traffic congestion in the cities and traffic present a strong positive correlation on the radio ratings. Drivers increase their radio listening periods during traffic thus presenting a lucrative opportunity in which dense customer traffic can be attained.

COMPETITIVE POSITIONING

Porter’s 5 Forces

Threat of New Entrants – Low

The threat of new entrants into the radio and TV broadcasting market is low due to the difficulties in establishing operations, market dominance from current players and the costs associated with obtaining broadcasting licences. Existing radio broadcasters benefit from established infrastructure, brand, customer base and contractual agreements which takes time to create. These factors demonstrate the industry’s high entry barriers. Similarly, TV’s high barriers to entry are associated with regulation, high costs associated with establishing infrastructure and the market dominance of established entities which benefit from existing audience loyalty, brand awareness, contractual agreements and content. TV broadcasters require licenses which are difficult to obtain due to limits in broadcasting spectrum.

Bargaining Power of Customers – High

SCA has a client base of roughly 1400 large national clients booked through advertising agencies as well as roughly 45,000 smaller local clients which are generally small to medium enterprises which may not have a national presence. Customers who advertise in metro areas tend to have higher bargaining power due to the option of alternative broadcasters while some regional clients may be limited in options. The costs associated with switching to alternatives are low and there is no loyalty to broadcasters instead their loyalty is to the content they produce. Advertisers are also highly price sensitive.

Threat of New Substitutes – High

The increasing fragmentation of advertising means Radio and TV broadcasters compete with other media platforms such as print, pay TV and the internet. Substitutes of SCA’s Radio and TV segments threaten to provide alternatives which perform the same function as SCA at a lower price.

Bargaining Power of Suppliers – Medium

SCA’S suppliers comprise of specialist service providers which perform certain functions with more efficiency, expertise and lower cost than SCA. The large size and scale of SCA and alternative options means smaller suppliers have low bargaining power. Larger service providers such as Broadcaster Australia which provide transmission have higher bargaining power due to lack of alternatives and heavy reliance on these services which without could disrupt SCA’s operations.

Rivalry Among Existing Competitors – High

Competition in the Radio and TV broadcasting industry is High. Both industries are highly concentrated with a few key players each. There is not a high degree of difference in the services that are provided by Radio and TV broadcasters resulting an increase degree of competition for clients.

FINANCIAL ANALYSIS

Income Statement

Revenues

Revenue is segmented into two categories, Radio and TV. Over the previous 2 years and forecasting into the future, their revenue has been stagnating yet increasing. From 2020 onwards, the growth trend is a result of slow growth in Radio and decline in TV, as well as our estimated shift in the product mix towards more radio based revenue.

Margins and Shifting Product Mix

Going forward we see a higher margin of revenues being earnt due to an increased percent of radio share in the product mix, with overall TV revenues decreasing along with their lower margins. Thus we could argue that that their ability to extract more profit out of revenues is a positive. Gross profit is expected to stay around 81.5% range and is predicted to stay this way going forward, whilst EBITDA margin is expected to be around the 22% mark.

Debt Payments

Structurally, SXL’s debt is in a manageable and tax cost-effective position, with almost all of their debt being long term arrangements. Thus SXL’s short term liquidity ratios such as the current and quick ratio are ahead of industry peers. Holding at least some long-term debt is advisable, as the tax affects would be beneficial, plus the large upfront costs of some investments make it more of a requirement. SXL currently does this well and is in line with current peers at a debt to equity ratio of 60% with the peer median being 59%. SXL’s leverage ratio is currently 1.76x -comfortably within company’s target range between 1.5x and 2.0x

Interest Coverage

Structurally, SXL’s debt is in a manageable and tax cost-effective position, with almost all of their debt being long term arrangements. Thus SXL’s short term liquidity ratios such as the current and quick ratio are ahead of industry peers.

Balance Sheet

Leverage And Debt Management

Currently SXL’s portion of debt is in long term agreements. Holding at least some long-term debt is advisable, as the tax affects would be beneficial, plus the large upfront costs of some investments make it more of a requirement. SXL currently does this well and is in line with current peers at a debt to equity ratio of 60% with the peer median being 59%. SXL’s leverage ratio is currently 1.76x -comfortably within company’s target range between 1.5x and 2.0x

Cash

With poor cash flow generation forecasts (see Appendix) we believe SCA is in a weak position to pursue growth opportunities without capital raising. We believe this will harshly affect SCA in the future as high levels of competition will mean SCA may lose its ability to compete. Property, Plant and Equipment is forecast to continue to decrease as outsourcing continues to be a main objective of SCA to improve operational efficiency. The recent outsourcing of transmission services to Broadcast Australia is a sign of this.  We believe this will increase the bargaining power of SCA’s suppliers which will decrease its size leverage over its operators.

Interest Coverage

SCA’s interest coverage ratio is forecast to fluctuate however remain over 4. This indicates that SCA can easily cover and pay interest on outstanding debt. Furthermore, SCA’s short term liability ratios such as current and quick ratio are decreasing as a result of weak cash generation and higher short-term liabilities, we believe this issue is due to poor cash management my SCA.

Cash Flow

Free Cash Flow Generation

SXL’s cash flow generation is quite high when compared to peers, hence their ability to pay their large dividend yield. Whilst net income has fluctuated year to year, cash flow from operations has been rather stable but without growth. Going forward we predict Free Cash Flow generation and their ability to pay dividends will come under increased pressure and market growth slows and profit margins contract.

CAPEX

Capital Expenditure has been primarily spent on Broadcasting Licenses. Going forward we predict capital expenditures to increase slightly as SXL attempt to hold onto and try regain market share, putting CAPEX at 32,000 per year.

Dividends

We estimate a significant slowdown in SXL’s dividend payout ratio and dividend yield due to the contracting margins and greater need for capital expenditure to retain market share. We estimate a payout ratio of mid 30% going forward, contrasted to management’s expectations of 65-85% of underlying NPAT paid out.

VALUATION

We issue a sell recommendation on SXL, based on an estimated price of $0.90, which presents a 22.37% downside.

Our target price calculation is based on a blend of the Discounted Cash Flow (DCF) to Firm model with a target price of $0.91 and 6.7x EV/EBITDA multiple with a target price of $0.86. The weighted blend of valuation models were 70% based on the DCF model and 30% for multiples. We decided to use the lower weighting for multiples due to the lack of comparable companies to SXL.

WACC

For our analysis we used a WACC of 10.01% for discounting the Free Cash Flow to the firm, with our cost of equity factoring in a relevered beta from competitors. A more thorough breakdown of our WACC calculation can be found in the table to the right.

Valuation – FCFF

We valued the Radio and Television segments using both the Free Cash Flow to the Firm model as well as the discounted cash flow methodology due to the stable nature of their growth,profitability, and cash flow generation. 

Terminal Growth Rate

We calculated our terminal growth rate as Australia’s long-term GDP growth projections at 1.25%. Since geographically SXL operates solely in Australia and has no plans to expand out of this market. Our estimated value for the firm, the terminal value consists of a significant proportion of total value at 68%. 

Comparables Analysis

SXL’s two closest competitors we used for comparable analysis were HT&E and Nine Entertainment Holdings. The multiple we decided to base our comparable calculation was Equity Value by EBITDA. We used this multiple based on the comparables as EV/EBITDA provides a clearer picture of the financial performance of peer companies since it removes debt costs, taxes and depreciation. SXL’s peers have relatively high depreciation costs as they are capital intensive businesses, so EV/EBITDA made the most sense.

Utilising our ratios of EV/Revenue, EV/EBITDA and PE ratio from comparable peers we derived intrinsic values of $1.16, $0.98 and $1.11 respectively. We believe the EV/EBITDA supports the SELL recommendation as implied by the DCF model.

Sensitivity Analysis

Based on our assumptions, we also performed a sensitivity analysis on the driving variables of the model by doing a Tornado Sensitivity Analysis by changing the variables Beta, Terminal Growth Rate, Tax Rate, Cost of Debt and the WACC up and down by 10% as shown in the table below.

INVESTMENT RISKS

Market Risks

Rise Of Online Streaming (MR 1)

  • Risk: Spotify and similar music streaming services are competing directly with SXL owned radio stations.
  • Impact: As online music streaming services can often offer a wider, more tailored range of musical options, this naturally siphons away traditional listeners of music on radio channels. Evidently in May 2018, 46 per cent of Australian adults had used a music streaming service in the previous seven days, an increase from 37 per cent in 2017, and this number is sure to grow even more.
  • Mitigation: Maintaining and even growing music radio station audiences will have to take into account current online music streaming options in order to remain competitive.

Shifting Advertising Spend (MR 2)

  • Risk: Increased share of total advertising spend is being spent online compared to traditional channels, SXL will have to manage and monitor this shift in advertising spend in order to minimise the impact to shareholders from their current options. On the contrary though, with the implementation of their new podcast platform, SXL should even be looking to benefit from this potential risk.
  • Impact: Radio and TV revenues are likely to stagnate or lower going forward.
  • Mitigation: Focus and have a presence in online markets, capturing the shift.

FTA Television Decline (MR 3)

  • Risks: FTA Television currently accounts for around 30% of SXL’s revenue and with streaming platforms such as Netflix, Stan and Disney+ among others, there is a real threat of declining FTA viewership resulting in lower revenues from advertising. Adding to the risk is a number of the newer market entrants are willing to sacrifice short-term profitability in order to create quality content to establish long-term subscriber growth, thus putting pressure established media companies’ operating margins.
  • Impact: Lower TV advertising revenues from lower viewers.
  • Mitigation: Either greater TV market share to offset or explore other revenue streams.

Podcast Market (MR 4)

  • Risks: SXL’s investment into PodcastOne Australia will have to compete with other similar up and coming podcast platforms from other providers sharing similar ideas on creating their own content on their own platform. Also with the relatively low barriers to entry for podcasting, and easy uploading to Apple Podcasts, SXL’s premium content generation may face stiff competition from the multitude of wide ranging potential podcasts.
  • Impact: Lower audience numbers resulting in lower advertising revenue.
  • Mitigation: Generate engaged and larger podcast audiences, higher quality content.

Financial Risks

Dividend Payments (FR 1)

  • Risks: Southern Cross Media currently pays out a large portion of their FCF through dividends at a current dividend yield of over 6% and has a current dividend payout policy range of between 65% – 85% of NPAT. Understandably this yield has attracted a large number of dividend investors looking for yields on their investment.
  • Impact: Dividend payments to be scaled back or even removed completely, affecting share price
  • Mitigation: Ensure a consistent and achievable payout ratio.

Operational Risks

Talent Retention (OR 1)

  • Risks: Talent flight is a significant risk evidenced as the hosts of popular radio shows are significant drivers and determinants of audience numbers,.
  • Impact: If keytalent are to leave, it can have a significant adverse impact on the company’s audience numbers
  • Mitigation: Offer longer contracts for key presenters.

Regulatory Risks

Licensing Changes (RR 1)

  • Risks: Current metro radio laws in Australia only allow 2 licenses per market, if these laws are to become stricter, SXL may have to sell a number of licenses to comply with updated laws.
  • Impact: Less licenses meaning less access to radio listeners from different stations
  • Mitigation: Diversify revenue streams and not rely too much on any one license.

Target Price Risks

The assumptions calculated in our analysis may not hold in the case of an unexpected slow down in the growth of SXL’s radio market, a faster than anticipated decline in TV advertising revenue, or in the case that PodcastOne fails to reach profitability and achieve growth. A small change in growth and valuation assumptions in turn can significantly affect the final target price per share. In order to get a better sense of understanding how the target price may react to unexpected changes, we undertook a sensitivity analysis in order to understand the impact of a changing WACC and terminal growth rate.

CORPORATE GOVERNANCE

Shareholder Base

SXL’s ownership is comprised of 71% institutional owners, whilst the remaining 29% comes from non-institutional ownership interests. When it comes to board members holding ownership stakes in SXL, just below 1 percent of shares are held by board members. All totalled, the board members hold 0.28% of all available shares. Currently the largest shareholders of Southern Cross Austereo is Allan Gray Australia, with a 15% stake, with Ubique Asset Management holding 10%.

Board of Directors

Southern Cross Media’s current Board of Directors is comprised of six non executive directors and one executive director which is CEO, Peter Bush. The Chairman of the board and the CEO roles are separated, with Grant Blackley as Chairman and Peter Bush as CEO. Four out of the seven board members have previous experience in the media industry, whilst the others have previous corporate finance and CEO experience. All board members hold at least 100,000 shares in the company and all have been a director at SXL for at least 3 years with Leon Pasternak the Deputy Chairman having 14 years at the company. Two members out of the seven on the board are female (28%), putting SXL ahead of the industry median of 20%.

Corporate Social Responsibility

SXL currently have a range of CSR initiatives focusing on diversity such as specific mentoring and executive development programs aimed at women, policies that encourage flexible working arrangements and return from parental leave, the recruitment and succession planning processes that support high potential women, as well as training for all managers on the topic of diversity and inclusion.

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