THE SECRET PM: BUY FOX

US TV and media content producers have suffered tremendous de-ratings over the past year. And in particular since Disney results in August, which showed a drop in pay-TV subscribers. Viacom, for example, which has delivered free cash flow of nearly $2.5bn during each of the past four years fell to a market cap of about $16bn, down from $40bn. In a market where stable earners like Colgate trade at PE ratios of 25x, Viacom’s PE ratio of 6x highlights the extent of the de-rating.

With the exception of the Disney Channel and HBO, US content producers make most of their profit from advertising. $5bn in advertising revenue is 113% of Viacom’s $4.4bn in TV operating profit. $4.6bn in advertising revenue is 150% Time Warner’s Turner Network profit. The way the model works is this: advertising is driven by viewership – advertisers pay for “eyeballs”. So to grow advertising revenues the content producers must grow viewership. The most obvious way to do this is to invest in more and better content. Scripps Networks, the producer of HGTV and the Food Network, for example, increased content investment from $492mln in 2010 to $779mln in 2014. This was successful in increasing distribution – the channels reached 50mln more people in 2013 compared to 2009. Consequently advertising revenue grew in tandem, from $1.3bn to $1.8bn.

The content producers, as part of their carriage agreements with TV distributors, pass on the cost of increased content investment on to the distributors. Partly because the distributors have no business without content and partly because increased content investment and viewership will ultimately drive more subscribers to the distributor or at least increase the value of the product to current subscribers – allowing distributors to take price increases. For example, between 2007 and 2010, DirecTV, the largest US TV distributor, paid around 8% more per year to the content producers and over this period it grew revenues about 10% per year (5% from new subscriber growth and 5% from prices increases).

In a sentence: increased content investment made TV better and this lured more people to TV and increased the amount they were prepared to pay. The “ecosystem” was healthy. The challenge to the system, however, was that pay-TV penetration by 2012 was 87% of households, leaving little room for new subscriber growth. So in recent years, for the first time, the content producers and the distributors have no longer been working in unison. The content producers still want to grow viewership and hence want to invest more, while the distributors, knowing that there are few new subscriber opportunities, want to preserve margins by containing costs. The distributors’ willingness to absorb content cost increases has diminished.

During 2012 and 2013 facing a saturated market DirecTV was not able to grow US subscribers but it nonetheless was locked into contracts paying 8% more per year for content. Better content did mean it could raise prices by 5% per year to existing subscribers but this still left a 3% gap, which shows up in falling US gross margins. DirecTV was able to preserve operating margins by cutting new subscriber acquisition costs by 3% a year, since there were fewer attractive new subscriber opportunities in which to invest.

However from 2013 it was clear that distributors could not continue to absorb higher content costs forever. DirecTV spends about $12bn per year on US content, or $50 per subscriber per month. With no subscriber growth and realistic price increases of 3-5% a year, DirecTV needs to limit content spend growth to 5% a year to preserve its margins. It cannot afford to keep paying 8% increases. The challenge it faces is that it has no business without content and the content producers can’t grow advertising revenues without more content investment. Content inflation is unlikely to slow. The only way distributors can slow content costs is to cut content altogether. In 2015 another distributor, DISH, took the radical move to launch a new “slim” product with about 10 channels at $20 per month. DISH aims to win new subscribers at this inexpensive price point, and by growing its subscriber base it will again be in a position to absorb rising content costs.

So essentially what this boils down to is that content producers need to grow viewership and hence keep investing but distributors have no new subscriber opportunities (in the current system) and hence need to constrain costs. The consensus thinking is that the content producers that have the least in demand content are likely to be forced to take price concessions or be cut out of the TV bundle. The content producers with the weakest content, in this scenario, are in the uneviable position of having to cut prices and: either lose margin on growing content investment, or cut content investment and lose viewership. Fear of this scenario is the main reason Viacom has de-rated more than other media companies. Viacom is perceived as having the weakest content because its content is youth focussed. Households with kids make up only one third of total TV households and thus the content is not “must have” for most TV subscribers.

The problem with this consensus view is that if, for example, DirecTV cuts out Viacom, saving itself 7% on content costs, it preserves margins in the face of rising costs only if it keeps raising the prices it charges to its customers. It seems likely that customers will defect to other distributors if they find their bills continue to increase but the channels they receive shrink. Unless the distributors can act in unison it looks like the big content producers are safe from being dropped from the major distributors altogether. While the threat to drop all the content from one of the big content producers seems weak, a more realistic outcome is that distributors threaten to move a provider’s content from the most widely distributed packages to premium packages where customers have to pay a supplement to access the content. Using this credible threat distributors may be able to win pricing concessions from the content producers.

The most likely future is thus one where distributors and the content producers both have to accept falling margins and roughly flat profits in the US. They will essentially accept that the US TV market is mature and they’ll both make margin concessions in order to preserve the ecosystem’s profits. The first quarter of 2015 agrees with this thesis. DirecTV reported 6% revenue growth driven entirely by prices increases but owing to rising content costs margins fell from 27.4% to 26%, meaning profits were flat at $1.7bn. Scripps Networks, producer of HGTV and The Food Network, reported 2% revenue growth and 8% higher content investments meaning total profit was unchanged at $260mln.

If US profits plateau instead of collpase then the de-rating in the media stocks is overdone. Even in the extreme case where distributors manage to force Viacom to eat all the cost of its future content investments, if advertising revenue stays unchanged, then TV operating profits should still top $3bn and net income $1.5bn. That’s a 30% decline in earnings power compared to a 50% decline in Viacom’s share price.

The delicate balancing act between content investment and subscriber prices increases while important is probably less important to TV content producers than the importance of maintaining and growing advertising revenues. Most big US content producers have done a good job building their channels but recent reports show they have likely maxed out channel distribution. All Viacom’s major channels, for example, are already distributed to almost every US TV subscriber. Unless they launch a new channel – and distributors have no interest in more content costs, which makes this very unlikely – then Viacom’s opportunity to grow US viewership is seriously limited. Discovery launched new channels in the past 7 years and insodoing grew distribution by 370mln people but since 2013 viewership has plateaued. The same is true for all the content producers. It is this realisation: namely that US TV subscriber growth and hence viewership and advertising revenues have plateaued that above all has driven the sharp de-rating in stocks like Discovery and Scripps. With flat profits Discovery will deliver about $1.2bn of free cash flow, good for a 6% yield at today’s $19bn market cap. That is round about fair value and very different from the 3.5% yield Discovery traded at in 2012 when it was valued at $32bn. It seems investors grew complacent in 2012 and 2013 with consistently rising US advertising revenues.

Across the media sector high valuations and high growth expectations have switched markedly lower. Low enough that the sector now looks like a compelling investment prospect. In particular since opportunities to grow profits outside the US are better than ever. Discovery and FOX exemplify this opportunity. Discovery has added about 1bn people, or 500mln international households, as subscribers over the past 5 years through acquisitions and distributions deals (Discovery’s content travels well). This added viewership has enabled it to grow international advertising dollars from $340mln in 2009 to $1.5bn in 2014. Yet international markets are far from fully monetised as ad dollars per subscriber are still roughly half the level of the US. Discovery has a growth runway of at least $500mln in international advertising dollars as it grows distribution, viewership and charges advertisers more. That’s enough to push group free cash flow over $1.6bn in the coming 5 years, good for a 9% yield.

FOX, though, more than any other US TV company stands out for its growth opportunities. US TV distributors want to save on content costs so they are very unlikely to agree to take on new TV channels. FOX was the last content producer to launch a major channel with Fox Sports in 2013. FOX used its bundle of channels to get wide distribution for Fox Sports – roughly 90% of pay-TV households. FOX is charging distributors about $1.5 per subscriber per month, providing it with a $1.4bn annual fund to acquire sports rights. FOX has been bold, spending more than $1.5bn per year on sports rights, which resulted in the company sacrificing about 3% of profit margin, all in an effort to build a serious sports channel that can rival ESPN for viewership. With an untested new channel FOX has not yet been able to monetise viewership with advertising in a meaningful way – Fox Sports booked about $400mln in advertising revenue in 2013 compared to $3bn at ESPN.

Unlike ESPN, which needs to defend its profits to support its valuation, Fox Sports is not contributing to FOX’s group profit. It thus has more scope to invest aggressively to build up content and consequently viewership. With the content it has already secured Fox Sports has the ability to deliver at least another $1bn in US advertising dollars, which would make it about half the size of ESPN. Such an opportunity to grow US profits is unique across US media and not reflected in the company’s valuation.

Moreover, FOX is building its sports business globally, through football rights in Latin America and Cricket rights in India. In both of these countries FOX is growing distribution at a rapid clip as the local pay-TV markets develop. The runway for advertising revenues in both markets is clearly very long. And as viewership builds FOX will be in a strong position to bargain for higher carriage rates from distributors giving it growing acquiring power for new sports rights. With the only global sports distribution network FOX is in a very strong position to acquire and monetise globally appealing content like football.

Across the US and internationally FOX has a $2bn advertising revenue opportunity thanks to its bold sports investments. That will drive group free cash flow close to $5bn a year by 2019 – all of which FOX can return to shareholders thanks to its unlevered balance sheet. A $5bn cash return on a market cap if $55bn is good for a 9% yield. With corporate bond yields at 5% FOX’s share can easily double over the next 5 years. The opportunity is already baked into the cake, all it has to do is execute.