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Morningstar | Kayo’ed by Pay TV and U.K. but News Remains Okay. See Updated Analyst Note from 07 Feb 2019

We maintain our USD 15.30 fair value estimate (AUD 21.50), albeit we trim our near-term EBITDA forecasts by 2% on average. Shares in no-moat-rated News currently trade at a 16% discount to our intrinsic assessment. We see this gap closing as the market becomes more comfortable with the potential of the digital-centric divisions (digital real estate, books) to hold the fort, while the structurally-challenged divisions (news and information, subscription video services) transition to more digital-led models.

The 13% lift in News Corporation's fiscal 2019 second-quarter normalised EBITDA to USD 374 million belied subdued performances in key units.

While consolidation of 65%-owned Foxtel's earnings drove the headline lift, the pay TV operator's underlying EBITDA more than halved to USD 54 million. The near-term cost of transitioning to a hybrid model took its toll, with a fall in traditional set-top-box subscribers and the costs incurred to stem this trend (content, marketing) and to launch new products (Foxtel Now, Kayo) exerting pressure.

The volatility in news and information services earnings also continued, with normalised EBITDA down 15% to USD 120 million, mainly driven by weak U.K. advertising. To cap it off, the mere 2% rise in digital real estate EBITDA to USD 121 million was the lowest quarterly growth in three years, hampered by soft trading conditions in both U.S. and Australia.

However, we are not perturbed these lacklustre showings. The slowing growth in digital real estate is mostly cyclically-induced. Management also deserves time to prove its new subscription video strategy can grow the current 2.9 million subscriber base, with an increase in streaming customers more than offsetting declining traditional pay TV customers, without undue impact on average revenue per user or churn. Further, the book division is continuing its renaissance, posting another 13% increase in EBITDA to USD 88 million, the sixth consecutive quarter of growth.

Of the two structurally uncertain units, investor concern appears to be increasingly focused on the subscription video services, particularly the Foxtel pay TV business. That is hardly surprising given the incursion made into the traditional set-top-box-based territory by subscription (for example, Netflix) and other video on demand services (for example, Youtube) in recent years. Their impact has been such that Foxtel's EBITDA has slumped from USD 932 million in fiscal 2013 (EBITDA margin of 29.3%) to USD 406 million in fiscal 2018 (EBITDA margin of 17.8%). This led to the decision to step-up investments in content (especially sports) and products (Foxtel Now, Kayo). While this is likely to cannibalise Foxtel's core satellite-based, set-top-box powered pay TV business, we see this as a better alternative than doing nothing and losing subscribers to other streamers. Our current forecasts for Foxtel are certainly not heroic, projecting an average annual EBITDA decline of 4% over the next five years, with margin settling at 17.0%.

As for the news and information unit, digitisation is progressing well. Nowhere is this more evident than in Dow Jones and The Wall Street Journal, where digital advertising and subscription revenues are offsetting print advertising revenue decline. Digital paid subscribers accounted for 67% of total subscribers at The Wall Street Journal, up from 60% last year. Indeed, we now get the sense that The Wall Street Journal is becoming an integral part of, not just the news and information division's, but the entire group's digitisation strategy. The potential implication of this is that the likelihood of this trophy masthead being sold is reducing, something that may disappoint shareholders who believe Wall Street Journal's true value is under-appreciated (we conservatively value it at USD 1.0 billion versus USD 1.5 billion paid for Financial Times by Nikkei in 2015).

In terms of the result details, News' fiscal 2019 second quarter normalised net profit after tax, or NPAT, fell 18% to USD 103 million, or EPS of USD 0.18. The board declared an interim DPS of USD 0.10, unfranked. The company ended the quarter with net debt USD 299 million (inclusive of USD 237 million retirement benefit obligations), equating to net debt/EBITDA of just 0.2 times.