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Despite Twists in Cable, Media Stocks Remain Undervalued

Recent developments strengthen our belief in the viability of the television bundle.

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The TV ecosystem is evolving, and the traditional bundle model has come under pressure recently as a result of cord-cutting and cord-shaving. Our thesis is that the media industry thrives only when as many consumers as possible have access to popular content, and those capable of producing a wide variety of programming are as well positioned as ever. We have noted several trends in the distribution side of the business, including the emergence of new bundles created by traditional players as well as new entrants. Here, we examine how these new pay-TV bundles from a diverse group of companies, such as Sony (SNE), Dish (DISH), and Verizon (VZ), fit within and validate our thesis. We also look at major technology firms and the potential for their entrance into content distribution.

Our belief that the traditional content bundle is broken but not dead is central to our wide moat ratings for  Walt Disney (DIS),  Time Warner (TWX), and  Twenty-First Century Fox (FOX). We believe these three media firms (along with  Comcast (CMCSA)) own the networks necessary to remain relevant to any bundle and to render irrelevant a bundle without them. These three firms are also best situated from a content production and library standpoint to anticipate and adapt to potential changes arising from the transition away from traditional distribution channels. While we expect this transition period to be rocky, we believe Disney, Time Warner, and Fox will all survive and flourish in the evolving TV ecosystem, with Disney as the best positioned of the three.

This view also plays a small supporting role in our wide moat rating for Comcast, thanks to the firm’s ownership of NBC Universal. However, the cable networking business, particularly its strong position in the Internet access market, informs the bulk of our view on Comcast’s moat. We believe merger and acquisition activity has generally stretched cable valuations beyond reasonable levels, leaving Comcast shares overvalued as a result. If anything, our take on the traditional TV bundle is a modest net negative for Comcast, as we expect the benefits the firm has seen recently from its X1 offering will dissipate as new TV offerings proliferate.

PlayStation Vue Evolving Into a Serious Competitor
We see Sony’s PlayStation Vue TV streaming service as one of the more interesting emerging competitors to the traditional pay-TV distributors. We believe Vue highlights a potential path forward for the continued relevance of the pay-TV bundle.

Vue targets those consumers steeped in the PlayStation hardware ecosystem, with a TV offering highly similar to the traditional bundle but with features that leverage PlayStation hardware. We suspected that Sony’s aim with Vue is not to profit on a stand-alone basis, but to extend the functionality of the PlayStation 4 and further lock consumers into the ecosystem. In addition, as it uses equipment the consumer provides and manages, the cost of delivering the TV service is further reduced. While Vue does require a relatively expensive PlayStation 4 or PlayStation 3 as a base system, both consoles provide considerably more functionality than even Comcast’s X1 platform, the current gold standard in pay-TV set-top boxes. The Vue service can also be extended to multiple TVs via Amazon Fire TV boxes or on mobile devices on the same home network. Vue uses a cloud DVR system in which shows are available for as long as 28 days after recording. The service also offers an extensive on-demand selection.

Vue now carries the Disney channels, including ESPN, and has rolled out nationally, albeit without the local broadcast affiliates (ABC, CBS, Fox, and NBC) in most markets. For markets with local broadcast networks (New York, Los Angeles, Chicago, Philadelphia, Dallas, San Francisco, and Miami), Vue offers three packages: Access (60+ channels) for $39.99 per month; Core (75+ channels) for $44.99 per month; and Elite (100+ channels) for $54.99 per month. The Access offering does not include any regional sport networks.

While Vue does require a broadband connection, most PS4 households probably already have one for using the PSN online service. Also, the $98 per month promo pricing in Chicago for Comcast’s X1 Starter package (140+ channels and 75 Mbps download speed) is still above the combined $95 per month price for the equivalent Vue Core package (in terms of important channels) and Comcast’s stand-alone Internet-access service. Comcast’s headline promotional pricing excludes a number of monthly fees, including a $5 broadcast fee and $3 regional sport network fee, along with monthly hardware rental fees, including $10 per additional receiver and an $8 DVR fee. The $85 “all-in” price for Dish and DirecTV packages that include ESPN and DVR service (outside of a promotional period) is far higher than the Vue Core price of $45.

For the markets without local broadcast networks, Sony has appended the packages to its Slim offering, lowering prices by $10 per month. The Slim packages include on-demand access to NBC, Fox, and ABC, with CBS on demand expected to be added soon. We think the company is continuing to discuss adding broadcast networks with local affiliate owners on a market-by-market basis. While this places Vue at a competitive disadvantage versus traditional players, Access Slim (at $29.95 per month) now competes for cord-cutters with Sling from Dish (at $20). For an additional $10, Access Slim provides more than 55 channels (versus 23 for Sling) including several top-20-rated networks that Dish does not offer. While Sling does offer A+E networks that Vue does not, the overall comparison does not favor Sling; it appears that the service will need to seriously expand its lineup in order to remain relevant.

At its current price points, Vue provides consumers with competitive channel lineups at prices we believe sit at a minimal premium to the underlying content costs that Sony is footing. We believe Disney, Fox, Time Warner, and many other media firms have forced Sony to pay comparable to slightly higher affiliate fees per subscriber than the traditional cable/satellite players. While any rate differential may decrease as the Vue service gains popularity, we believe that moving toward Internet-based distribution of bundles will allow media firms to keep raising affiliate fees as more bundlers enter the space.

We believe that by fostering competition that provides innovation, including improved efficiency of delivery and pricing discipline, the media companies will be able to keep the bundle both affordable and relevant to consumers. Doing so ensures broad content distribution, which is critical to remaining relevant with consumers over the long term, while continuing to extract steady affiliate fees that are the industry’s lifeblood.

Sling Has Slowed the Pay-TV Decline, but Only Slightly
While we’re not bullish on Dish Network as an investment, the company’s Sling TV service, which delivers a limited set of cable networks over the Internet, has proved relevant to a meaningful subsection of the market. The firm provided Sling subscriber figures in the first quarter of 2015, shortly after the service launched, but has declined to do so since. Media reports in early 2016 claimed the firm currently has around 600,000 Sling subscribers. All Dish has officially revealed, however, is that metrics such as subscriber acquisition costs and churn in its core satellite TV business have remained fairly constant over the past year. Using this information, we estimate that Sling TV claimed around 450,000 customers at the end of 2015. Given that Dish reported a consolidated net loss of 81,000 customers during 2015, the implication is that the firm hemorrhaged traditional satellite TV customers--more than 500,000 for the year or about 4% of its customer base, far worse than the 79,000 net losses posted in 2014.

For context, the pay-TV industry as a whole had a decent end to 2015, by our estimates, adding roughly as many customers in total during the fourth quarter as the year before (the first and fourth quarters are seasonally strong). These firms saw a particular lift from efforts to improve customer service at the cable companies, notably ramping deployment of Comcast’s X1 offering, coupled with the continued rise of Internet access penetration (nearly 85% of Comcast’s customers now subscribe to its Internet service, up from about 73% three years ago). The cable firms we track posted a quarterly subscriber gain for the first time since the first quarter of 2008.

While the cable companies have improved their TV customer metrics, the picture across the rest of the industry isn’t nearly as rosy. DirecTV, in its first full quarter under AT&T’s (T) ownership, posted a big jump in customer growth (214,000, versus 149,000 the year before), but this gain came at the expense of the U-verse TV offering, which shed 240,000 net customers. In other words, the combined AT&T/DirecTV complex lost a net 26,000 during the quarter, far worse than the 222,000 combined net additions posted a year ago. Verizon’s TV growth has also hit a wall (only 20,000 net additions during the quarter, down from 116,000 the year before), and CenturyLink’s (CTL) TV business remains tiny. If we remove our estimate of Sling TV subscribers from the mix, we calculate that the traditional pay-TV business continues to decline at an accelerating pace, hitting nearly 1% during 2015.

Dish has consistently maintained that Sling isn’t cannibalizing the traditional pay-TV market, stating on its fourth-quarter earnings call that “the vast majority” of new Sling customers weren’t previously pay-TV subscribers. The implication of this comment is that the pay-TV industry is fragmenting into two parts: a declining traditional bundle and an ascendant over-the-top model. We don’t believe this is the case. While the Sling customer base undoubtedly skews heavily toward younger households, certainly some percentage of Sling customers would have signed up for a traditional pay-TV service, had Sling not been available. Furthermore, Dish acknowledged later in the same earnings call that it hopes to expand the Sling bundle.

Setting aside CBS and its eponymous broadcast network, Sling’s initial offering was missing cable channels from three major broadcast groups: Twenty-First Century Fox, Viacom (VIAB), and Comcast’s NBC Universal. Dish recently announced agreements to add both Fox and Viacom content to a separate Sling offering that will allow customers to access multiple concurrent streams, but this service excludes all Disney-owned networks. The Disney networks will remain available on the original single-stream Sling offering.

We believe Dish’s reasoning behind the expansion of Sling content is multifaceted. First, Dish clearly has concerns about the economics of the core satellite TV business, where per-customer acquisition costs run in excess of $800, aggressive promotions hurt profitability in the early years of the customer’s life, and increasing over-the-top options call into question how long each customer will stick around. The decline in Dish’s core satellite customer base in 2015 stems directly from the firm’s growing conservatism in courting new customers, as evidenced by a dramatic drop in gross customer additions (2.2 million in 2015 versus 2.6 million in 2014) set against stable churn among existing subscribers. Nevertheless, management has said it hopes to expand the TV business over time. Offering a wider array of content on Sling is likely to be necessary to compete effectively in the TV market over time.

While broader content availability is probably necessary to appeal to a wide audience, we think the more critical element here is the need to keep content owners happy. Media reports have consistently hinted that Dish’s agreement with Disney places limits on the number of Sling customers it can serve. Also, as evidenced by the new Fox Sling offering, Disney required its content to remain limited to a single concurrent video stream. We suspect Dish was forced to offer these concessions to get Disney and other early partners on board with the Sling concept. We believe adding additional content will provide comfort to existing Sling partners, fostering the ability to relax the conditions Dish faces under its existing agreements. In other words, we believe the content owners know that allowing services with limited content, such as Sling, to flourish holds the potential to upset the current ecosystem, which provides generous affiliate fees and broad distribution to the major content owners. If someone like Disney decides to risk breaking the bundle with an a la carte offering, we suspect it would go direct to consumers via the Internet, not through an intermediary like Dish, to ensure that it captures the lion’s share of profits. We’ve seen this happen, albeit on a fairly small scale, with HBO and CBS, neither of which is core to the traditional bundle, in our view.

Verizon Capitulates on Custom TV, Further Displaying Content’s Power
At the time of its launch in April 2015, Verizon’s Custom TV provided a fairly small number of core stations and the ability to pick two interest-focused packs for about $20 per month less than the traditional offering. These interest packs included two sports tiers, one of which included ESPN. A number of content owners weren’t happy with the offering, and Disney filed suit for breach of contract.

In February, Verizon altered its Custom TV packages to look much more like the traditional cable bundle, though its new offering still allows customers to avoid channels with exposure to sports rights costs. Custom TV now allows customers to choose one of two basic packages. Both packages include a number of the same basic channels, but one includes several additional entertainment choices and the other includes channels with sports programming. Verizon has indicated that customer adoption of the new Custom TV offering has been higher than the original, but we highly doubt this will be the case over the longer term. The new Custom TV is now only $10 per month cheaper than Verizon’s standard basic TV package, and customers are forced to make hard choices between channels. For example, customers who want both Discovery and TNT are out of luck with Custom TV.

Verizon has denied that the revamped Custom TV offering was in response to its disputes with content owners, but contract considerations were the driving factor. As it happens, Disney and Verizon agreed to ask the court to put the Disney lawsuit on hold shortly after the new Custom TV packages were announced. As in the case of Dish’s Sling offering, we believe the changes with Custom TV highlight content owners’ power to keep the traditional bundle intact.

Major Tech Continues to Drag Its Heels
One of the ongoing stories regarding the video marketplace is the possible disruptive entrance into content distribution by major tech firms like Apple (AAPL), Google (GOOG) /(GOOGL), Microsoft (MSFT), Facebook (FB), and Twitter (TWTR), among others. We expect some of these firms to move even further into content distribution, the potential forms of which include bundling the traditional networks (a la Vue or Sling), broadcasting sports, or creating and distributing original content.

In early 2015, rumors began to circulate about Apple offering a $40 streaming TV subscription that would offer 25-30 channels. These rumors were updated over the course of the year, with news sites predicting an announcement at every Apple event, but no product was forthcoming, and sources in December reported that Apple had put its plans on hold.

The sticking points apparently included the inability to get local broadcast channels and disputes over the allocation of the subscription fee, as media firms wanted to receive fees similar to the affiliate fees paid by the traditional television distributors, while Apple wanted to keep its traditional 30% cut of app sales. We also believe some media firms were wary of working with Apple, owing to worries about ending up in a position as poor as that of the record labels after the ascension of iTunes. We expect Apple to continue monitoring the marketplace with a view to possibly resurrecting its streaming plans. Alternatively, it could acquire a major media firm.

Sports remains one of the few forms of video that viewers prefer to watch live, making it an interesting challenge to stream over the Internet. While the NBA, NHL, and MLB all sell out-of-market streaming of local games via their own apps, the streaming of games on national channels has been largely restricted to TV Everywhere channels associated with the network that broadcast the game. The NFL had largely restricted out-of-market viewing in the United States to DirecTV’s NFL Sunday Ticket package. However, in the most recent season, it began to experiment with online viewing by selling the global rights to the NFL London game between Buffalo and Jacksonville to Yahoo (YHOO) for an estimated $20 million. However, the game began at 9 a.m. on the East Coast and was still broadcast on CBS in both teams’ local markets. We believe that the game was probably a financial loss for Yahoo.

The NFL apparently viewed the test as a success, though, and decided to open up bidding for global streaming rights for as many as 18 games during the 2016-17 season. After NBC and CBS won the rights to split a 10-game package of Thursday night games for the next two seasons for $450 million, the NFL reached out to a number of tech firms, including Google, Apple, Facebook, Verizon, Amazon (AMZN), and Twitter, to request bids. Apple and Google apparently decided against bidding for the rights, owing to the lack of exclusivity and other restrictions, while Facebook apparently believed that the restrictions around advertising were onerous.

We believe that the lack of exclusivity, advertising restrictions, and other constraints allowed Twitter to win the rights for the 10-game package for a relatively low sum of $10 million. Twitter will rebroadcast the CBS or NBC streaming feeds, with most of the digital ad inventory being held by the broadcasters.

We believe the NFL awarded the rights in an effort to experiment with new platforms for its games, with an eye toward the 2022 expiration of its contracts with the broadcast networks. By signing relatively low-risk one-year contracts, the NFL can gauge the viability of the new distribution channels and partners while also getting global exposure for its product.

While journalists have long hyped the war to control the living room, we are still waiting for the battle to heat up. In the meantime, media stocks should still fare well, as subscriber growth from any one of these tech titans might serve to offset ongoing declines in traditional cable subscribers, all while prospering without having to place a bet on a single technology.

Microsoft has ceded first-mover advantage to Sony in the battle between the two console heavyweights. While Microsoft originally hyped the Xbox One as a media center at its May 2013 introduction, the firm has quietly backed off marketing that aspect of the console. The Xbox One can act a pass-through for a pay-TV set-top box and can also be used a DVR for over-the-air broadcast by using an adapter and digital antenna, but these functions pale in comparison with Sony’s Vue.

Google has been content to slowly build out Google Fiber across the U.S. While Google Fiber does offer a TV bundle, the firm sells this TV service only as an add-on to broadband access, pricing the bundle slightly above its programming costs. We view this initiative as a regulatory and technological demonstration project. We believe Google’s primary aim with this project is to highlight the current regulatory hurdles that make new broadband expansion difficult and to scare the traditional phone and cable companies into investing more aggressively. On the living room side, Google appears to be focused on creating platforms for Internet-based content distribution, such as Chromecast and Android TV. The company has also refocused YouTube on original short-form content. We believe Google, like Apple, will continue monitoring the success of Sling and Vue, with an eye toward expanding its bundle offering nationwide, outside Google Fiber markets.

Amazon continues to set its own path with its Prime Video and Fire TV device lineup. The firm recently began offering its Prime Video as a stand-alone service with a monthly price of $8.99, a dollar below Netflix’s (NFLX) standard HD price. The firm continues to produce new original series for its Prime offering while also adding older HBO content to this service. While the firm did acquire Twitch to provide an entry into e-sports, the company has been unable to acquire live sports rights. With its ecosystem of devices growing and its desire to make Prime as valuable as possible for consumers, we still believe a traditional TV offering from Amazon makes clear strategic sense. The firm’s willingness to earn thin margins on portions of its business seems to indicate that it would have little trouble reaching agreements with content owners.

Yahoo has already attempted to create a new distribution platform and failed. In 2015, Yahoo dove into original content by funding prime-time-level production budgets for three shows. While the company lined up big launch sponsors for this effort, it failed to generate a large enough audience to attract advertisers. While these shows were on Yahoo Screen Hub, there was little other content on the site and little reason for potential viewers to discover the site or the original shows. As a result, the firm took a $42 million write-down on the three original series and shuttered Yahoo Screen Hub. Yahoo’s future TV direction will probably depend on who acquires the business.

AT&T has announced that it will enter the online TV market through DirecTV at some point in late 2016. The firm plans to launch three separate services, including DirecTV Now, a big-bundle offering that will probably look similar to Vue. AT&T has said its scale in the TV business and the resulting low content costs it enjoys will be an advantage in this market. As such, we would expect the firm to price DirecTV Now at least as attractively as Vue. AT&T is also planning a mobile-focused service that sounds similar to Verizon’s Go90 and a preview service that will allow customers to sample DirecTV content. As with Go90, we don’t expect these two slimmed-down services will have much of an impact on the TV market.

Where to Invest
Of the media and cable firms we cover, three--Walt Disney, Time Warner, and Twenty-First Century Fox--stand out as having both a wide moat and the ability to sustain the moat in the face of the ongoing changes across the pay-TV landscape. Given our thesis on the evolution of the bundle, we expect the impact of declining traditional bundle subscribers to be largely offset by subscribers to the new bundles over the long run. We believe that Disney, Fox, and Time Warner receive comparable to slightly higher affiliate fees per subscriber from the new distributors, such as Sony, than from the traditional cable/satellite players. While any rate differential could decrease as the Vue service gains popularity, we believe moving toward distribution of bundles over the Internet will allow media firms to continue raising affiliate fees as more bundlers enter the space. The shares of each company trade at a discount to our fair value estimates.

Of the three wide-moat firms, we believe Disney is the best positioned to survive and flourish in the evolving TV ecosystem, with its combination of strong networks, production studios, and well-loved characters. Time Warner and Fox are right behind Disney, in our view. We see Time Warner as one of the strongest TV content producers in terms of current and historical production, with two well-known and respected studios in Warner Brothers and HBO Studios. The company also owns a strong network of U.S. and international channels. Of the three, Fox is the most highly leveraged to international growth, with channels in every region and its studios.

We believe the evolution of the traditional bundle will create a modest net negative for Comcast over the next couple of years. While the X1 platform has closed the TV quality gap with the satellite players and the phone companies, enabling Comcast to post net TV customer additions, we believe this surge will prove short-lived. As Sony and others enter the TV market, we expect Comcast will continue to price its service at a premium to these offerings to protect the economics on its existing subscriber base, resulting in a resumption of heavy net TV customer losses in 2018 and beyond.

The residential TV business generated $21.5 billion in revenue for Comcast in 2015, or $11 billion net of programming costs. We expect the erosion of this net revenue stream will more than offset modest growth in the cable and broadcast segments within NBC Universal ($18.2 billion in combined revenue during 2015). In addition, we expect these segments will face margin pressure as NBCU invests aggressively in content to compete with companies like Disney and Time Warner, which have far stronger content development capabilities. We believe we are more negative than the market on Comcast’s TV prospects, and this is a key difference between our fair value estimate and the price of the stock.

Comcast does remains very well positioned in the Internet access market. The growth of Internet-based TV offerings should serve to make this connection increasingly important to consumers, allowing Comcast to take share from the phone companies and increase pricing over time. This ability sits at the core of our wide moat rating.

Neil Macker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.