• by Diane Mermigas , January 14, 2008

Media companies are in a valuation nightmare. Their problem: being valued almost exclusively on old models and metrics, while not yet reaping the balance-sheet benefits of an unfolding digital nirvana. Their challenge: to accurately assess their stagnating traditional businesses and rising revenue streams while shaping growth prospects.

This inevitable valuation quandary is underscored by a spate of grim earnings forecasts for media and entertainment companies from Wall Street analysts, who are also wrestling with the complex assessment challenge. It is an issue for investors and deal-makers trying to project beyond the single-digit, even negative growth expected for more traditional TV, film and print. It is also an issue for labor and management, which are struggling to construct plans for future income.

Over the past four years, that digital interactivity has exploded on the scene, and the S&P Media Index has underperformed the broader S&P 500 by more than 40% due to continuing structural concerns about future growth, according to Bernstein analyst Michael Nathanson. These include the adverse impact of technology (DVRs, time-shifting devices), the shift of ad dollars to the Web, and the pressing need to completely reinvent traditional media models. The negative impact of slower economic growth on advertising and discretionary media spending is becoming more assured. This lethal combination has pushed earnings multiples for media stocks to historic lows.

Nathanson estimates that a worst-case recessionary scenario in 2008 would lower earnings at even the conglomerates: CBS (down 20%), Disney (down 12%), News Corp. (down 9%), and Viacom and Time Warner (each down 7%). Because 2008 revenues and earnings could also be adversely impacted by a protracted writers' strike, Bernstein now is using 2009 relative price to earnings to value the media conglomerates.

The massive realignment of media-related businesses and their economic fundamentals will take time, but will benefit from any structural changes imposed by the writers' strike. These include creating content directly for online distribution and bypassing networks, studios and other gatekeepers. It creates more pressure to move to a continuous production of new content and the sale of advertising as needed, supported by actionable metrics. Companies may become more compelled to integrate, track and monetize digital interactive content into their existing businesses.

While new digital revenue would be an important offset to moderating traditional income, it hasn't come fast enough to save media balance sheets or valuations. Last week, Goldman Sachs reduced its estimates for communications, media and entertainment company returns to virtually flat growth, based on firm recessionary call, before factoring in any of the economic backlash from the strike. Analysts say that media risk-rewards cannot be fashioned on unquantifiable future digital gains.

"While the market can clearly see that broadband video offers content owners an opportunity to tap growing ad budgets and changing consumer behavior, the digital opportunity appears either too small or too distant to matter at present," Nathanson observes.

Even if Internet advertising grows by 50% this year, the incremental impact would be only 1.5% on aggregate revenue for the media conglomerates. Time Warner, News Corp., Viacom, CBS and Disney reap $140 million in revenues from Internet ads--comprising just 3% of their overall revenues, which are largely based on garnering 70% of all television viewing.

JP Morgan Friday bluntly declared "traditional media companies' exposure to the projected $21 billion global online graphical ad market should remain limited in 2008" (News Corp.'s MySpace being the exception), as developing revenue-sharing agreements and unobtrusive video ads are challenging.

Media companies are destined to remain undervalued until they fully integrate new digital business models and develop the metrics necessary to quantify gains. Revenues, earnings and cash-flow projections are based on core businesses, many of which are declining or in flux. Companies' legacy operations will require a complete overhaul. This involves such formidable tasks as physical and technical conversion, as well as workforce reconstruction and reduction.

Many new businesses are not a budget line item, since they don't yet generate enough revenue to make a big difference. Many digital interactive pursuits require the creation of new metrics and standards by which to measure their success. There is no meaningful way to compare emerging and traditional media businesses and performance. While new revenue streams are still materializing, media's core advertising income source is just beginning a sea change --from passive pitch to interactive transaction.

It will be years before media-company balance sheets, forecasts and valuations substantively reflect digital growth potential. Until then, this schism will handicap everything from routine finances to major acquisitions.