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British Sky Broadcasting– BSY: The Bull Case

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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


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.


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.


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 has been a headcount freeze in “back office” to manage costs and there has been an unspecified decrease in “number of calls per customer” – suggesting product satisfaction?

“The Key Driver to the Investment Thesis”

The business is profitable and growing as it is. The “build-out phase” is complete. What we see as key to the outperformance of analyst expectations, which will drive the shares higher, is that Sky will accelerate it’s existing track record of delivering MORE content at a higher ARPU to it’s existing subscriber base.

There is an enormous amount of untapped potential amongst customers not currently taking up the “full product suite”. Sky Broadband currently has 16% market share and growing. Broadband is currently 13% of group revenues. Why can Sky not be the one stop shop provider of programming content, 3D content, televised sport, broadband and telephony for the vast majority of it’s customers?

We can hopefully get an indication of the potential of cross-selling from how they are fairing with offering the full proposition to new clients. These trends are very positive and indicative of successful marketing and well trained call centre staff.

The size of the prize can be imagined when considering one key stat –  ONLY 24% of the subscriber base is on “Triple Play” of TV, Broadband and Talk.

Rationalising Costs

Sky operates a business which is naturally operationally leveraged – their costs of having in place the programming, infrastructure and network is fixed – these costs are then divided over larger and larger numbers of users, reducing average cost and increasing profitability.

Key metrics demonstrating this is “Cost to Serve/Revenue” this has fallen from 7.1% in 2008 to 5.2% in 2010.

Admin/Revenue has also fallen from 8.9% to 6.5% over the last 4 years too.

Clearly their costs of production/service are falling – this has been disguised by the capex of installing set top boxes/infrastructure.

By ensuring that all customers have the same Sky Box, as opposed to the 10 models in use in 2008, Sky saves an average of £122 per box compared to 2006 cost per unit. This will bear fruit in the future but has been detrimental to short term earnings.

Similarly, signing a customer up to an HD Box incurs a £200 depression to that year’s profits on that User.

These examples also demonstrate a conservative accounting approach rather than capitalising the box costs.

HD Boxes are “future-proofed” to some extent. They are also capable of delivering 3D and Video-on-Demand content which should push back the date of the next investment cycle for BSY. Previously each new product required box refreshes for customers – eg. Sky +.

Operational Leverage

As mentioned above only 24% of customers are currently taking up the “Triple Play” offer, showing much opportunity for future growth. This has already come a long way from just 7% of customers in 2007. The trends demonstrate the operational excellence delivered by Sky. Is it possible that these trends are set not just to continue but to accelerate as the business spreads it’s wings and begins to focus less on growth and more on delivery at an attractive return?

BSY is spending 6.5% of sales (£400m) in Capex on a double investment programme in broadband and HD. The company has stated no plans for further “extraordinary” capex projects (partly a result of aforementioned “future proofing) and so this £400m should reduce substantially going forward.

This opens the door for increased cash flow and ultimately for accelerated dividend growth and/or buybacks.

Cash Flow not Earnings

This is a story about cash flow not earnings. Currently as we are in the final phases of the growth story and the product suite build out we believe that earnings are understating the power of the business. Earnings will lag cash flow. But they are both headed in the same direction. Fast.

Levers to Drive Free Cash Flow?

1)      ARPU increases to £600 from £540

2)      Full Product Suite rolled out to more subscribers

3)      Margins are higher on HD, Sky+, 3D than on traditional products.

4)      Increase volume of subscribers from 10m

5)      Efficiency/Operating Leverage drives through to bottom line

6)      Improve balance sheet efficiency – £750m buybacks p.a through 2015?

It is difficult to arise at a price target because of all these moving parts however what we can be comfortable with is that BSY has a track record of delivery on these 6 metrics and that success on a number of them could drive earnings materially higher than the market is currently discounting. However, we will make an attempt at a hypothetical conservative valuation (which takes no consideration of the clear premium a strategic acquirer like News Corp places on the cash generation).

Let’s say EBIT of £1.04bn in 2011 grows at 12% a year for the next 3 years – that takes us to £1.46bn of EBIT in 2014. This is broadly inline with street consensus which I believe understates the operational levers and competitive discussion we have covered.

At the current rate of buybacks (6% of shares outstanding annually) the share count will have shrunk from 17.5m to 14.5m by 2014.

£1.46bn/14.5m shares = 100p per share of EBIT by 2014 on a company that will have completely de-geared it’s balance sheet OR alternatively have re-geared to accelerate more buybacks.

In addition to this we’ll be collecting a 3.5% yield which is growing at 12% per annum as well.

It doesn’t seem unreasonable to imagine that BSY has a downside of 600p and an upside of 1000p and 1100-1300 should News Corp try to revisit the bid in a year or two.

Legal/Political Issues

We have to presume that the bid is dead for the next few years, on the back of the News Corp withdrawal and in light of the fact that the News Corp interest is easy pickings for political point scoring in Parliament.

Current prices reflect no “bid premium” and value only the fundamentals of the business. This note is NOT about playing an M&A angle. There is however a “free option” on the bid coming in the future.

It is worth noting that before the News Corp offer was withdrawn – the price at which the directors deemed it acceptable was creeping north of 900p a 25% premium to the price today.

Regarding “Media Plurality” – it seems undeniable that Murdoch and News Corp are very keen to own Sky and therefore would likely be willing to divest either Sky News or alternatively The Times (which is loss-making) to make sure the deal happened. I do not believe this is an impediment in the face of the desire to own this prize, strategic asset. They will sacrifice less important parts of their business to add BSY to their News Corp portfolio.

One danger in this regard is that in light of the criminal activity at NOTW that OFCOM could force a divestiture of News Corp’s stake in BSY or alternatively threaten to revoke their broadcast license. This is an unlikely event given that anyone who is charged with criminal activity will likely be replaced immediately. Despite being low probability, this event would create a very large overhang as the stock was sold.

The political heat of the situation is demonstrated by this being the first time ever that Parliament has requested a bid to be withdrawn. There remains residual headline risk in the story however this has clearly dissipated over the last few months. We need to remember that Sky is a company that sells media and television content to subscribers – it is only vicariously and weakly linked to the sleaze that went on at the News of the World.

The Downside?

  • Credit Suisse recently issued a report called “Life is Tough” on BSY with a neutral rating and a 610p price target – given this is below the current price that’s basically a SCREAMING SELL from the perennial optimists on the sell side. The arguments used are “consumer headwinds” and a full valuation in comparison to other Telco’s. I would counter these twofold – A) as mentioned above BSY managed to grow revenues and subscribers through the last downturn – it is increasingly becoming a consumer staple, not a luxury.  B) Sky is not a Telco, Sky has a relatively differentiated offering in an oligopolistic industry, it is more akin to a media or a tech company than a Telco.
  • The biggest risk to the downside is that News Corp are forced to divest their 39% stake. The weight of this selling would have a brutal effect on the share price, however I just don’t see this as a realistic outcome given how quickly the storm has subsided over the scandal.

Skin in the Game

  • CEO Jeremy Darroch increased his holding by purchasing £400,000 more shares at 706p in August 2010. He now owns 296,000 shares worth circa £2m. CFO Andrew Griffith simultaneously bought £300,000 worth. He now owns circa 100,000 shares.
  • Odey own 2.66% of the company and it is the biggest (5-8%) holding in a number of their funds. On Crispin Odey’s numbers referenced in his quarterly call at 720p it is 4-5x 2013 cash flow. They added more stock after the bid fell through.
  • News Corp own 39% of the stock.

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