“In a commodity business, it’s very hard to be smarter than your dumbest competitor.” – Warren Buffett
The current facility-based video (cable and satellite) market enjoys 30% EBITDA margins which we believe will quickly move toward commodity margins of 5% as substitute products with better technology from over-the-top (OTT) players force a price war. We believe this disruption presents a very attractive risk/reward opportunity for shorts within this space.
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Is Facility (Cable And Satellite) Video A Commodity Business?
A commodity is a good that is generally interchangeable with another of the same type. All cable TV vendors offer a selection of hundreds of high definition video channels including broadcast, DVR functionality, commercial breaks, premium channels, and a program grid for around $80 per month for the TV portion of the bundle. If we scrubbed the label off the remote and on-screen guide, we think the average consumer would be hard pressed to identify DirecTV from Comcast from Charter.
Then Why Are EBITDA Margins So High?
Cable's physical infrastructure evolved such that most are regional monopolies. Some areas have limited competition from telco or with overbuild from smaller vendors. Extremely limited competition provided cable the luxury of near monopoly margins as firms consolidated and economies of scale developed.
Wait A Minute; Satellite Is A Competitor To Cable
True, satellite is a competitor, but the cost structure of satellite requires high upfront initial investment in equipment and marketing. These upfront costs are then recouped over the next 20 months as customers tend to be in two (2) year service contracts. Satellite cannot undercut cable on price, meaning all players enjoy relatively high EBITDA margins.
Recently Some "Dumb" Competitors Entered The Market
In this instance, “dumb” is merely shorthand for competitors with orthogonal businesses to selling video and are thus making decisions with vastly different motivations. AT&T is using its streaming video service DirecTV Now (DTVN) primarily to defend market share in wireless from low price leader T-Mobile. Google’s YouTube TV (YTTV) is a way for YouTube to win television ad dollars. AT&T and Google have different motivations than traditional vendors and are using video to grow other businesses.
Even More "Dumb" Competitors Are Eyeing The Video Market
Facebook, Apple, and Amazon are slowly entering the video market but currently lack truly competitive products to current facility offerings. The pay TV market is not their core market, so they would assuredly use video to further other businesses. Facebook wants TV ad dollars, Apple wants to preserve iPhone margins and potentially find another growth market, and Amazon wants to feed its dominant ecommerce operation. Amazon should be particularly terrifying to video as we cannot think of another industry that was better off for incumbent firms with legacy technology after Amazon entered the market. In each case, customers are better off and existing providers get displaced. 30% EBTIDA margins look extremely attractive for Amazon to disrupt. These ulterior motives are detrimental to incumbent cable margins.
Commodity Businesses Have 5% EBITDA Margins
Mature commodity markets such as automotive (Ford, GM), grocery (Kroger, Walmart), and distribution (Tech Data, Avnet) have EBITDA margins of around 5%, which is well below the current 30% margins for cable/satellite. The OTT video providers are spending material marketing dollars to drive awareness and market share. The superior combination of easy on and off, low price, and mobility will allow OTT to take share and pressure prices industry-wide, resulting in margin compression for incumbent firms. Why do you think Comcast and Charter have been so reluctant to offer OTT products outside their footprints? Probably because they do not wish to create a commodity market until they are dragged kicking and screaming into one.
The Risk/Reward Of Shorting Incumbent Video Providers Appears Very Favorable
Cable stocks such as CHTR and CMCSA have appreciated over the last few years as a result of consolidation, multiple expansion, and lack of competition. With stocks priced for perfection and significant institutional sponsorship, we believe the risk/reward is very much skewed to the downside as fierce video competition drives down margins and the industry overall shrinks. We are observing many signs of increasing competitive pressure using our proprietary JSTARS big data tools, and we think base case downside is (50)% with potential for (100)% if we see pronounced acceleration in consumer behavior.
Thank you and please reach out with any questions,