FPA U.S. Value Fund, Inc third quarter presentation titled, “Making a case for the Pay-TV industry with the help of Mark Twain.”
If you listen to the media these days, you’d think pay-TV has one foot in the grave and will soon be six feet under altogether. Headlines screech about a small but growing number of people, mainly millennials, who are foregoing cable television and becoming cord “cutters” or “nevers.” What’s more, negative news reports trumpet declining live TV ratings, which have prompted advertisers to increase the shift of ad dollars away from TV to digital formats. All of this doom and gloom has resulted in a sector that is out of favor. Many stocks are trading at a below-market valuation and are at or near 52-week lows. Pay-TV executives—not to mention yours truly—should be forgiven for the urge to paraphrase Mark Twain and declare that reports of the industry’s death have been greatly exaggerated. So much so that, as of September 30th, U.S. media companies made up approximately 20% of the portfolio1. “Mr. Market” is providing us the opportunity to buy some wonderful businesses at what I believe are attractive valuations with very good, long-term growth prospects.
Valuation of investments is an important part of my stock selection process. My primary measure of value is the price/earnings ratio. I seek out companies that are undervalued compared to the present value of its estimated future cash flows and to the market (i.e. S&P 500). To provide an illustration of my valuation approach applied to the media companies in the Fund’s portfolio, as of September 30 the Fund’s media investments traded at ~12x 2016E EPS2 and ~10x 2017E EPS (based on consensus estimates) compared to the S&P 500’s valuation of ~15x 2016E EPS and ~13.5x 2017E EPS (based on consensus estimates).
The Fund favors media companies that first and foremost possess “must-have” content including valuable sports rights locked up for many years and are priced at a good value for pay-TV distributors. I define value in terms of the ratio of ratings share to the share of a pay-TV distributor’s network affiliation expenses. What’s more, the companies should be poised to meaningfully grow their international businesses and ideally have less revenue exposure to advertising for non-sports programs. Exceptions to the last point are networks whose audiences skew older (median age 50+). This demographic represents about half of consumer spending and is much less likely to watch video online compared to the under 50-year-old cohort. If advertisers want to reach that older demographic, an effective way to do so continues to be through the most popular TV networks.
FPA U.S. Value Fund - Robust industry economics
The large cable and broadcast networks enjoy very good economics in large part due to the subscription-based model of pay-TV, which provides a recurring, predictable revenue stream. The economics for the best networks, which own or control rights to quality content, are poised to continue to improve over time. This is due to a couple of reasons. One is expected mid-to-high single digit growth of so-called affiliate fees per subscriber, which pay-TV distributors pay to cable networks. The other is retransmission (retrans) fees per subscriber—which pay-TV distributors pay to broadcast network affiliates—are expected to grow even faster. The growth of both fees should more than offset flat-to-low single digit declining subscribers and advertising revenue.
The average operating margin for pay-TV companies is ~30%. The average pre-tax return on capital is in the high-teens while pre-tax return on tangible capital is ~50%. These are very capital-light businesses with just ~5% of earnings before interest, taxes, depreciation and amortization (EBITDA) going to capital expenditures. This affords these companies the ability to return a lot of free cash flow to shareholders via dividends and share repurchases while continuing to grow organically.
Pay-TV is made up of basic cable networks, premium cable networks (such as HBO and Showtime) and broadcasters. Basic cable networks enjoy higher operating margins than broadcasters (see table below) because they have a more balanced dual revenue stream of affiliate fees and advertising revenue and less expensive programming costs. Broadcasters don’t have that balance and continue to acquire highly inflationary sports content rights. Over time, the operating margin gap between broadcast and basic cable networks should narrow somewhat as broadcast networks grow their retrans fees at very high rates in the coming years as affiliate contracts come up for renewal.
A Growing Industry
The U.S. is the leader in content origination for both TV and theatrical release. There is a strong positive correlation between GDP and the consumption of pay-TV (see chart below). As the global economy grows over time, so should the demand for high-quality content to feed a growing pay-TV industry.
It is easy to see just how strong the international demand is for pay-TV content when one considers that the international box office is 2.5x the size of the U.S. and advertising on TV outside the U.S. is 2x the size of the U.S. market (see table below).
This bodes well for the growth of the international pay-TV industry, which is currently similarly sized to the U.S. despite having 6.5x the number of subscribers and a 40% lower household penetration rate (see table below). Global Media Markets (2013)
The rest of the world is 20+ years behind the U.S. in household pay-TV penetration rates (see graph below). The consumption of content should continue to increase through a combination of greater household pay-TV subscription and/or use of more affordable online services like Netflix—all of which puts content owners in a good position as more demand for their product will come through in very high-margin, incremental sales.
When one looks at the major U.S. media companies’ revenue mix, it is currently ~70% U.S. and ~30% international. Over time, the relative size of the international pay-TV market compared to the U.S. should resemble that of the global box office market (see bar chart below, right). This should play out as international subscription video on demand (SVOD) outpaces domestic demand and international pay-TV subscribers and fees per subscriber grow at a faster rate as well (see graph below, left).
While there are many headlines talking about a growing number of Americans who are becoming cord cutters, nevers or shavers, the data shows few people have done so. And the ones who do are typically younger, single people who do not have the means to afford a pay-TV subscription and primarily consume video digitally via mobile and/or broadband connections. One reason why the pay-TV bundle remains popular is because the average person in the U.S. continues to watch five hours of TV per day (see chart below). While more time spent using