Versant: Mispriced Cash Flow After Spin-Off | Investing.com

On January 5th the Comcast spinoff Versant, Inc. (NAS: VSNT) began trading on the market as a standalone company. The newly spun off public company fell 18% in the first couple of days of trading. It is no surprise why investors did not want to own the stock. Its assets are primarily legacy cable television networks like USA Network, E!, Oxygen, CNBC, and others that were previously housed within NBCUniversal. Linear media faces pressure from cord-cutting and changing advertising dynamics. The spinoff was intended to free Comcast from the muddiness of the legacy cable networks that were hurting the narrative for the company. In doing so, the newly formed Versant has $2.25 billion in debt on its balance sheet. On the surface, this is not the type of business most investors are eager to own.

However, the sharp decline following the spin-off should not be interpreted as a reflection of Versant’s business quality, at least not fully. As with most spin-offs much of the selloff was mechanical forced selling. Many institutions are unable or unwilling to hold a standalone legacy media company. When the company profile no longer meets the criteria for ownership, index funds and other institutional investors sell the stock. This creates a selloff that can drag prices significantly lower, occasionally creating value opportunities for investors willing to look past short term mispricing.

Despite the negative outlook on legacy media, Versant’s assets still generate substantial cash flow. This is not a growth business, it is a mispriced cash flow runoff business, where the market is pricing a collapse that is not yet happening. Versant’s portfolio of established U.S. cable television networks generates revenue primarily through affiliate fees and advertising revenue tied to viewership. While advertising revenue is cyclical and sensitive to macroeconomic changes, the economic backbone for Versant is the affiliate fees from cable, satellite and virtual MVPDs. These fees are typically negotiated through multi-year contracts and are often bundled with other channels. These contracts are also spread across hundreds of distribution partners and are renegotiated on a staggered basis over multiple years. Thus, even when individual renewals come in at unfavorable terms, the revenue impact is gradual rather than concentrated. This creates recurring and predictable revenue streams where networks can often offset volume losses with pricing increases. Although subscriber counts have declined due to cord-cutting trends, distributors have historically offset a portion of these losses through pricing adjustments and contract renewals. As a result, affiliate fee revenue has often proven more resilient than headline subscriber trends might suggest. Thus, affiliate fees behave very differently from advertising revenue and do not translate the same into free cash flow deterioration. Based on the company’s disclosed revenue mix, approximately 5565% of revenue comes from affiliate fees, with the remainder derived from advertising.

Furthermore, because Versant is a mature media company they do not require large ongoing capital expenditures like movie studios or streaming platforms. This means annual capital expenditures should be modest relative to EBITDA and most operating cash will fall directly to free cash flow. This would give the company annual free cash flow of $1.85 billion derived from $2.02 billion of operating activities. Here is a summary table of the company’s cash flow.

At the current stock price, the free cash flow yield is above 24% and the EV/FCF ratio is ~4.2x. This is a low valuation for a business that can consistently produce these levels of free cash flow. The low multiple implies the market expects free cash flow to collapse by 50% and never recover.

Below is a comparison chart of Versant’s peers. I mainly focus on Nexstar and Fox Corp for comparison, as Paramount and AMC are running at a loss, and Warner Brothers is being acquired. When we use a conservative EV/FCF multiple more in line with its competitors the fair value share price is ~$139.

This is not the only metric that shows Versant could be undervalued. Their current EV/EBITDA is 3.2x which highlights the market is placing a low value on the company’s operating cash flow ability. Again, if we use an EV/EBITDA multiple closer to their competitors the fair value share price is ~$120.

While Versant is not a growth business, there are several catalysts that could cause results to be less severe than what the market currently appears to be discounting. These should not be interpreted as growth catalysts, but rather as factors that influence the rate of decline. First, affiliate fees remain the primary source of Versant’s cash generation. As mentioned before, distribution agreements are typically negotiated on a multi-year basis and are often bundled across multiple networks. This structure limits the risk of abrupt revenue losses and instead results in gradual adjustments to pricing and volumes over time. When declines are assumed to be severe, modest fee preservation can materially impact free cash flow.

Versant’s bundling dynamics also provides a source of stability. Although cord-cutting trends have reduced total subscriber counts, distributors continue to face incentives to maintain broad channel offerings in order to limit churn and preserve pricing power. This could help explain why affiliate fee revenue across the industry has historically declined at a slower pace than subscriber metrics. If this pattern continues, cash flows may prove more durable than what the market is pricing in.

Finally, Versant’s cost structure provides an additional margin of safety. The company operates a portfolio of mature networks with limited capital requirements, allowing a high proportion of EBITDA to convert into free cash flow. As mentioned earlier, Versant does not have to heavily invest in studios and production as other media companies like Netflix. Therefore, management retains the ability to manage content and operating costs in line with revenue trends, which can mitigate the impact of top line pressure.

Taken together, these considerations do not imply a return to growth. Rather, they suggest that Versant’s operating results may deteriorate more gradually than the break scenario implied by current prices. Thus, the DCF presented assumes no margin expansion and a steady decline due to the lost of subscribers and headwinds legacy media is facing. The negative growth rate reflects the pace of decline is more important than absolute growth.

Altogether, these valuation approaches suggest that Versant is undervalued and the market is pricing the company as though a severe and permanent deterioration in cash flow is inevitable rather than merely possible.

At current levels, the market is pricing in Versant’s free cash flow declining sharply and significantly without stabilization afterwards. It would require a 40-50% permanent reduction in cash generation instead of gradual erosion. Importantly, this outcome would likely require a structural break in the affiliate fee model rather than a gradual and steady decline consistent with historic cord-cutting trends as assumed in my DCF. In other words, the market is pricing a tail risk as a base case.

As long as free cash flow doesn’t fall too far from the present levels the stock looks extremely undervalued. The most dangerous scenario is if affiliate fees have a mass renegotiation. If MVPD’s simultaneously dropped key Versant networks or forced steep affiliate fee cuts this would produce a serious reduction in revenue. A 20-30% cut across major distributions would reduce EBITDA drastically and would create a decline in free cash flow by 30-40% permanently. Some bearish analyses have predicted such a scenario where FCF is 50% less by 2030, which with forced selling could be the other reason why the stock price is so low. These analysts assume a plausible scenario where the fee structure breaks and not bends.

If we rerun the DCF with these assumptions, we can see the fair value share price is ~$38. This scenario is possible, however, represents a lower probability outcome rather than a base case. Historically, these negotiations are staggered and the contracts are bundled. But it is worth considering before investing.

Versant sits in an unfavored sector of the market where investors have priced in most of the negative outcomes. At the current levels, the market assumes Versant is headed for steep revenue and FCF reductions. Even if the company doesn’t decline as much as the market is pricing, the valuation of the stock could see a significant revaluation. Luckily for shareholders the management’s incentive structure is in line with their interests. According to their Form 10, Versant adopted a Long Term Equity Incentive Plan (LTEIP) that includes restricted stock units (RSUs) directly linked to share price performance. These RSU’s vest over a three-year period and provide pure stock exposure for management. The LTEIP also includes performance-based equity awards (PSUs) based on EBITDA, cash flow, and absolute stock performance. Finally, the plan includes stock options with strike prices above the current market price. Even modest stock price appreciation can make equity compensation economically more meaningful than base salary for senior executives. Since management’s compensation plan is heavily equity based, it aligns their behavior with per-share preservation although the structure does not guarantee success.

The core takeaway is straightforward. This is a declining but highly cash-generative business and the market is pricing in a much faster deterioration than may actually occur. At current prices, the market appears to be discounting a rapid and permanent collapse in free cash flow rather than a gradual, manageable decline. Versant does not need to grow to justify a higher valuation, the company just needs to decline at a slower pace than what the market is pricing. Even under negative growth assumptions the business continues to produce meaningful owner earnings. Furthermore, significant management bonuses are tied to higher stock prices which creates management and shareholder continuity. The rapid decline in share price is at least partly due to forced selling by institutions and may continue over the short term. However, these situations can create compelling opportunities for the value investor.

This content was originally published on Gurufocus.com