British Sky Broadcasting – BSY
Price – 695p
Market Cap - £12.0bn
2011 EPS – 41p
2011 P/E Ratio – 17x (at 20% CAGR EPS growth this becomes 13x 2013 earnings)
Div Yield – 3.3% (7 years of 12% CAGR)
2011 Revenue - £6.4bn (grown at 10% CAGR since 2006)
2011 EBIT - £1.05bn
2011 Operating Cash Flow - £1.40bn
LT Debt - £2.5bn (balance sheet should be completely de-geared by 2013)
Gross Margin – 67%
Operating Margin – 16.3%
Buyback Program - £750m
BSY is ending a period of heavy investment in the rollout of it's broadband and TV delivery initiatives – it is currently in a phase of strong profit growth, margin expansion, cash generation and cost realization. Did News Corp have the right idea trying to buy all of BSY before they hit their operational sweet spot?
Unlike my usual preference for "dependable compounders" in my portfolios SKY offers a genuine quality growth story that adds something to the equity mix. It is the dominant player in the UK home entertainment oligopoly.
British Sky Broadcasting Group plc (Sky) operates pay television service, as well as broadband and telephony services. On July 12 2010, Sky acquired Virgin Media Television.
Sky also has a "Sky Bet" subsidiary which now has 100,000 unique users contributing operating profit of £21m per annum (very small part of the business – 0.3%) however it has a CAGR of 60% over the last 5 years leveraging their sport/poker coverage.
Selling TV advertising contributed £236m of revenue (3.7%) in 2010. We see this number increasing as Sky offers specialist channels (marketers will pay more for focused marketing) and as total viewers increase so will cost per second.
Sky is a Great British company - the end of the bid situation lets the UK keep one its great companies "over here". BSY has proven to be resilient to recession contrary to perceptions because 80% of its revenues are from relatively sticky subscriptions. Their recent one year price freeze has been seen as a friend winning exercise when they drew comparison to "other utilities where bills are increasing". Do people stay in with Sky TV and a Dominos rather than go out for dinner in periods of Austerity? Is that just me? Alternatively, one could view the price freeze as an indication of a lack of pricing power – currently I'm giving them the benefit of the doubt.
Sky has finally crossed the 10m subscriber mark in the UK, a target set by James Murdoch in 2003. Although clearly nearing maturity regarding a presence in households we can see this number continuing to creep up over the next few years towards 12m as they manage the churn rate lower and the product becomes more ingrained as a staple rather than a luxury.
- Pubs and Clubs produce £240m (3.7%) of revenue per year – this is high margin business and is absolutely essentially to the bars and clubs own business to get customers for big games.
Penetration of Product Suite
- 10.1m DTH (Direct to Home) customers. (BT Vision has 0.6m, Freeview has 10m)
- Pay TV is in 55% of UK Homes.
2.2m for "Multi-Room"
3.9m for Sky + HD
5.0m for Sky Sports
3.3m for Broadband
3.1m for Telephony.
Product Penetration is expected to drift higher in Sky + and HD towards 90% and 50% over the next 5 years. Up-selling of Multi-Room, Broadband and Telephony are potentially great ways to deepen the relationship with the customer and make them stickier.
Average Revenue Per User (ARPU) was £541 in 2010, up from £421 in 2007 (6.4% CAGR). Currently Sky are taking £45 a month on average from their households – a multi-room, total package household could reasonably be closer to £100 per month or ARPU of >£1000. In light of this, a rate of £600 seems very achievable in the next few years with only modest prices rises.
Reasonably, we could postulate that the "levers" are there for further revenue growth from the existing subscriber base. Over the next year or two the HD and Sky + offerings will likely become more standardised and users will pay up.
Sky touch 10m homes with their products but only a tiny fraction take up the full suite. The full offering potentially benefits the customer in that they receive only ONE household media bill and further that they perhaps enjoy cost benefits from "bundling". For example "products sold" in 2006 was just under 10m with the vast majority being Direct-to-Home TV, by 2011 results we expect 25m products to be sold, with 10m DTH TV sales but an additional 15m units of HD, Broadband, Voice, Line Rental etc.
The key from a returns perspective here is that because the business and service infrastructure is a fixed cost and already in place, after the initial set top box outlay – the marginal profit extracted from adding new service lines to existing customers is very large. It costs very little to send more data down a cable to existing customers. R&D requirements regarding this are covered below.
I believe Sky to be somewhat resistant to pricing pressures due to their best of breed product offering. Whereas price competition is high in telephony and broadband because differentiation is difficult – the television is a service where quality is more evident/valued.
The problem of losing existing customers.
I would suggest that the product suite on offer from Sky is superior to that of its competitors. The Sky+ functionality plus the additional access to content and HD place it above the offerings of BT and Digiboxes. Investment in top quality content like Sky Atlantic is a further differentiator from the competition.
Therefore we would hope that the "churn" lowers from here as customers realise that although they may save with another provider they are foregoing quality.
Service improvements regarding "get it right first time" on installations and handing complaints have shown improvements in the last few years. Demonstrably, there has been a headcount freeze in "back office" to manage costs and there has been an unspecified decrease in "number of calls per customer" – suggesting product satisfaction?
"The Key Driver to the Investment Thesis"
The business is profitable and growing as it is. The "build-out phase" is complete. What I see as key to the outperformance of analyst expectations, which will drive the shares higher, is that Sky will accelerate it's existing track record of delivering MORE content at a higher ARPU to it's existing subscriber base.
There is an enormous amount of untapped potential amongst customers not currently taking up the "full product suite". Sky Broadband currently has 16% market share and growing. Broadband is currently 13% of group revenues. Why can Sky not be the one stop shop provider of programming content, 3D content, televised sport, broadband and telephony for the vast majority of its customers?
We can hopefully get an indication of the potential of cross-selling from how they are fairing with offering the full proposition to new clients. These trends are very positive and indicative of successful marketing and well trained call centre staff.
As the third chart shows below – only 24% of the subscriber base is on "Triple Play" of TV, Broadband and Talk.
Sky operates a business which is naturally operationally leveraged – their costs of having in place the programming, infrastructure and network is fixed – these costs are then divided over larger and larger numbers of users, reducing average cost and increasing profitability.
Key metrics demonstrating this is "Cost to Serve/Revenue" this has fallen from 7.1% in 2008 to 5.2% in 2010.
Admin/Revenue has also fallen from 8.9% to 6.5% over the last 4 years too. Clearly, their costs of production and "cost to serve" are falling – this has been disguised by the Capex of installing set top boxes/infrastructure.
By ensuring that all customers have the same Sky Box, as opposed to the 10 models in use in 2008, Sky saves an average of £122 per box compared to 2006 cost per unit. This will bear fruit in the future but has been detrimental to short term earnings.
Similarly, signing a customer up to an HD Box incurs a £200 depression to that year's profits on that User. These examples also demonstrate a conservative accounting approach rather than capitalising the box costs.
HD Boxes are "future-proofed" to some extent. They are also capable of delivering 3D and Video-on-Demand content which should push back the date of the next investment cycle for BSY. Previously each new product required box refreshes for customers – eg. Sky +. Clearly, there is a worry that there will always be a "new thing" such as 3D or HD was which Sky will need to provide to customers to stay current. This worries me, but they seem to have pushed back the next investment cycle a few years already by installing the functionality on the current box. I would also contend that new technology uptake is slow over the first few years (eg. HD has been around for years but is only now commonplace) and so this won't be a worry until circa 2015.
The trends below demonstrate the operational excellence delivered by Sky. Is it possible that these trends are set not just to continue but to accelerate as the business spreads it's wings and begins to focus less on growth and more on delivery at an attractive return?
BSY is spending 6.5% of sales per annum (£400m) in Capex on a double investment programme in broadband and HD. The company has stated no plans for further "extraordinary" capex projects (partly a result of aforementioned "future proofing) and so this £400m should reduce substantially going forward.
This opens the door for increased cash flow and ultimately for accelerated dividend growth and/or buybacks. We have seen the first sign of this last Friday when they announced a £750m (5% of the market cap) buyback program and a 20% increase in the dividend.
Cash Flow not Earnings
This is a story about cash flow not earnings. Currently as we are in the final phases of the growth story and the product suite build out we believe that earnings are understating the power of the business. Earnings will lag cash flow. But they are both headed in the same direction.
Levers to Drive Free Cash Flow?
1) ARPU increases to £600 from £540
2) Full Product Suite rolled out to more subscribers
3) Margins are higher on HD, Sky+, 3D than on traditional products.
4) Increase volume of subscribers from 10m to 12m over 3-4 years.
5) Efficiency/Operating Leverage drives through to bottom line
6) Improve balance sheet efficiency – £750m buybacks? Special dividend?
It is difficult to arise at a price target because of all these moving parts however what we can be comfortable with is that BSY has a track record of delivery on these 6 metrics and that success on a number of them could drive earnings materially higher than the market is currently discounting.
I presume that the bid is dead for the next few years, on the back of the News Corp withdrawal and in light of the fact that the News Corp interest is easy pickings for political point scoring in Parliament.
Current prices reflect no "bid premium" and value only the fundamentals of the business. This note is NOT about playing an M&A angle. There is however a "free option" on the bid coming in the future.
It is worth noting that before the News Corp offer was withdrawn – the price at which the directors deemed it acceptable was creeping north of 900p a 30% premium to the price today.
Regarding "Media Plurality" – it seems undeniable that Murdoch and News Corp are very keen to own Sky and therefore would likely be willing to divest either Sky News or alternatively The Times (which is loss-making) to make sure the deal happened. I do not believe this is an impediment in the face of the desire to own this prize, strategic asset. They will sacrifice less important parts of their business to add BSY to their News Corp portfolio.
One danger in this regard is that in light of the criminal activity at News of the World that OFCOM could force a divestiture of News Corp's stake in BSY or alternatively threaten to revoke their broadcast license. This is an unlikely event given that anyone who is charged with criminal activity will likely be replaced immediately. Despite being low probability, this event would create a very large overhang as the stock was sold.
The political heat of the situation is demonstrated by this being the first time ever that Parliament has requested a bid to be withdrawn. There remains residual headline risk in the story.
Skin in the Game
· CEO Jeremy Darroch increased his holding by 33% purchasing £400,000 more shares at 706p in August 2010.
· Odey own 2.66% of the company and it is the biggest (5-8%) holding in a number of their funds. On Crispin Odey's numbers referenced in his quarterly call at 720p it is 4-5x 2013 cash flow. They added more stock after the bid fell through.
· News Corp own 39% of the stock.