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Scottish Radio: The Folly Of Acquisitions

By Maynard Paton (TMFMayn)
December 12, 2002

Recent preliminary results confirmed Scottish Radio Holdings (LSE: SRH) remains a fundamentally sound business. Following a brief -- and costly -- foray into billboard advertising, the company's management is now able to refocus on two appealing industries: commercial radio and local newspapers.

Nevertheless, like most other media firms, a penchant for further ambitious acquisitions could scupper shareholder value. Largely mitigating this threat, however, is the scope for a larger rival to buy Scottish Radio for itself. Unfortunately though, the current 655p share price looks to be factoring in a bid premium.

(For those wanting a refresher on Scottish Radio, this company review and rundown on commercial radio will help.)

The financials

The table below summarises Scottish Radio's five-year financial performance:

Year to September 30th        1998    1999    2000    2001    2002

Turnover (m)                 43.8    55.1    71.1    79.8    83.5
Operating Profit (m)         12.5    16.8    18.6    13.7    14.1
Pre-tax Profit (m)           12.1    15.7    20.0    14.8    12.8

Earnings per share (p)        29.0    41.1    44.6    27.9    29.5
Dividend per share (p)        11.3    13.6    16.0    17.5    18.0

(all figures adjusted for goodwill and exceptional items)

The results for the year ending September 2002 were a complex affair. Taking centre stage was the 32m disposal of Scottish Radio's outdoor advertising business, which generated a 22m exceptional write-off. It's worth remembering that it was not so long ago, between March 1999 and April 2001, when the group spent 62m on acquisitions to create the advertising hoarding division.

With the billboards all gone, Scottish Radio is now left with its far more attractive commercial radio and local newspaper operations. However, a lacklustre advertising market has provided mixed divisional performances of late. Within the latest full-year results, underlying radio turnover inched 3% higher to 35.2m while operating profits slipped 8% to 10.2m. Newspapers saw their underlying sales and operating profits edge 3% higher to 26.8m and 7.1m respectively.

Bolstering the group numbers were four acquisitions made during the year. Scottish Radio forked out 72m during the period, most of which was spent on radio stations Wave 105 and Radio Ireland. In the year under review, the purchases brought in an additional 6.8m of revenues and 1.3m of operating profit. All the corporate activity left a relatively comfortable 38.4m net debt position.

Notably, operating margins held up well during the somewhat tricky year. Margins of 27% were generated at both the radio and newspaper subsidiaries.

Cash flow and return on equity

Year to September 30th        1998    1999    2000    2001    2002

Operating Profit (m)         12.5    16.8    18.6    13.7    14.1

Change in Working
    Capital (m)               1.1    (4.3)   (1.8)   (0.9)   (1.8) 

Depreciation (m)              1.3     1.7     2.0     2.5     2.7
Net Capital Expenditure (m)  (0.8)   (1.1)   (2.8)   (2.9)   (3.8)

Reported earnings at Scottish Radio are substantially underpinned by cash flow. Cash absorbed into working capital averages about 10% of operating profits every year. Meanwhile, over the past nine years, net expenditure on fixed tangible assets has been just 5% higher than the aggregate depreciation charge.

However, in a similar vein to Halma (LSE: HLMA), the asset-light nature of the business doesn't come through in the incremental return on equity calculations. Purchased goodwill has become a notable drag on the profit reinvestment performance.

Since September 1994, Scottish Radio's acquisition spree (6 radio purchases totalling 72.8m, 8 newspaper purchases totalling 52.5m and 7 billboard purchases totalling 61.9m) caused the group's intangible assets to balloon from 6.5m to 148.6m (including the aforementioned 22m write-off)

Over the same eight years, Scottish Radio's asset base (adjusted for goodwill) has swelled from 16.0m to 145.9m while earnings have gone from 2.8m to 9.8m. The resultant incremental return on equity comes to a dismal 5.4% ((9.8m - 2.8m)/(145.9m - 16.0m)). Having spent over 60m on assets generating next-to-nothing in profit, the poor reinvestment performance stems largely from the hoarding venture. Between 1994 and 1999 (prior to the billboard purchases), the incremental return on equity was 25.5%.

Summary and valuation

On the face of it, Scottish Radio is an attractive long-term business. It's a simple, straightforward company with a robust position in local radio and newspaper markets. Although the present calculations tell a different story, the company's inherent asset-light nature should be capable of generating high returns on equity in the future. The big question, of course, is whether the Scottish Radio boardroom will continue to retain excess cash for further empire building. Prospective shareholders will hope the management team has learnt its lesson following the disastrous outdoor advertising venture.

In fact, it's fair to say the tables could eventually be turned on the company management. The forthcoming liberalisation of UK media ownership rules will undoubtedly put Scottish Radio in the spotlight. Tartan media firms SMG (LSE: SMG) and DC Thomson already own significant stakes in Scottish Radio and, as one of the more digestible media businesses on the stock market (Scottish Radio is valued at just 217m), predatory interest can't be too far away.

Using current broker forecasts, at 655p, Scottish Radio shares stand on a forward price to earnings ratio of 18.8 and offer a prospective dividend yield of 2.8%. On the assumption reported earnings are reflected as free cash, the company is valued on a historic free cash flow yield of 4.5%. Even if free cash were to expand by 10% over the next twelve months (reflecting a full contribution from recent acquisitions and an upturn in the advertising industry), the shares would have to fall to 433p to get a prospective free cash flow yield of 7.5%.

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