Will YouTube TV Kill Big Cable?

YouTube, which has entertained the world with kittens and helped fix innumerable clogged drains, has announced it will launch YouTube TV, a low-cost cable TV service. In other words fewer channels than conventional cable at a lower price. YouTube TV plans to offer some 40 channels for just $35 a month and add a number of features, including a virtual DVR (digital video recorder).

It’s the latest spinoff from the Alphabet Inc. (GOOG, Financial)(GOOGL, Financial) empire, which wisely purchased YouTube some years ago and has since built it into a powerhouse in its own right. By the end of 2016, fans were watching YouTube 1 billion hours a day.

Will YouTube TV kill cable, as an article in Computerworld argues? It says, “The bottom line is that cable has lost its monopoly on high-quality TV shows.”

In this article, we examine the pros and cons of this new service, and the cable companies that will be affected by this would-be disrupter, from an investor’s perspective.

Also, we ask, “What do the investing gurus at Dodge & Cox think of this development? And why single out Dodge & Cox?”

What is YouTube TV?

On its website, the company offers few details beyond the promise of a better price than cable. But several publications have looked beyond the website and into the details. A Time magazine Money article says the service will provide:

• All four big broadcast networks (ABC, CBS, FOX, NBC).
• About 40 channels for $35 per month (the bundle also includes ESPN).
• Lots of sports (but many MLB, NBA and NCAA men’s basketball games won’t be available).
• Within each individual subscription, six account profiles within the same household can be set up, along with streaming to three devices simultaneously, allowing each family member his/her own viewing package.
• Unlimited DVR storage at no cost.

What’s missing from the package, according to the Time Money article is a number of popular specialty channels, including: AMC, IFC, TLC and Discovery. Political junkies be warned: YouTube TV won’t have CNN.

Investors might wonder if this will affect Alphabet’s top or bottom lines. Given Alphabet's size it seems unlikely gains or losses on YouTube TV would have any material affect in the near and medium-term future.

Among the investing gurus followed by GuruFocus, PRIMECAP Management (Trades, Portfolio) is the biggest holder with 2,434,183 shares, good for a 0.35% share of the company. Dodge & Cox owns 329,282 shares.

The competition

YouTube TV is neither the first nor the cheapest to enter this space. Time Money says existing low-cost competitors include:

• Sling TV from The Dish Network; it starts with a $20 "Orange" package that includes about 30 pay channels, including AMC, CNN, Cartoon Network, TBS, TNT, Comedy Central and three ESPN channels. Another $5 gets subscribers the "Blue" package, which adds some Fox and NBC channels, and for those who pay $40 a month, there is yet another upgraded but discount package.
• AT&T Inc. (T, Financial) offers DirecTV Now for $35 a month, and that provides a whopping 60 channels, but CBS is not available in every market. It does have a hefty helping of sports channels, but not as many ESPN channels as YouTube TV.
• Sony’s (SNE) PlayStation Vue provides 45 channels for prices starting at $30 per month ($40 per month in seven major markets); the service streams through PlayStation, of course, as well as third-party devices such as Google Chromecast, Amazon Fire TV and Roku.

Then there are nonlive services including:

• Netflix (NFLX, Financial), the original disrupter in this space, which is also becoming a major content producer as well as content distributor.
• Amazon (AMZN, Financial) Prime, which is following somewhat in the footsteps of Netflix but has its own competitive advantages.

And still to come: Apple (AAPL) is indicating it may get into this business, and there is also Hulu, a joint venture with the Walt Disney Co. (DIS, Financial), Twenty-First Century Fox (FOXA, Financial), Comcast (CMCSA, Financial) and Time Warner (TWC, Financial), all with big and popular catalogs.

The big cable companies

The Big Four, as they’re known, are Comcast, DirecTV (owned by AT&T), Charter Communications Inc. (CHTR, Financial) and DISH Network Corp. (DISH). We look at each of them individually in a later section.

Statista.com provides this quantified list of cable company subscribers, as of the third quarter of 2016:

• Comcast: 22.43 million.
• DirecTV: 20.78 mililon.
• Charter: 17.28 million.
• Dish: 13.64 million.

Currently, there is what might be called a cable conundrum, which is that cable revenues were – and still are to a certain extent –Â a great source of revenue (and earnings) in the not-so-competitive past. With the growth of online alternatives, cord cutting is disrupting that once-stable business. Cord cutting comes in many forms, including the forms offered by the cable companies themselves; cannibalization can be better than losing the customer altogether.

Seen from the other side, the consumer side, cord cutters are known by a couple of names: over-the-top (OTT) consumers and connected consumers (as in internet-connected TV). Some consumers have gone over to services like Netflix and Amazon Prime while others are embracing what’s known as Skinny-TV –Â smaller bundles with lower prices.

The big four cable companies

Comcast

The biggest of the Big Four, Comcast operates in five segments, but the company reports in its 10-K for 2016 that almost three-quarters of revenue originates in cable operations.

Within cable, its biggest is the distribution arm, XFINITY, which not only distributes content but sells high-speed Internet services.

The GuruFocus system gives it a 5 out of 10 for financial strength and a 9 out of 10 for profitability and growth:

The company is carrying long-term debt and a proportionately higher load than in the past.

The WACC (weighted average cost of capital) vs. ROIC (return on invested capital) is not encouraging with returns just slightly above the cost of capital.

Otherwise, it is generally doing well. The operating margin is strong and growing; ROE (return on equity) is in the midteens, which is good; revenue and EBITDA are both (barely) in double digits and holding their own while earnings per share have slipped a bit compared to those it posted in the past.

Among the investing gurus followed by GuruFocus, 33 have put capital into Comcast. Dodge & Cox has the biggest holding with 76,631,690 shares, good for a 1.62% stake in the company.

DirecTV

This direct broadcast satellite service was bought by AT&T in 2015 and no longer posts its own financial results. Within AT&T, it is part of Video Entertainment, which, in turn, is part of the Entertainment Group. The latter accounted for 22% of AT&T’s revenue in 2016, according to the 10-K for 2016. All of which means it would take a large loss by DirecTV to have a material impact on AT&T.

Ownership by AT&T means this cable service enjoys the backing of a company with deep pockets. And, presumably, management at AT&T saw benefits. An analysis of the deal at Forbes notes that the acquisition of DirecTV gave AT&T a new bundling opportunity, a more diverse and robust distribution footprint (AT&T’s in-house cable company, U-Verse, had only 5 million subscribers, compared to DirecTV’s 20 million) and access to the Latin American market, which is growing faster than the American market.

Charter Communications

Charter, with 17.28 million subscribers in the third quarter of last year, is the third-largest cable company in America. In its 10-K for 2016, it reports that video, Internet, voice and commercial services provided through its cable systems accounted for 90% of its revenue.

From an investor’s perspective, the GuruFocus system gives Charter a 4 out 10 financial strength rating and an 8 out of 10 for profitability and growth.

Looking across this financial scorecard, the messages are mixed. A high Piotroski F-Score and a low Altman Z-Score; a poor WACC vs. ROIC score, despite having a double-digit operating margin; and the ROE is strong while three-year EPS is declining.

The GuruFocus system also generates four severe warning signals:

• Beneish M-score.
• Operating margin.
• Long-term debt.
• Asset growth: faster than revenue growth.

For those wondering about the discrepancy between the positive margin assessment on the financial dashboard versus the negative assessment in the warning signs, it depends on the fiscal years chosen. With sizable fluctuations from year to year, the margin metrics also vary.

Among the GuruFocus investing gurus, Dodge & Cox is the largest holder of Charter shares, with 10,361,488 – good for a 3.85% piece of the company. Warren Buffett (Trades, Portfolio) is a close second with 9,443,491 shares.

DISH

DISH Network Corp. operates through two segments: Pay TV & Broadband, and Wireless. Within Pay TV & Broadband, it operates two cable services: DISH and Sling.

In its 10-K for 2016, DISH reports it depends heavily on its subscriber revenue (to both pay-TV and broadband).

The GuruFocus system gives DISH 5 out of 10 for financial strength and 7 out of 10 for profitability and growth.

The company does not carry long-term debt, which provides a measure of comfort to investors.

It too receives a poor Altman Z-Score along with an acceptable Piotroski F-Score. Its return on invested capital (ROIC) is marginally better than its weighted average cost of capital (WACC).

The operating margin looks fine on the dashboard (although it is the subject of a severe warning sign; see the comments on Charter’s margins above). Both revenue growth and EBITDA growth rates have slowed, although the earnings per share (without nonrecurring Items) growth rate has remained positive.

Nine of the investment gurus followed by GuruFocus have shares in DISH. The biggest holder is, again, Dodge & Cox, with 16,265,180 shares, representing a 3.5% stake in the company. Interestingly, Jeremy Grantham (Trades, Portfolio) has a holding of 76,506 shares – and 250,000 puts. Investors buy puts when they expect the price of a stock to go down; Grantham is either insuring his stock holdings, or he is making a separate bet, one that assumes the gains from a decline in price will be greater than the loss on long position.

None of the big four cable companies is likely to be killed by YouTube TV, or for that matter more than slightly hurt. While they will undoubtedly lose subscribers in coming years, perhaps hastened by YouTube TV, they still have immense bases, skinny offerings of their own and the financial strength to compete aggressively.

Marketing issues

Price points

Undoubtedly, there is a big market for lower-cost cable/entertainment. Yet it is only one part of a much bigger and perhaps more profitable market.

YouTube TV seems unlikely to be a major disrupter when it offers a limited number of channels. Consumers have shown they’re willing to open their wallets to make the most of their leisure hours; look no further than the smart phones and tablets close beside us.

The internet-connection connection

So far, there’s been no discussion of access to the Internet; every kind of plan, whether cable, over-the-top, or Connected consumers, requires some type of Internet access, and preferably high-speed. The major cable companies sell that service, which gives them an additional incumbency. In other words, big cable should get a piece of the cable spend, regardless of where subscribers decide to park.

Demographics

Give the nod to YouTube TV on this score. It already has the attention of younger users/viewers, who have grown up with YouTube as their primary media.

Event TV

Event TV refers to live coverage of any kind that engages a television audience, and cable has thrived with such programming, especially sports coverage. The Computerworld article noted that “the options for cord cutters are often inadequate for sports fans, especially for college sports and less mainstream sports,” and “YouTube TV offers nearly all event television, including sports.” Mark that as another competitive advantage, and a significant one, over both skinny and full packages from big cable.

Potential brand extension failure

Let’s face it: YouTube TV is hitching a ride on its famous parent’s brand name. But not all brand extensions are successes; many fail and leave egg on the faces of those parents. When was the last time anyone heard of the Harley Davidson Cake Decorating Kit or Zippo Female Perfume, just to name two from a list from the Adweek article, The Best (and Worst) Brand Extensions.

Life cycle

Another important marketing concept is that of the product life cycle. Some companies are good at managing innovative companies developing new products and services while at the other end of the spectrum, there are companies that excel at managing mature products and services.

Cable TV, of course, is in the latter category while Google Search and YouTube are in the former. Can executives who are very good at managing the new also effectively manage the mature?

Conclusion

Will YouTube TV kill big cable? The short answer is no.

There’s a good possibility YouTube TV will find a place in the world of Comcast and Netflix. However, it’s not likely to be a dominant place. While it has a famous name and the vast resources of the Google organization behind it, it also faces competition from existing skinny packages from the cable companies and from firms such as Netflix.

As noted, it does have the advantage of demographics and Event TV, but in both cases the appeal will be to only a segment of the broader audience that wants to be entertained.

Alphabet has little to lose with this venture; it reportedly has cash flow it needs to put to work. Even a complete failure of YouTube TV would likely make only a small dent in its financial fortunes.

And big cable is unlikely to do much more than flinch if YouTube TV is a success. There is a huge market and the cable companies can likely adapt and find new revenue sources as cord-cutting continues. Remember, too, that many of the cable companies may benefit as the unconnected sign up for high-speed Internet to watch YouTube TV.

Fragmented is the word that comes to mind in summing up the future world of television, video, and other streaming or recorded entertainment. As The Atlantic puts it, “The future is not going to be YouTube TV alone, but some larger hodgepodge of options.”

What was once a cozy, near-monopoly for a few firms has exploded into hundreds, if not thousands, of different pieces. Yet there is a vast audience willing to pay so many companies should be able to operate profitably in it.

Finally, it will be worth watching what the investment team at Dodge & Cox does over the next few quarters. They have sizable holdings in three of the big four cable companies, as well as in Alphabet, and no doubt the analytical power to assess the future of big cable.

Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.

Start a free seven-day trial of Premium Membership to GuruFocus.