Description

(This is a UK stock idea - as non-US ideas get less coverage on VIC your votes will be appreciated)

This note on BSkyB ought to be read in conjunction with the VIC idea we have submitted today on Virgin Media.  Indeed readers may wish to consider playing the pair of long Virgin Media vs short BSkyB. However since the BSkyB idea is dependent on a regulatory catalyst (discussed below) we would suggest readers stay close to the story and put the short on as the market becomes concerned about the issues discussed below - we may be weeks to months ahead of the market in the ideas we discuss below (dependent on press coverage and regulatory comments).

We appreciate that as a UK stock this will receive less votes than a US stock - so please, please vote for this idea.

First let us say that BSky is a good company with good management and so this is not a recommendation to short to zero but rather relative to the market or to Virgin Media.

 (For non-UK investor's BSkyB's satellite offering is known as 'Sky' - we use both names interchangeably in this idea).

The key points that we believe the market is overlooking are:

(1)    Wholesale pricing

a.       Currently BSkyB has a virtual monopoly of premium content, especially films and football (sport).

b.      It does resell its content to competitors - especially Virgin Media - but at prices that can be at a premium to retail prices (thus competitors such as Virgin end up selling premium channels from Sky at a loss).

c.       With the ongoing regulatory review BSkyB will be forced to resell at a discount to retail prices to competitors such as BT and Virgin Media. The exact discount is still being considered by the regulator but could be as high as 25% (though 10-15% is also possible).

d.      The key point is that finally Virgin and BT will have a more even playing field versus Sky and therefore either gain market share or force Sky's customer acquisition costs up

e.      This is the first formal review of Sky by Ofcom (Office of the Communication regulator). Sky has never faced a review by Ofcom before and most analysts have not modelled in any specific impact (historically Ofcom only looked at telecoms companies)

f.        We have spent considerable time talking to regulators, analysts and the various companies to get a feel for the conclusions. The key consultation documents are at http://www.ofcom.org.uk/consult/condocs/third_paytv/paytv_condoc.pdf - but we have been surprised at the number of Sky analysts who have not gone through them or dismissed them as having no impact or that they will wait until the final document. Our belief is that these documents are going to set the agenda impacting UK media and telecom companies over the next decade. Anyone interested in investing in the UK media and telecoms area should read them. Furthermore we believe a number of other regulators across Europe are looking at Ofcom to set principles that can be used in other parts of Europe. Therefore these documents could have widespread implications.

g.       Note that the Ofcom analysis assumes that Sky will gain volumes from wholesale reselling. We think that the loss of market differentiation / uniqueness is a much more important issue (the Ofcom analysis is on a 'static' market basis)

(2)    Loss of tiering

a.       Until now in order to sign onto Sky's premium products (ie films, sport etc) viewers had to first sign up with Sky's basic package. Thus eg one had to pay roughly £20 per month for a basic package and then £15-20 per month in addition for films and for sport.

b.      We believe that the regulator will force a change so that viewers can choose to subscribe only to selected packages (ie just sports or just films) and avoid the basic package (see discussion on Freeview below).

c.       Historically Sky has been able to increase APRU every year. We believe that the loss of tiering, if it comes to pass, could lead to ARPU rising slowing or even reversing. Virtually no analyst appears to have considered this

(3)    Freeview

a.       The UK is currently undergoing an analogue switch off. The digital terrestrial television package is known as Freeview. It offers more than 20 free to air digital channels

b.      Whilst the switch over has been happening for a while it has really been this year that the analogue transmitters have begun to be switched off in volume in major population areas.

c.       Many (but not all) of the Sky basic channels are available on the Freeview platform.

d.      Our hypothesis is that going forward many viewers will select to use Freeview and augment it with selected premium channels from Sky - ie bypass Sky's basic packages.

(4)    Weak competition

a.       Sky has had an extraordinary 36 months with a number of competitors suffering issues.

b.      ITV and Virgin Media tried to merge. BSkyB blocked them by acquiring a blocking stake (17.90%) in ITV.  Competition commission investigations have led to a ruling that BSkyB sell the stake. This is still being litigated in court. However we believe that the soft issues surrounding this have antagonised the regulators.

c.       ITV currently is frankly leaderless (is having difficulty finding a new CEO and a new chairman) and being priced as if it will never recover (we may consider writing on this in the future on VIC). Analysts are just not forecasting any improvement in ITV market share going forward.

d.      Setanta, a sports content aggregator and channel, went bust.

e.      We believe that the market is assuming that there will be no recovery for the competitors at all

f.        In our write up on Virgin Media we suggest that Virgin is becoming a serious competitor. We believe analysts covering Sky have not considered the impact of this.

g.       BT (via BT Vision) has always had the potential to compete but been unable to deliver. We believe that the fibre roll out to the home due to start next year could bring BT back into the game and lead to investors questioning what investing Sky needs to make in broadband. (It will also improve the availability of the BBC's iplayer - discussed below).

(5)    'The killer app'

a.       In the previous cycle Sky's 'killer app' was the Sky Plus box (ie a PVR / DVR) which had a large hard disk drive inbuilt and an attractive EPG

b.      Analysts are assuming that HDD and the associated PVR will be the equivalent for this cycle for Sky. Early numbers do suggest this is true to some extent.

c.       However we believe that a lot of the market is missing the impact of the BBC's iPlayer service - this is a online video download / streaming application which makes a number of the BBC's programmes available for free in the UK for upto 7 days. In fact using a 'lab' beta version of the iPlayer it is possible to download programmes for upto 30 days and at high definition.

d.      A couple of interesting features of the iPlayer are that it is free for UK households (technically does not even require a TV license) and is also available on the Virgin settop box, the BT Vision Box (though BT charges) and on the Sony PlayStation 3 (and on and off on the Nintendo Wii). (It is also available on the Apple iPhone and the Nokia N96).

e.      The future roadmap for the iPlayer includes Project Canvas where other broadcasters will have access to the technology (eg ITV and Channels 4 and 5) though the exact relationships are still a matter of debate. Project Canvas specific settop boxes are planned towards the end of 2010.

f.        It is also worth noting that Freeview boxes with built in PVR capability are increasingly available in the UK.

g.       The impact of this we believe is that marginal DVR users will not bother upgrading to Sky's new PVR / HDD offerings.

h.      If BT's fibre to the home plan starts delivering then upto 10 million homes in the UK will over the next couple of years be able to download high def video at relatively fast speeds within the next couple of years. Access to the BBC iPlayer / Project Canvas will be the major app for this network and will undermine BSkyB's monopoly of delivering high def video to the home.

(6)    'Killer content'

a.       As well as killer apps Sky has been successful in gaining a monopoly on content in the UK - particular film and sports as discussed above. We have highlighted above that part of the Ofcom review is likely to force Sky to resell packages at discounts to retail prices to competitors

b.      We also believe however that video on demand over the net (as discussed above) will lead to more 'long tail' content being viewed. The archives of ITV and the BBC will thereby draw eyeballs away from Sky. Youtube also does this to some extent

(7)    Impact of broadband

a.       Most analysts who cover BSkyB are media analysts rather than telecoms analysts. They tend to treat BSkyB's involvement in broadband as a necessary evil rather than analyze it in depth.

b.      Most are assuming that fibre to the home will make no difference to pricing or costs in the UK.

c.       However as we mention in our Virgin Media note the regulator (Ofcom) has agreed to allow BT's fibre to the home project to be outside the regulated asset base for a number of years (probably 5 years from 2012 but the exact terms are subject to review). This means that BT will have no obligation to resell or unbundle its fibre offering to competing ISP (internet service providers such as Sky) at a discount to retail price.

d.      We do not think that analysts covering Sky have considered the implications of this. Either Sky will have to withdraw from broadband (and thereby lose video on demand / interactivity features) or run broadband as a loss making product or invest significant amounts of money in its own infrastructure.

Taking a step back from the detail we would argue that Sky had benefitted from having the monopoly route to deliver multiple channels of television to the home in the UK for several years. However as the above makes clear a number of new routes are opening up which mean that the monopoly is potentially broken (ie Freeview, internet / iPlayer, BT Vision, Virgin's network).

Analyst models in essence assume that Sky continues to deliver 6-7% revenue growth per year with the main variation between analysts being the mix between ARPU rises and the addition of new subscribers.

However we believe that at some point in the next 12 months (and it could be as soon as within days, or in several months time) analysts will start questioning the strategic positioning of Sky because of the reasons we have highlighted.

Valuation

In the following table we have put consensus numbers for BSkyB and our own numbers. Rather than try to split the mix between ARPU growth and subscriber growth we have looked at modelling aggregate revenue growth.

It will be seen that the consensus numbers require the company from 2012 to exceed the EBITDA margins it has had in the last few years and that it continues to grow at over 5% until 2014. We actually expect that the June 2010 number might actually beat on the upside as Sky aggressive tries to acquire viewers ahead of impending completion. But going beyond that we believe that the consensus numbers are too high. It will be seen that by 2012 we are over 20% below consensus.

Catalysts

(1)    Currently we believe that Ofcom's review of Sky's wholesale pricing structure will complete in Q1 2010. Further the loss of tiering will hurt Sky's ARPU growth

(2)    We believe that Sky will fight aggressively in court and will challenge Ofcom in particular. However we think that analysts will start adjusting their models before the conclusion of any court hearing.

(3)    The BBC Trust (the BBC's governing body) is likely to make final decisions on Project Canvas (and in particular the relationship with other broadcasters) by the end of 2009 with implementation during 2010. (The BBC announced some decisions on 20 Oct 2009 but we believe that there is still discussions ongoing)

(4)    Virgin Media delivering will damage growth prospects for BSkyB

(5)    BT rolling out fibre to the home commencing in 2010 will force BSkyB to either make major investments in its own infrastructure, or lease access from BT at unattractive prices (BT will have no obligation for attractive pricing on its FTTH products)

(6)    The current switch off of analogue transmission will lead to more consumers switch

Risks

(1)    Short term BSkyB will switch more viewers to HD and continue to increase ARPU faster than the market is expecting.

(2)    ITV will continue to implode

(3)    Court action will keep implementation of regulatory changes in the courts for years.

(4)    Falling USD makes content costs cheaper for Sky

Catalyst

(1)    Currently we believe that Ofcom's review of Sky's wholesale pricing structure will complete in Q1 2010. Further the loss of tiering will hurt Sky's ARPU growth

(2)    We believe that Sky will fight aggressively in court and will challenge Ofcom in particular. However we think that analysts will start adjusting their models before the conclusion of any court hearing.

(3)    The BBC Trust (the BBC's governing body) is likely to make final decisions on Project Canvas (and in particular the relationship with other broadcasters) by the end of 2009 with implementation during 2010. (The BBC announced some decisions on 20 Oct 2009 but we believe that there is still discussions ongoing)

(4)    Virgin Media delivering will damage growth prospects for BSkyB

(5)    BT rolling out fibre to the home commencing in 2010 will force BSkyB to either make major investments in its own infrastructure, or lease access from BT at unattractive prices (BT will have no obligation for attractive pricing on its FTTH products)

(6)    The current switch off of analogue transmission will lead to more consumers switch