CBS brings domestic dominance and Viacom brings international distribution.

Sumner Redstone couldn't have been more wrong. When CBS Corporation (CBS) and Viacom (VIAB) split in 2006, he suggested the age of the diversified media conglomerate was over. Dividing CBS and Viacom was expected to create more value. To say this split has turned in disappointing results is a vast understatement. With the two companies getting back together 13 years later, will the combination provide better returns to investors? In short, the new company looks so cheap, investors should finally get the big payoff they have been waiting for.

Breaking up and breaking shareholders' hearts

The timing couldn't have been much worse for the CBS and Viacom split. In 2006, Netflix (NFLX) was still a DVD company. Walt Disney (DIS) was known for its theme parks and classic movies. The theory sounded good - CBS would represent television assets and Viacom would represent the film company.

By September 2006, (AMZN) introduced video on demand, and the next year, Netflix launched streaming video. In the following years, we've seen mergers to combine companies like Comcast (CMCSA) and NBCUniversal, and more recently, AT&T and Time Warner. The market obviously didn't feel comfortable with the prospects of either Viacom or CBS, and the stock returns have not lived up to the billing of the split.

On Viacom's first day of trading, the shares were at $41.59. By 2014, investors thought the company was headed in the right direction and the shares reached about $88. The company was in a fight with Google (GOOG, GOOGL) over shows appearing on YouTube and was looking for $1 billion in damages. However, this dispute ended with the two companies coming to an agreement without money changing hands. In addition, Viacom signed a deal with Sony (SNE) for its live and on-demand Internet-based service. Though Sony offers PlayStation Vue today, this deal wasn't quite the blockbuster that Viacom investors were counting on. With Viacom shares trading at around $25 today, excluding dividends, this represents a compound annual loss of about 3.8% over the last 13 years.

From the CBS side of the equation, the stock has fared slightly better. On CBS' first day of trading after the split, the shares traded at $26.20. In 2017, it looked like the shares had finally broken out, reaching a high of nearly $70. Today CBS shares trade around $42, representing a 13-year compound annual gain of less than 4%. Investors in CBS have collected dividends over the years, so the total return is somewhat better, but again, not what investors might have hoped.

By point of comparison, Disney stock went pretty much nowhere for years but broke out in a big way in the last couple of years. Since 2006, the stock has shown a compound annual growth rate of just under 14% excluding dividends. Clearly, breaking up Viacom and CBS didn't create value - maybe getting back together would solve this problem.

Domestic dominance meets international distribution

Viacom will be at the beginning of the new company's name, yet it will be Viacom shares that will convert into the new company. For each share of Viacom, it will receive 0.59625 shares of ViacomCBS, whereas CBS stock will convert one for one. The combined company says it has a three-part growth strategy moving forward.

(Source: CBS and Viacom merger info)

First, the company wants to accelerate its direct-to-consumer business to adapt to the changing marketplace. With the rise of cord-cutting, over-the-top live TV options, plus new streaming services coming in the next year or so, ViacomCBS knows it must be a player in this arena. When it comes to streaming and OTT services, the combined company will have something for users who want live TV, movie releases, free OTT or premium content.

Pluto TV gives users an ad-supported free OTT option with, "more than 100 channels and thousands of free movies and TV shows." Though Pluto TV offers a somewhat unpredictable offering of on-demand movies, some of the channels may offer a good value for certain viewers. There are channels such as MTV Pluto TV, BET Pluto TV, NBC News, Nick Pluto TV and multiple music channels.

Paramount+ offers recent movies, classic movies and "more than 1000 episodes" from MTV and Comedy Central. The company is launching BET+ this fall as a standalone service as well. Viewers who want Showtime can subscribe directly at $10.99 per month. Arguably, the core of ViacomCBS' streaming options is CBS All Access.

"CBS finished the 18-19 season as the ratings leader for an 11th consecutive year." Users can watch CBS live TV in many areas, plus on-demand and original shows. For $5.99 per month, you get CBS with commercials, or $9.99 per month eliminates the commercial interruptions. This service offers, "over 10,000 episodes" and is available to stream on almost any platform. Whether users want free streaming, premium, curated channels or CBS live, there is truly something for everyone.

The second growth strategy is to "enhance distribution and advertising." The merger seems to bring together two companies that can leverage each other's strengths. CBS said on its most recent conference call that, "international is our biggest opportunity." The company is a leader in the domestic market, but acknowledged, "we haven't been able to exploit these opportunities internationally yet, we're really limited to the United States."

On the flip side, Viacom has strong international distribution capabilities. Viacom says it is, "one of five major film studios operating on a global basis." The company lists operations in the U.S., Europe, Latin America, Australia and Asia. Given Disney's global presence and Comcast's acquisition of Sky, ViacomCBS should be able to more effectively compete worldwide.

The third growth strategy is to be a "leading producer and licensor of premium content - broadcast and cable networks, subscription and ad-supported streaming. In short, ViacomCBS isn't going to pigeonhole itself into saying everything will go through its own services. We've seen in streaming the company has multiple options to serve customers. When it comes to producing shows, CBS said multiple times it would look at each series individually to determine the best value.

If CBS believes it can do better for shareholders by licensing the content to another streaming service, the company will strike a licensing deal. However, part of bringing Viacom's worldwide distribution into the fold is to generate returns by keeping content under its own roof. The point is, CBS brings dominance in the domestic market and Viacom brings international expertise. The combination seems to offer investors a better value than either company on its own.

What will the financials look like?

Whenever two companies merge, it makes sense to look at how their financials stack up once combined. If we look at what CBS and Viacom generated in the most recent quarter, we get a sense of ViacomCBS's size.

(Source: ViacomCBS Inc. Presentation)

In the last quarter, the combined company would have generated more than $7 billion in revenue. The companies have operating margins of between 18% and 23%. Neither company is weighed down with interest expense, representing less than 4% of each company's revenue. When it comes to core free cash flow, CBS significantly outperformed Viacom. In the last six months, CBS generated about $0.26 of core free cash flow per dollar of revenue. Over the last nine months, Viacom produced almost 50% less core free cash flow at $0.14 per $1 of revenue.

ViacomCBS is expected to generate more than $28 billion in annual revenue and generate an operating margin of around 21%. The combined company expects to pay a "modest" dividend. With both companies sporting a core free cash flow payout ratio of less than 20%, whatever dividend is paid should be well-covered.

It bears pointing out that even together ViacomCBS will still be a smaller company to Disney. One poignant example is the revenue comparison. ViacomCBS could produce $28 billion in revenue for 2019. By point of comparison, Disney generated more than $20 billion in revenue in the last quarter alone. Disney carries an operating margin of nearly 20%, and that is without the expected cost savings coming out of the Fox merger. The point is it seems to make sense that Viacom and CBS would merge, as they need scale to compete with the Mouse House.

A value impossible to ignore

While the promise of ViacomCBS seems to make sense, looking at the value of the combined company is what should get investors' attention. At present, CBS is expected to grow 2020 revenue by a little more than 4%. Viacom has returned its domestic business to growth, and analysts are calling for 2020 overall revenue growth of just under 4%.

If we look at the 5-year projected EPS growth rate of each company, CBS seems to be ready to carry the load. Analysts believe CBS will grow EPS annually by more than 12%, whereas Viacom is expected to grow EPS by just over 3%. While CBS carries the EPS growth, Viacom offers investors a better yield. At present, Viacom's yield is north of 3%, while CBS' yield sits at less than 2%.

If we combine the two companies, analysts believe they could reach nearly $30 billion in annual revenue by the end of 2020. CBS is expected to generate more revenue and more relative core free cash flow. In 2020, CBS would produce 55% of the combined company's revenue, and Viacom would generate the other 45%. If we use this same split and apply it to the 5-year projected EPS growth for each, we get a long-term combined EPS growth rate of 8.3%. Since Disney will be spending heavily to grow its Disney+ service, dealing with Hulu and integrating Fox assets, analysts are calling for negative 2.5% EPS growth in the next five years.

CBS carries a 2020 projected P/E of 6.7, and Viacom sits at a projected P/E of just 6. If we use the 55% to 45% split again, this means a combined P/E of about 6.4. With a low P/E ratio and a projected 8.3% EPS annual growth rate, the stock looks dirt cheap. The combined company said it expects the merger to be "EPS accretive with estimated run-rate annual synergies of $500 million."

Investors in Viacom and CBS are probably haunted by the split of the companies. The good news is, the new ViacomCBS looks like a cheap stock, tied to a company that can leverage its parent companies' strengths. As multiple streaming services, strong cash flow and great content combine with a cheap stock, investors should keep their eye on ViacomCBS for future gains.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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