Media Moats Are On Sale
Overreaction to subscriber losses provides a buying opportunity for some wide-moat names.
Given the recent volatility in media stocks, we are addressing some concerns that may be behind the recent price declines. We believe that research reports on ESPN's subscriber losses and subsequent discussion by management at Walt Disney (DIS) generated an overhang over the sector and downward pressure on all media shares. Given that these subscriber losses were well known and relatively small, we believe the resultant sell-off was overdone and has created a buying opportunity. We prefer wide-moat-rated names such as Disney and Time Warner (TWX), both of which are trading well below our fair value estimates.
In its recent quarterly earnings call, Disney management noted that cable subscribers at ESPN would decline roughly 1% primarily because of cord-cutting in 2016. We note that the company discloses the Nielsen subscriber numbers for its channels in its annual 10-K filing. ESPN reported household subscriber levels of 98 million in 2012, 99 million in 2013, and 97 million in 2014. However, these numbers are lower than the actual number of subscribers that Disney gets paid for by distributors. Given the tremendous hype around cord-cutting and cord-nevers, we see the projected subscriber losses as both relatively low and expected. We also note that competitors such as Time Warner have explicitly included similar subscriber losses in previously issued long-term guidance. ESPN generally receives more than 5% annual increases in its affiliate fee per subscriber as part of its carriage, which significantly outweighs the projected subscriber decline. Given these circumstances, we believe ESPN will remain an important driver of growth at Disney.
Both Time Warner and Discovery (DISCA)/(DISCK) have said that their long-term planning anticipates similar levels of subscriber deterioration. We believe all the media companies use comparable numbers for planning purposes, given that the basic cable bundle looks remarkably similar regardless of the pay television provider.
Disruption Will Come, but Timing Unclear
While the reaction to the subscriber loss guidance may have been overdone, we acknowledge that the streaming service and skinny bundles will disturb the traditional pay TV bundle in the near future. However, the timing of the disruption remains unclear. We believe that the legality of Verizon's VZ skinny bundles will ultimately be decided in court as Disney, Time Warner, and Fox (FOX)/(FOXA) all appear unwilling to concede on the issue. The media companies believe that their current carriage agreements obligate pay TV distributors such as Verizon to place certain channels such as ESPN, TBS, or FX in the basic bundle offering and that the skinny bundle offered by Verizon without those channels violates the agreement. Verizon's public position is that the agreements allow for its specific version of the skinny bundle. The cases covering these agreements may drag on for years, thus possibly halting other major distributors from selling a similar offering. We believe Verizon's attempt is a reflection of the weaker position of distributors that are being squeezed by declining video subscribers on one side and rising affiliate fees on the other.
On the streaming side, Disney, Time Warner, CBS (CBS), and Fox all either run their own SVOD service (HBO Now for Time Warner and CBS All Access) or own part of one (Hulu for Disney and Fox). We believe that in a shift to an over-the-top world, media companies with both deep content libraries and must-watch live programming (sports and news) will be able to create a compelling SVOD service. The service for channels like TNT or FX could look like CBS All Access, with a combination of linear programming and a deep library of on-demand content including new shows available sometime after airing (with full season stacking). ESPN's service could mimic its WatchESPN/ESPN3 service with multiple live streams and archived events. One advantage of moving to an OTT world for media companies would be deep and meaningful data concerning viewer watching habits and demographics, similar to the data that Netflix (NFLX) currently obtains. This data would be used to not only better understand what programs to green-light and to renew, but also to better target advertising and measure its efficacy.
Pricing Still a Question
One potential issue with an OTT or SVOD world would be pricing and overall cost to the consumer. The basic pay TV bundle works via subsidizing, as the cost per channel is borne over the entire subscriber base. One of the main reasons used to support the move to skinny bundles or even a la carte pricing is that the average household watches 17 channels. Under current OTT pricing (from $5 per month for CBS All Access to $15 per month for HBO Now), that bundle of 17 channels would cost between $85 and $255 per month, at or well above the current cost of the basic cable bundle. Also, we expect that current pay TV providers with the ability to offer broadband would increase the price of broadband, given additional usage and the lack of video revenue or profit. While the large media firms with large numbers of high-demand networks could create individual company bundles to alleviate this pricing pressure, smaller media firms with a smaller number of networks such as AMC (AMCX) or Scripps (SNI) could be priced out of the market. Another method of alleviate this pressure is for pay TV distributors and media firms to work together to offer bundles attached to broadband or video service.
Against this backdrop, we believe the wide-moat firms with the best production studios, deep content libraries, and live programming rights will have the best chance to navigate any of these potential changes in the space. Three of our wide-moat names--Disney, Time Warner, and Fox--fit these criteria and are now trading well below our fair value estimates because of the recent pullback.
Neil Macker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.