The Media Stocks “Meltdown” by Ben Strubel, Strubel Investment Management

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Dear Investors,

Last week Disney released earnings that fell short of Wall Street’s expectations, specifically Disney announced that Nielsen estimated that ESPN lost over 3.2M subscribers over the previous twelve months. That set off a wave of selling in not only Disney’s stock but other media companies as well. As other media companies released earnings later in the week it didn’t matter if they beat, met, or fell short of expectations, they still went down. Disney, Twenty-First Century Fox, Viacom, and Discovery Communications were some of the hardest hit. The fear among Wall St. is that cord cutting by consumers, getting rid of traditional cable TV packages, will mean lower profits for media companies. The Disney report has everyone particularly worried because ESPN has been seen as the most immune to this trend as there is not really a streaming alternative for live sports.

We think the reaction on Wall St. has been completely overblown. Over the past year my intern has been helping us research media stocks, in particular Discovery Communications, and I thought now would be a good time to share with you what we’ve been finding as we’ve been researching the media industry. I should also point out that I’m writing this from the point of view of someone who has cut the cord themselves. I have no cable TV package, just cable internet, at home. (We’ll see how long I can hold out once the NFL season starts!) So we are definitely not naïve when it comes to assessing the threat that cord cutting and streaming poses to the media industry.

Let’s get the biggest and easiest issue out of the way first. American’s (and the rest of the world) still love planting their duff in front of the magical electronic entertainment box.  Pick any study you like, I copied one below, and it will show Americans keep watching more and more TV.

Media Stocks

Last year we surpassed 5 hours per day! So, Americans love being entertained and that is not changing. Americans still want high quality video entertainment, the type of products that the major media companies produce.

The biggest issue is how that entertainment is delivered and consumed. The world is switching from traditional cable television to other alternate methods.

How Viable is Streaming?

Right now streaming and time shifted viewing services like Netflix represent a great value to consumers, the basic service only costs $7.99 per month. That is far cheaper than even the most basic of basic cable plans. However there is one thing worth noting.

The market for streaming services is not economically viable as it is currently composed. Over the past three years Netflix has lost a cumulative over $142M on a cash basis (Netflix shows an accounting profit because its amortization charges for content rights run about a billion dollars below what it actually pays). The table below shows Netflix’s cash flows and capital expenses for the past three years.

(in $M) FY2014 FY2013 FY2012
Cash Flow From Operations $16.48 $97.83 $21.59
Capital Expenditures $-69.73 $-54.14 $-40.28
Additions to DVD Library $-74.79 $-65.93 $-48.28
Total $-53.25 $-22.24 $-66.97

Netflix is under pricing its product in order to drive subscriber growth. In order for Netflix to be profitable it would need to charge consumers much higher prices. What would cord cutting look like if Netflix charged 20%, 50%, or even 100% more than it does?

Right now cord cutting is a bigger threat because Netflix is pricing it’s product below market rates, it’s likely that once Netflix and other services begin charging market rates the cord cutting phenomena will slow. However, it won’t disappear and it will still present challenges for the media companies.

The Cable Cramdown

The other area that worries Wall St. is that media companies have used what I’ll call a cramdown strategy to force cable companies to carry a certain channel. If you want ESPN, well guess what Disney is going to make you carry less popular channels like ABC Family and they are going to charge you for the privilege of carrying the channels you might not want. The fear is that as the TV market begins to fragment between cable and streaming it will be harder for media companies to bring in as much money from their unpopular channels as they do now.

But there is a flip side. Scripps Networks (I just randomly selected a company whose financials I had open in my browser) brought in $2.6B in revenue in the last fiscal year and spent $725M of that on content costs, that’s almost 28% of the company’s revenue that’s being plowed back into developing content. If companies are forced to give up the cramdown channels no one watches there is fat that can be trimmed from the budget. Furthermore, it’s possible that streaming services might even represent a better opportunity for the marginal channels a lot of cable companies have. It’s VERY expensive to fill out a programming roster to form an entirely new channel. For example, Discovery Communications lost money for years on the Oprah Winfrey Network when they first brought that to life and the uncertainty of the channels success weighed on the stock. I’d imagine some Oprah and Oprah endorsed streaming shows might be a hit right off the bat and profitable from almost day one.

So in summary there are threats from a fragmenting market but there are also opportunities as well.

New Era in Advertising

The other challenge for media companies in the new era will be how to turn time shifted and streaming viewing into a viable ad platform.

Right now advertisers view television as a shotgun. You can blast out your ads to a whole bunch of people and be pretty sure most everyone will see them. You probably have a vague idea what the demographics are based on the timeslots and shows where the ads are shown but all in all it’s pretty inexact. Companies such as Nielsen also keep track of how popular channels and shows are and ad rates are partially linked to Nielsen ratings. The problem now is that Nielsen ratings do not appear to accurately capture all time shifted viewing (such as people DVRing shows) and those who watch via streaming services. Viacom had been constantly blaming flawed Nielsen ratings for some of their shows poor showings but now with Disney reporting Nielsen ratings that don’t square with what they are seeing internally (Disney said it lost less than 1M subscribers compared to Nielsen’s 3.2M estimate) we can probably start to believe the media companies assertion that the methodology for compiling Nielsen ratings and numbers needs some tweaking.

Streaming services do offer one advantage to advertisers. With streaming services that are partially ad supported such as Hulu the media companies will be able to target ads much more efficiently and these targeted ad campaigns should command higher rates all else being equal than traditional television ads.

The other area which I see growing is product placement in programs. Right now the big strike against ads on streaming services and other time shifted viewing is advertisers are unsure just how many viewers are actually watching the ads and how many are fast forwarding or just not paying attention. If advertisers put the product in the program itself, and it’s done in a subtle enough and tasteful manner, it should be acceptable to both viewers and advertisers. Companies get their products in front of eyeballs and consumers don’t have their program interrupted.

An example of this trend can be found on the show New Girl. One of the characters, Schmidt, drives a Ford Flex. I’m kind of a car guy and that choice of a vehicle sort of caught me off guard because it didn’t fit with his character (in my opinion anyway). I watched the credits closely and sure enough, it was sponsored by Ford. Other than just being a strange choice, everything was done well. In the episodes his car appears in there are plenty of shots of the exterior compared to how most sitcoms film scenes involving cars and the Ford is always in pristine condition, but the whole thing is relatively inoffensive and everything flows together (especially if you’re not a car person).

Summary

In my opinion the media companies will do fine in the new landscape, they are the ones that produce the content that consumers want to watch. The core of their business is not under threat. They own the rights to popular characters such as Mickey Mouse, Batman, and all the Marvel superheroes. People love watching big budget movies like Transformers and TV shows like Game of Thrones and professionally produced sitcoms like The Big Bang Theory. The challenge for media companies is to shift their products profitably into a new era of media consumption. They have what consumers want; they just need to monetize their assets better in the new world.

No Company Profiled

No Company Profiled This Month.

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