Of Moats & Media – Part 1: Setting the Scene
Long-term investors in quality companies always need to be on the lookout for disruptive changes that might impair a company’s competitive standing. In recent years, the success of Netflix and other streaming video options have put the media industry in the crosshairs of disruption. Media related companies have historically been able to earn strong returns on invested capital supported by the moats they’ve built. It’s important for investors to try to analyze the nature of these moats and the impact of the disruption on the existing moats in order to identify the companies that will emerge on the other side with either new or strengthened moats.
Over the past year, the media sector has come under pressure with the widespread recognition that media consumption patterns are changing in the US, home to a nearly $200 billion media/pay-TV ecosystem. The confluence of Internet video delivery (streaming video), increasing mobile device usage, the long-term trend towards instant gratification, and more intuitive user interfaces across technology-enabled services are driving behavior changes among traditional consumers of media in the US. Signs of this behavior change have been a decline in the penetration of traditional Pay-TV services since they peaked in 2010, as well as overall declining viewership statistics among most major networks (Matthew Ball has done some great analysis on the Media ecosystem at REDEF). Note the decline has predominantly been driven by an increase in new households that are not subscribing, though absolute numbers of subscribers have also been falling for the industry. This represents the first time the industry has seen a decline in subscribers outside of a recession.
What at first seemed like complacency in the market suddenly turned into a bloodbath among media stocks in the summer of 2015, precipitating a decline in a representative basket of media stocks of about 30%.
This piqued our interest since Media has traditionally been a great investment area, driven by strong moats that have attracted investors, like Warren Buffett who owned 25% of CapCities/ABC before its acquisition by Disney, as well as high-value leaders like John Malone, CEO of TCI, and Tom Murphy, CEO of Capital Cities. In his insightful book, The Outsiders, William Thorndike, Jr. cited both leaders as 2 of only 8 great “outsider” CEOs identified, who generated a stupendous amount of value as leaders of their respective companies relative to both their peers and the overall stock market. Buffett, a regular investor in media, including old media newspapers, was another in the group.
The fact that three of the eight CEOs identified by Thorndike operated/invested in the Media space is probably no coincidence because it happens to be an industry where strong moats can be built and maintained, which when combined with great strategic capital allocation skills, make for some phenomenal returns for their investors over time. According to Thorndike, the 8 outsider CEOs he identified were able to beat market returns by ~30x over 25 years!
Below are graphs showing performance relative to the S&P 500 of the eight outsider CEOs in aggregate.
TCI under John Malone
Capital Cities/ABC under Tom Murphy
Source: Reproduced from The Outsiders by William Thorndike, Jr.
One sign that there is a strong moat around a business is the presence of a sustained, high return on invested capital (ROIC) with a significant spread over its weighted average cost of capital (WACC). The table below shows a representative list of companies in the media content and infrastructure sectors with ROIC, ROE, and WACC data culled from Morningstar Research, whose analysts focus on evaluating companies’ moats and sustainability, ROIC, and cost of capital (special thanks to analysts Michael Holden and Neil Macker for their help in compiling this table).
In this post, we’d like to frame the current environment for pay-TV. In our next post in this series, we’ll discuss the changes the industry is experiencing and how that could threaten media companies’ moats as well as opportunities it presents. In our third and final installment, we’ll discuss what the future could look like and characteristics that would be important moat sources as we make the transition to a more open, global scale media world.
We build off the work of many different analysts, journalists, and company reports that have focused on the changes taking place. We are going to try to frame our discussion in the context of the moat that the companies in the space have and how the changing structure of the media value chain strengthens or weakens their moats as we transition through the disruption so that we may identify the signs of the moat winners to come in a much larger opportunity ahead. Generally speaking, periods of uncertainty are when high-quality companies are found trading at significant discounts to fair value and can present an opportunity for long-term investors who have a well researched, well thought out view of how the future could play out.
Let’s dive in…
The current state of the pay-TV ecosystem can be represented by the diagram below published by Credit Suisse:
The aggregate value of the Pay-TV market is probably somewhere closer to $200 billion in 2016 as prices for subscriptions have continued to rise, somewhat offset by losses of about 2-3% of subs. Consumer subscription fees comprise over 60% of revenues into the ecosystem while advertising comprises the rest. MVPD, or multichannel video programming distributor, references the cable, satellite, and telecom providers such as Comcast, Charter, Verizon, AT&T, and Dish. We can see the legacy that they come from when their primary role was to just distribute video programming before the age of broadband Internet and other IP-based services like telephony.
To better understand the value chain, we can segregate it into content companies (also referred to in this post as media companies) and distributors (including cable companies, satellite TV and telecom companies like AT&T and Verizon). Below is a schematic illustrating this simply and effectively published by Ben Thompson at his very insightful blog Stratechery.com:
Content companies traditionally curated and financed the production of content (directly in-house or by licensing from third party studios) and aggregated them into feeds called channels, each representing a certain type of video content that consumers could expect to find. The content was initially broadcast free over the air (advertising provided the revenue to broadcasters) before cable companies built out the physical cable infrastructure throughout the country, initially to bring the broadcasters’ signals to more rural consumers reliably (physical/geographic obstacles got in the way), then more broadly because they could expand the bandwidth available to carry more channels than broadcasting technology at the time. For this, the cable companies charged the consumer for access to the video service they provided. Eventually, they started to share the revenue collected with the media companies and also added advertising into the revenue mix.
For the cable companies, the big upfront expense of wiring up the country earned them local monopolies similar to the one AT&T benefited from. Another part of the investment was also the cost of actually going out to sign up customers (customer acquisition costs or CAC), which was an expensive up front cost (sales people, installation, on premise equipment costs) as well as ongoing customer service costs. Subscribers, once signed up, were stuck and could reliably be expected to provide a good return on initial investment once a cable company scaled and ran its operations efficiently enough.
Since cable companies now controlled the pipe to the consumer that delivered the video (their moat!), content companies had to get access to push their video product through and that meant scaling up and aggregating various types of content. The larger bandwidth for video delivery meant that cable companies could partner with new content sources outside of the broadcast networks (ABC, CBS, NBC) in order to continue adding value and charging higher subscription fees to their customers in order to leverage their existing investments in infrastructure/CAC that had already been installed. This led to the creation of CNN, TNN, BET, Discovery, HBO, MTV, Disney, ESPN, Nickelodeon, The Disney Channel, etc to serve an increasing number of sub groups/niches of customers. However, as the gatekeepers to the distribution network and the end user subscription/advertising revenue share, the cable companies were generally in the driver’s seat in allowing or denying access.
As would be expected, certain content providers proved to have more leverage with cable companies because of their power to draw new subscribers such as HBO, which drew early subscribers from free broadcast TV to pay-TV because it brought blockbuster movies into people’s living rooms (hence the name Home Box Office). For that, it was able to charge an unbundled separate fee for access from the subscribers as a premium channel, unlike most other content. Bundling made a lot more sense as a sustainable model for most of the channels being added to create a scaled sustainable flow of revenue to reinvest in creating content as it distributed small incremental costs across the entire subscriber base while serving smaller segments’ content needs. It also made revenue maximization/collections and customer service costs much more attractive for the cable companies.
What followed was a consolidation on both sides of the industry, as cable companies like John Malone’s TCI and Ralph Roberts’ Comcast consolidated networks around the country (and eventually with each other) to gain scale and aggregate recurring subscriber revenues. The media companies like Time Warner, CBS, Disney/ABC, 21st Century Fox, and NBC (part of GE, now owned by Comcast) did the same on the content side to gain scale and leverage on the consolidating distributors and garner a greater share of advertiser dollars. Mark Robichaux’s biography on John Malone, The Cable Cowboy, does a great job of outlining the history of the cable industry as a part of Malone’s story.
The media companies came to control what got financed, produced and distributed by the cable companies to consumers of video as their scale increased. They were able to get new channels and new fees from cable companies by leveraging the strength of their portfolio into bundled offerings sold by the cable companies to their subscribers. Scale, access to low-cost financing, the content talent seeking financing and an audience, and access to a portfolio of channels (feeds) to the end consumer through cable companies (distributors) are what eventually became key elements of the media companies’ sizable moat. The coalition of the media companies’ moat in curating and supplying the product and the cable companies’ distribution moat in reaching the consumer led to a lucrative, big business to be shared between the two sets of partners. This led to increasing, more diverse content in the form of more channels that brought more value to the subscriber (and charged higher fees for it) that occupied an increasing portion of their leisure time, which could also be monetized some more through advertising.
The virtuous cycle this partnership created has been a lucrative one that has driven strong sustained growth over time for media and infrastructure companies, while also generating strong margins and ROIC for both sets of companies. This has resulted in massive value creation for the industry’s investors as well due to the strong moat characteristics of the underlying companies. In the next posts, we’ll explore how the Internet and the rise of streaming media companies impacts the quality of the moats, which has created uncertainty around these companies, and elements of what comes next as a key to understanding the long-term moat and investability of companies in the industry.
See Part II of this series here.
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