By Kelpie Capital

British Sky Broadcasting – BSY

Price – 675p      Market Cap – £11.0bn    2011 EPS – 41p

2011 P/E Ratio – 16x (at 20% CAGR EPS growth this becomes 13x 2013 earnings)

Div Yield – 3.5% (7 years of 12% CAGR)

2011 Rev – £6.4bn (grown at 10% CAGR since 2006)      2011 EBIT – £1.05bn

2011 OpCF– £1.40bn

LT Debt – £2.5bn (balance sheet should be completely de-geared by 2013)

Gross Margin – 67%  Operating Margin – 16.3% and improving

Thesis

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?

A DISCLAIMER – I am a Sky Customer, I use their product a lot, they take £1100 a year from my bank account and constantly squeeze me for more cash – despite all of this, and mediocre customer service in my experience, I would NEVER switch because of the awesome array of viewing it offers me!

Unlike my usual preference for “dependable compounders” in my portfolio 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. Plays the “enterSTAY-INment theme”.

The bid from News Corp at circa 900p (a 30%+ premium to today), prodigious cash generation and a £750m buyback program (43p per share) provide our margin of safety. The balance sheet and cash flow could allow them to buyback 5-10% of the stock every year for the next 5 years.

Description

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. I 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.

BSY can tailor which products they emphasize based upon the macro environment – in tough times they can upsell the cost saving of the TV/Phone/Broadband “Triple Play” and in good times they can sell 3D, HD, multi-room and extra channels. It is worth noting that BSY was the best performing media stock in Europe in the last market downturn from September 2008 to March 2009. BSY grew revenue through the recession of 08/09, testament to it’s flexibility and the quality of the product.

The Customers

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. The recent court case in this regard does put some of this revenue into jeopardy – we shall continue to monitor the situation but it is not hugely material.

Penetration of Product Suite and ARPU

  • 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 – television is a service where quality is more evident/valued.

“Churn”

The industry term for the problem of losing existing customers.

I would suggest that the product suite on offer from Sky is superior to that of it’s 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. (Boardwalk Empire, The Ultimate Fighter, Sopranos, Curb Your Enthusiasm and the rest of the HBO suite).

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

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