By Nayut Sitachitt, Emerald Springs Asset Management
Company Overview:
Pay TV programming generates two-thirds of the company's profit with the remaining one-third generated in film entertainment and television broadcasting. Key pay TV channels include Fox News, Fox Sports 1, FX, National Geographic, YES and many RSN. The company also holds around 40% stake in SKY, 50% stake in Shine-Endemol-Core Media and 30% stake in Tata Sky. The company holds some spectrum assets through its ownership of TV stations in major metro areas.
Summary- Company:
1. Its key pay TV channels are investing to expand contents and to establish brands after the consolidation of contents into a few key channels. This hurts near term profit, but will ensure strong profitability in later years.
2. Fox’s first-rate contents and channels give it significant pricing power even after the consolidation of the cable/ satellite TV companies.
3. Fox News is a one-of-a-kind channel with very loyal following among its large core viewers. This gives Fox the ability to demand affiliate fee increases. At the same time, its star talents are usually not viewed as desirable by the competing networks, helping Fox keep good control on costs.
4. Shares trade at a very reasonable valuation given its growth prospect and the competitive advantages surrounding the company. Total annual return in the high teens or more through the end of this decade is highly likely. The return is achieved though at least a mid-teen growth in FCF and earnings plus the use of FCF to buy back shares. Buying into the shares at current price present a highly favorable risk/reward trade-off.
5. Over the last two years, business fundamentals of the company’s core US pay TV programming operations improved significantly, while shares remain stagnant partly due to factors such as forex headwinds and weak rating on broadcasting side.
Summary- Industry:
1. Pay TV business model can monetize contents better than free TV business model. The shift of contents from free to pay TV is still in an early stage. The shift will lead to more revenue and profit generated on the same amount on content in the long-term, but may introduce short term uncertainty to earnings.
2. Higher profitability from escalating pay TV prices will more than offset subscriber losses for years to come. Pay TV will still represent a great value compared to other form of entertainment despite the price increase.
3. Current linear TV bundles will be transformed to multi-platform premium TV as contents delivery move from single platform to multi-platform. At the same time, content providers will continue to introduce cheaper bundles via OTT to fill the gap for those who do not want to pay for the standard bundles. The variety of bundles will help content providers maximize revenue by ensuring that they can charge close to the maximum amount that consumer is willing to pay.
4. Consumers will face an increase in content distribution infrastructure costs as popularity of OTT increases.
5. Unbundling will not lower the price but will lead to fewer choices for consumers. It is highly unlikely that an a la carte model will ever be offered as both content providers and consumers would be worseoff.
6. First-rate channels will continue to deliver strong performance while second-rate channels could disappoint. Content monetization can be done a lot more effectively when they are combined into a few first-rate channels, as opposed to many second-rate channels.
7. Content creation is not nearly as attractive of a business as content aggregation. But in certain cases, content aggregation business model will not work unless it is integrated with content creation.
8. The control of key contents by a few large companies who are looking to maximize profit will ensure a stable operating environment with consistent margin expansion.
Industry Perspectives:
Impact of advertising headwind on second-rate channels: The shift to on-demand television means consumers are watching less advertising. Since advertising subsidizes the cost of pay TV bills, consumers would get less of that subsidy and have to pay more out of pocket. That has an unequal effect on different channels. The second-rate channels that people watch when nothing that they really want to watch is on, will be impacted a lot more than the first-rate channels. Currently, these second-rate channels may get a lot of air time but not a lot of affiliate fees, as they don’t have much negotiating leverage in the form of highly desirable contents. Those airtimes can be converted to advertising revenues. Going forward, however, those advertising revenues would face headwind due to recorded/delayed viewing. First-rate channels can demand affiliate fees to replace the lost advertising revenue. But a company owning a collection of second-rate channels doesn’t have enough negotiating leverage against cable/satellite companies to do that.
Bundled service is better for all: Despite the criticisms, bundle provides a net positive effect for both operators and consumers. When a channel is offered on an a la carte basis, the operator will have to charge a much higher price per channel. This is because the viewer base of the channel is much smaller. For the same amount of money, consumers pay in bundled services, they may only get a few channels that they watch a lot. The a la carte model would essentially strip the consumers of the ability to watch the channels that are outside of their favorite for free. Consumers would watch less TV and get less entertainment for the same amount of money. For operators, it means lower viewership and lower advertising revenue which leads to the need to push even more of the cost to consumers.
The true cost of OTT: The quoted price of OTT services include only the content costs and exclude the cost of the delivering infrastructure. Cost of delivering infrastructure makes up approximately half on the traditional pay TV cost. To get access to OTT, the consumer has to pay separately for broadband internet (the delivering infrastructure). The significant increase in bandwidth requirement due to significant usage of OTT will result in an increase in broadband internet price. Cable companies have a natural monopoly for high capacity broadband internet in many areas as phone lines cannot handle the amount of data required for large data consumption and fibers are prohibitively expensive to roll out. This monopoly means it is certain that many consumers will at least have to pay the fair price for the distribution infrastructure regardless of whether they consume the content through OTT or traditional pay TV services. When the popularity of OTT overwhelms the phone line, the pricing power of cable companies on high capacity broadband will become very clear.
Shift of Contents and Resources from Free TV to Pay TV
Margins are much weaker on Free TV side compared to Pay TV side and a careful shift of contents and resources to Pay TV side will lead to a meaningful improvement in margins. While weak advertising is partly to blame, the key reason behind the superior margins of Pay TV is the superior pricing power of the business model. Free TV/ Broadcast networks make a bulk of their money from advertisers who generally have multiple media choices to weigh the costs and benefits. First-rate pay TV channels sell addictive contents to retail consumers in return for affiliate fees. Advertising plays a much smaller role in comparison to free TV. Consumers are in a relatively weak negotiating position because they want to watch their favorite sports and shows and often have to pay the price asked.
A shift to pay TV can take multiple forms- 1) reduction of resources placed behind free TV and increase the resource placed behind pay TV 2) moving of contents from free TV to pay TV 3) increasing affiliate fees of the broadcast channel so that eventually this revenue stream will be larger than advertising revenue stream. The shift may lead to weak near term earnings and weak free TV ratings but stronger long term profitability when the new affiliate fee rates kicks in.
The influence of large content owners: Much of the TV contents today are owned by or licensed to a few large companies (Fox, Time Warner, Comcast, Disney, Viacom, and Discovery). They will only cooperate with new distributive players to the extent that they can benefit from the arrangement. On their own, disruptive new players without vast array of contents cannot survive. This is why the shift to on demand TV is much slower than many expected. Large content owners want to ensure that consumers are paying for the lost advertising revenues before significant portion of the premium contents are available on demand. Even a highly innovative company with deep pockets like Apple (AAPL) had trouble cracking into this space without the full support of multiple large content owners.
The great value that pay TV provides: While many complain about the price of pay TV, it is actually among the cheapest form of entertainment one could get. Even with the significant increase in the cost of sports programming, watching sports on HDTV still cost a small fraction of attending the game itself. Watching sports on TV also allows for a much better viewpoint than a majority of seats in the stadiums. For many, sports over TV provides a better value and this will likely remain true even if sports content prices are doubled.
An average dinner and a movie for a family of three would have a total cost in the range of $60-$75. That’s for a few hours of entertainment. For a similar price or not much more- consumers can get pay TV contents for a full month. The escalation in high quality content cost will continue as the content still deliver great value. This will benefit content owners and content aggregators.
Content aggregation is a lot more profitable than content creation: While companies such as Fox, Disney and Time Warner are considered content providers, a significant portion of their income are derived from aggregating 3rd party contents as oppose to creating and distributing their own contents. In other words, they make a lot of money from being a middle man.
Content creation and content aggregation are quite different. Sports channels such as Fox Sports and ESPN are mainly performing the task of content aggregation. Content aggregation business model is to buy various contents, then aggregate them into a channel and resell those contents as a channel at higher prices. Movie studios, sports teams etc. are in the content creation business. They make their money selling their content to aggregators or direct to consumers. Some of Fox channels (Fox News, FX) are integrated. This means they do both the creation and aggregation in-house.
Some say that “content is king”. But the simple fact is that content creation as a standalone business is not very attractive. Content creation consumes a lot of cash and usually has volatile profitability. It cost a lot of money to produce movies or TV series. There is a significant revenue mismatch which would require significant investment of FCF into working capital. And if the show is a flop, all is lost. This poor financial characteristic does not only apply to the studios but across many content creators. Take sport teams for example, many are consistently operating at a loss even though popularity of sports broadcasting has increased significantly. The input costs in creating good contents (mainly talents) are expensive and it tends to rise faster than content creator’s revenue.
The business of merely aggregating contents is a lot more attractive. Once established it doesn’t consume a lot of capital, provides good FCF and is usually much less volatile. High demand channel has significant pricing power to enable it to pass on the increase in content costs to cable/satellite company and ultimately to the consumers. Pay TV companies need the popular channels in the line-up because consumers demand them and may switch to the competitors should the pay TV companies not get the channels.
Aggregating contents, though, has some key risks. It needs to be fed with high quality contents. If, for example, all contents are owned by competitors who are unwilling to sell the content to an aggregator, the aggregator’s business model will fail. New technologies may also make it easier for some content owners to bypass content aggregators and go direct to consumers. These two risks are much higher for general entertainment channels as oppose to sports channels. Fox’s move in recent years to produce a larger share of contents in-house reduces or eliminates the two mention risks for its entertainment channels. With the production of TV series in house, Fox is able to ensure that the profitability of the channels (the contents aggregator) can remain strong. However, the economics of content creation is not strong and Fox has taken a hit with swollen working capital requirements in recent years.
Company:
The Pricing Power of Fox’s Channels
Consolidation cable/ satellite companies will impact the smaller/ weaker players a lot more than large player with highly sought after contents. Due to its first-rate channels Fox exposure is limited.
Fox has done an excellent job at consolidating their contents from multiple average channels into a fewer first-rate channels. The same contents scattered across many channels are less valuable than that same contents consolidated into one or a few first-rate channels. In addition, the company has added key sport programming rights and other contents to these first-rate channels. Fox has three channels on a national level that is first-rate – Fox Sports 1, FX and Fox News. On a regional level YES and selected other RSNs. These first-rate channels will allow for significant negotiating leverage during a contract negotiation. They are also a large source of cash flow and form a competitive advantage around the company.
Because Fox sports contents are a must-have, it adds to the negotiating leverage to the entire portfolio of channels that Fox owns. Sports programming has distinct desirability because it cannot be recreated on competing network in the way other types of programming can be done. The supply of key sports contents are also limited and cannot be increased at will by the content providers.
Fox News – Loyal Core Audiences, Good Cost Control, Highly Strategic
One the revenue side, Fox News has the power to demand an ever increasing affiliate fee from pay TV companies while keep costs under control at the same time. Pay TV companies have to package Fox News on the line up or risk alienating their conservative audience base. It is a unique, one of a kind, channel with very loyal core audiences. Its viewers don’t watch it just for the news but to give themselves satisfaction that their political views are being supported. This type of attachment to the content is found in few other cable channels. It provides comprehensive politically biased entertainment content that their core viewers are looking for. This strategy in turn results in strong ratings due to higher engagement and more viewership which allow Fox to negotiate favorable affiliate fees. It is also much easier for Fox to maintain and increase the ratings. Channels that attracted viewers by producing hit TV series will have to consistently come up with a hit. Fox News doesn’t have that risk. They just have to keeping producing the politically biased contents which is not very hard to do. Fox gets $1 a month for the channel, and there is quite a lot of room for price increase. To many conservatives, the channel likely delivers more value to them than ESPN.
On the cost side, Fox News as a content creator has a good control of the input costs. Key beneficiary of the content cost inflation are the talent that goes into making the content. That is true whether it is in sports (star players) or entertainments (actor/ actress/ TV personalities). Content creators compete to get the talent and it drove up the value of talents. This is less of a problem for Fox News. Because of its political biasness, there is not much demand for its star performers on other channels or networks. Key personalities on Fox News don’t have a strong appeal to people outside of their core viewers on the channel. This gives Fox News a good leverage against these talent in a way that few other content creators has.
Fox News’s ability to raise price while keep cost under control will lead to consistent margin expansion. The channel will likely see a moderate revenue growth and a very strong profitability growth for some time to come. Also, Fox has consistently used its strategic media assets to successfully advance its own interest to the benefit of its shareholders. Fox News is the asset that can tilt the playing field a little more in its favor. Although I questioned the value to the society of Fox News, there is no question about the financial benefits of this business model and the value it has and will create to Fox’s shareholders.
Managements – Visionary, Strategic, Long-Term Focused
The managements are among the best strategic thinker in the media industry. Throughout the company’s history, management was able to out-maneuver its competitors to scores many seemingly impossible come from behind victories. Because of the network effect, second rated properties in media are extremely difficult to turnaround and new entries usually have huge competitive disadvantage compared to the incumbent. With the odds against it, the company was able to find success times and times again. Second rated money loosing newspapers was brought and turned around. Fox News outmaneuvered CNN when CNN domination was previously unquestioned.
Transformation of the company over the last 10 years has been remarkable. 10 years ago publishing made up just over 1/3 of company profit while film entertainment and broadcast TV made up slightly less than 1/3 each. Under an average management, the company with such exposure to these rather unattractive industries would have been far less valuable today. The management, however, was able to grow the pay TV programming business’s OIBDA from 488 mm in FY2004 to 4,407 mm in FY2014 – a 9 folds increase in 10 years. This growth rate far outstripped any of its competitors by a wide margin. Today more than 2/3 of income is generated from pay TV programming.
Fox Sports 1 – An Emerging Competitor to ESPN
Fox has significant sports broadcasting rights to build Fox Sports 1 into a viable competitor against ESPN. It is currently under-earning on these rights partly because the company doesn’t have the name recognition in sports the way Disney’s ESPN has. The two company’s national sports programming rights are listed below:
Fox – World Series, One MLB league championship series, Two MLB division series, 64 MLB regular season games including 12 on Sunday afternoon, Yankee games, Super bowl 2017/2020/2023, NFC championship, NFL regular season games on Sunday afternoon, NFL one wildcard game and one/two divisional playoff games, First 16 races of NASCAR sprint cup series including Daytona 500, US Open Tennis, World Cup 2018/2022/2026 and significant other soccer rights, UFC
Disney – MLB Sunday, Monday, Wednesday night games; NFL Monday night games, One wild card game, NBA finals, 88 NBA regular season games, NBA playoff games including one conference final series, NASCAR Nationwide series, Indianapolis 500, key golf tournaments (some shared), most major tennis tournaments (some shared)
Fox current national sports programming rights are not far behind Disney in term of quality but the company is getting much less revenue from it. Its leading sport Channel, FS1, gets around $1 in affiliate fee compared to $5-6 a month for ESPN. With the current line-up of sports rights, the company has significant negotiating leverage to increase affiliate fees. The affiliate fees gap will likely close in the coming years to accurately reflect the value of contents being delivered.
Sports content cost escalation is not necessary a negative thing as companies like Fox and Disney can pass on the increased cost to consumers. Because the cost can be passed on, the escalation actually has positive impact for large incumbent player like Fox because it increases the barrier to entry.
Fox as the Consolidator in Pay TV Programming Space.
The profitability of a pay TV channel rest largely on negotiating power against the companies that control the distribution infrastructure. The larger the size and the more desirable the content is, the higher negotiating leverage the pay TV channel has. Consolidation among the distribution infrastructure companies makes this negotiating leverage more important than ever. Discovery, Viacom, AMC and Scripps lack enough negotiating power in this new environment and will likely have to be acquired by a larger company. Among these companies, Fox is the most aggressive and will likely end up being the key consolidator in the industry.
The potential deal with discovery makes a lot of sense for both companies. On a standalone basis, Discovery lacks scale and highly desirable channel /content that can serve as a negotiating leverage. The US side of the business will likely suffer as the cable/satellite companies consolidate. In Fox’s hand Discovery can add a lot of value in several ways. Frist, some of Fox channels are in direct competition with Discovery (ex. National geographic vs. Discovery channel). Combined, the competition will decrease and the pricing power will increase. There is also the ability to rearrange contents between channels in a way that will maximize affiliate and advertising fee revenue. Second, Fox with its size and negotiating leverage, can extract more affiliate fees than Discovery can. Third, there are a lot of costs that can be taken out of the combined entity- there are likely a lot of overlaps in the administrative and content creation area. Fourth, much of the deal can be financed with cash on hand and cheap debt giving a nice boost to EPS.
Although the acquisition of Time Warner at this point is not likely, the deal would have been highly beneficial to Fox. It will allow for contents to be rearranged and bundled in multiple super channels. Both companies combined have more key sport broadcast rights than Disney/ESPN but independently they are not able to monetize these rights as well as ESPN can. The sport rights can be combined into a channel with more complete sports coverage. The channel would have the negotiating leverage to potentially command affiliate fees above that of ESPN’s.
Fox Cable Channels are in an Investment Phrase
Fox Sports 1 and FX are in the investment phrase and significant profitability increase is certain once the new rates are in effect across the board. During the investment phrase, the channels have to borne increase programming cost while the affiliate revenue stays the same at the previously negotiated rates. This generally decreases the near term profitability of the channels. At renewal, the channel can often demand a higher affiliate fees. When the channel goes from an average channel to a first-rate channel, the increase in affiliate fee can be significant. For example, Fox Sports 1 current deal with Comcast was signed when the channel was just an average channel (Speed). It is highly likely that the channel will be moved to the standard tier and commands much higher affiliate fee at renewal.
Key Risks:
International Exposure
International markets have two key risks: currency fluctuation and comparatively low barrier to entry. Latin America and India, where fox have major operations have seen their currencies depreciated significantly against the US dollar not just in the past 9 months but over the course of the last 30 years. The barrier to entry in the international markets is not as high as those in the United States. For example, in the US, very few companies have a deep enough pocket to bid for key sports rights. In emerging markets, those rights are much cheaper and a lot more companies have enough resources to bid for them. The high market growth further induces new competitors to enter the market.
Threat to Content Aggregator’s Business Model
Fox sports channels are acting as a content aggregator or a middleman. Some sports content owners in the past have found ways to bypass the aggregator by forming their own channels. This risk is more significant in the regional sports network than in national sports network. It is important to note that unless the individual sports team has significant followings, coordination among multiple local sports team are usually required to have a successful launch of the new channel. So it is not easy and doesn’t happen often. But from time to time, sports teams have decided to not renew the rights with Fox and started their own RSN or demand a large equity stake in RSN.
On a national level, it is highly unlikely that multiple sports leagues will band together to form a competing multi-sports channel such as ESPN or Fox Sports 1. It is hard to get agreements from the participants on key terms such as size of equity stake, programming etc. However, sport channels owned by major sports leagues do compete with Fox for pay TV dollars. But consumers continue willingness to pay for sports over TV will mean that the size of the pie is growing which should benefit all leading participants.
Valuation:
At $33.24 a share, the company trades at 19.7x forward PE (FY2015-ending June 2015). Normalized FCF yield for FY2015 is around 5%. EV to FY2015 EBITDA is approximately 12.6x. The shares would fall into the GARP, growth at reasonable price, category. Reasonable because 1) Fox’s earnings quality is high. Fox’s significant economic moat limits downside and volatility of earnings 2) near 20% a year EPS growth over the next 5 years 3) good FCF yield, and the a significant return of cash to shareholders through tax-efficient buybacks. FCF growth will likely be strong a few years out as working capital requirements are reduced to a more normal level. In the current market where shares are traded in a relatively tight multiples-band, company with good earnings quality and significant growth potential, such as Fox, are undervalued.
Investor in FOX can expect at least annual returns in the high teens through the end of the decade. This is driven by at least a mid-teen net income growth combined with the return of excess cash to shareholders through shares buyback and dividends. The shares present a very good risk/reward trade off as investor doesn’t have to take a lot of downside risk to get a very strong return. Downside risks are limited because 1) at the current multiples, the risk of multiples contraction over a long period of time is not high. Even if it happens, the high earnings growth rate should offset any multiples contraction risks as long as the investor is willing to hold the shares for at least a few years 2) Due to Fox’s earnings quality and economic moat, a large and permanent earnings drop-off is highly unlikely.
The opportunity exists due to a few reasons. First, the strength of the dollar and the extreme weaknesses in some of the currencies that the company operates in hurts its earnings and force multiple downward revisions in earnings guidance. Second, people are concern that the consolidation in the pay TV industry will allow for an increase in bargaining power against content providers. Third, revenue/earnings take a hit from sale of Sky Deutschland and Sky Italia. The first and third has no impact on Fox’s business fundamentals. The Second, will have limited impact due to the strength of Fox’s channels.
The company has two classes of shares (FOX, FOXA) with the voting shares actually trading at a discount to the non-voting shares. The non-voting shares are about 3-4 times as liquid as the voting share although at around 2-4 mm shares traded a day, the liquidity of the voting shares is as good as many 5-20bn USD market cap names. It is unclear why the company does not shift its buyback focus to class B voting shares. Over a longer period of time, the voting shares would be trading at some premium to non-voting share and I would recommend buying the voting shares. Should the discount continue to persist for a long time, the company will likely allow convertibility from B to A.
Among the contents companies, risk/reward of fox’s shares is more attractive due to the following reasons:
· Disney: Fox has higher potential growth rate and trades at lower valuation. Disney’s profitability too concentrated on ESPN.
· Time warner: Risk to HBO’s role as content aggregator, Fox’s mid to long term growth will be stronger
· Viacom/Discover: channels lack enough pricing power to demand meaningful increase in affiliate fees to replace lost ads revenue. Both revenue and profit would come under pressure.
