Description

Concerns surrounding a declining pay TV subscriber universe and negative ratings across many networks have driven significant multiple compression in the traditional media space.  While we do expect there ultimately to be winners and losers in the ongoing shift in video consumption habits, some misplaced concerns have created the opportunity to buy certain growing media companies at heavily discounted multiples.  CBS Corporation (CBS) is our favorite name in the space. While CBS is priced as though it were in secular decline, the company is actually a net beneficiary of the trends changing today’s media landscape, and as a result earnings should grow at a double-digit pace for the next several years.  Recent lawsuits between the CBS board and controlling shareholder National Amusements (NAI), along with CEO Les Moonves’s harassment scandal, have put some extra downward pressure on the stock. Meanwhile, the media space continues to consolidate. We believe CBS is likely to be acquired by a larger tech or media company in the next few years.  CBS has been written up several times on the VIC, and most are familiar with its business lines. We have arranged this write-up as an outline of the bear case points as we see them with our commentary on why they are wrong. We also include our basic model below.

Bear Point #1 – Cord cutting acceleration indicates that TV is in secular decline

Just as with most bear cases, including the incorrect ones, there is some truth to the view.  Let’s start with stating the problem: Pay TV is losing subscribers at an accelerating rate. Disney CEO Bob Iger raised the alarm on that company’s second quarter 2015 conference call saying,

“We're realists about the business and about the impact technology has had on how product is distributed, marketed, and consumed. We're also quite mindful of potential trends among younger audiences in particular, many of whom consume television in very different ways than the generations before them. Economics have also played a part in change, and both cost and value are under a consumer microscope.  All of this has and will continue to put pressure on the multi-channel ecosystem, which has seen a decline in overall households as well as growth in so-called skinny or cable-light packages. ESPN has experienced some modest sub losses, although those have been less than reported by one of the prominent research firms.”

These comments touch on several key factors at play here; we will unpack them below. Prior to Iger’s comments, it is important to note that the cable bundle had been slowly eroding for several years, as shown in the graphs above.  The large cable bundles that took off in the 1990s and eventually penetrated 90% of US households began losing subs in 2010. Initially this was due to what Iger refers to above as economics: pay TV became too expensive. The cable bundle, made up of broadcast networks – principally CBS, ABC, NBC and Fox – basic cable networks – AMC, FX, CNN, TBS for example – and premium cable networks – HBO and Showtime, costs on average $106 per month, up 44% since 2011 according to Leichtman Research Group.  According to Tivo, 85% of people who cut the cord do so because they viewed the service as too expensive.

Packaging an increasing number of channels, often with decreasing consumer value, into the bundle was a fantastic business for the cable/TV industry, which generated some $170 billion in revenue last year, roughly split evenly between advertising and subscriber fees.  Oversimplifying the dynamic, once the industry reached maturity, cable companies would add a new channel as a justification to increase fees. Distributors were forced to carry all channels, eventually leading to dozens of channels from several programmers. The average number of channels in the bundle more than doubled between 2005 and 2015; yet, customers only watched 17 channels on average throughout.  Distributors would in turn markup that content cost significantly for consumers. On the customer facing side, the cable industry has notoriously poor customer service. These businesses were often capitalized primarily with debt and managed for cash. Many markets were effectively monopolies, so customers were held hostage to some degree. Consumers were willing to consume content at an arbitrary on a twenty-year-old user interface, constantly interrupted with commercial breaks as long as there was no alternative.  The situation, marked by high profit margins, too many layers in the value chain, and complacent participants, was ripe for disruption by Silicon Valley.

Netflix was the first mover in the rise of Internet TV/streaming video on demand (SVOD).  After launching its streaming service in 2007, Netflix now has around 130 million subscribers globally.  Built around the consumer instead of the cable company, Netflix offers on demand viewing in an elegant, customized interface with no commercial breaks.  Which brings us to the second Iger point above: consumption of television in different ways. Once consumers experienced this alternative, they were hooked.  While most domestic Netflix subscribers also have a pay TV subscription (i.e, Netflix is a complement, not a substitute), Netflix and other OTT offerings have essentially stolen 20% share of total US viewing time.  That is to say, of the five hours of daily video viewing, digital is two of them. Much to the frustration of the traditional TV ecosystem, the majority of video viewed on SVOD is legacy media content.

For years, traditional media companies ignored the threat from Netflix.  Structural factors like long-term licensing contracts between content creators and distributors prevented obvious moves like making all Pay TV subscriber content available out of the house and on mobile (TV Anywhere) from happening quickly or being ubiquitous.  Pay TV only recently has started to respond with participation in SVOD and virtual MVPD services like Hulu, Direct TV Now and Sling, and by offering their distributed content through apps. These services offer smaller, more economical “skinny” bundles of the same content available in the linear feed as well as an increasing amount of exclusive content.  Others have decided to seek direct relationships with consumers. CBS falls into both categories, participating in virtual MVPD platforms, licensing content to essentially everyone in the ecosystem and offering its own branded OTT products – CBS All Access and Showtime OTT. Virtual MVPD platforms have grown to a high-single-digit percentage penetration of the ecosystem from a zero base in just a few years, with growth accelerating in recent quarters.

Without a doubt, these digital offerings are responsible for an acceleration of longstanding linear subscriber erosion trends; however, it is inaccurate to assume that all of those lost linear subscribers have left the ecosystem.  Many of the consumers who cut the cord pick up at least one of these digital offerings. In fact, the 50% of US households that subscribe to a streaming service, including Netflix, have an average of three digital video subscriptions.  Clearly these offerings are a substitute for linear TV on one level, but they are also complimentary on another. According to Horowitz research, 78% of OTT SVOD users are also MVPD subscribers. 75% say access to broadcast networks is a significant reason for having this mix.  In addition, Nielsen estimates that there are around 2 million viewers in skinny bundles that previously did not have a pay TV service. In other words, they are new to the ecosystem and are an offset to the traditional pay TV erosion. Once we look at those same subscriber trends including new vMVPD subscribers, the long-term erosion of 1-2% per year looks still very much intact.  Consistent with other industry data points, on Disney’s conference call last week, Bob Iger stated that subscriber trends are improving:

Although the erosion of the expanded basic bundle continues, the impressive growth of these vMVPDs has steadily slowed overall sub losses. To that end, we've seen noticeable improvement in the rate of sub loss in each of the last four quarters.

We also believe the installed pay TV base has varying degrees of willingness to drop out of the ecosystem.  Clearly, those consumers that saw limited value in their video subscription would be the first to drop out. Looking at the amount of time spent watching linear TV – 70% of primetime viewing is still watched live –  there is still a large percentage of the population that is unlikely to drop its cable subscription anytime soon. The rate of erosion is obviously a very important number to get a handle on as it is a driver for valuation multiples in the space.  Prior to subscriber losses accelerating in 2015, media companies often traded at premium multiples to the S&P 500. Discounts imply an accelerated shrinking subscriber base with little to no terminal value. Valuation discounts in the space have, in general, narrowed recently, mostly on consolidation news and speculation.  

One of the reasons we really like CBS is the fact that is has been able to grow subscribers and revenue/earnings while the overall pay TV universe continues to shrink.  In fact, the company reported accelerating subscriber growth in the March quarter and subscriber growth of 6% in the June quarter, marking its fourth sequential quarter of subscriber growth.  It’s outperformance of industry trends is a result of being well ahead of the game in launching and ramping CBS All Access and Showtime OTT. The company claims the two OTT offerings will have 8 million subs next year and 16 million by 2022.  While still subscale, especially at All Access, this is no small feat. CBS’s inclusion in a variety of third party OTT offerings speaks to the must-have nature of its content. One of the reasons we like CBS is that it does not carry the baggage of dozens of channels consumers wouldn’t widely pay for a-la-carte.  The most vulnerable segment of the ecosystem today is basic cable, an area where CBS has no significant presence.

Subscriber count is only one part of the fee revenue calculation; the other is dollars per sub.  CBS has the “must have” content in its network to provide pricing power with distributors and consumers.  Importantly, it makes more money on subs that drop a linear subscription and go with an SVOD subscription instead.  This is especially true in the case of CBS All Access, where 1/3 of its subs are paying $9.99 per month for a commercial-free version.  This compares to $2-3 per sub in the traditional ecosystem. All-in revenue per sub was up 30% y/y last quarter. Even at these higher rates, CBS is still underpaid, generating 12% of linear viewership but only receiving about 3% of available fees.  Some industry peers, in contrast, have struggled to justify their rate card and have not been included in SVOD offerings.

The current TV ecosystem is in flux, and the pay TV distribution model is being forced to change.  The good news is people are still watching a lot of TV, by some metrics, more than ever before. In fact, if you consider how people spend free time, it’s mostly watching TV.  The difference is they are watching less on an actual television and more on their phone and tablet.

To us, this is a distinction without a difference, especially for CBS, which is platform agnostic and relatively untethered to the existing model.  Our basic view is that the distribution portion of the TV value chain is being heavily disrupted, but content creation is still very valuable. CBS has been somewhat indifferent as to if, how or when the bundle breaks; CBS is well positioned in virtually any scenario.  As traditional distributors are being disintermediated by emerging OTT players, we will have truer price discovery for video content. This should benefit CBS. As long as CBS can offset linear erosion with SVOD gains, while getting some rate gains, the evolving ecosystem should at least be neutral for the company.  For the next few years, we see decent, low-risk growth in retrans and licensing fee revenue.

As traditional pay TV is replaced by OTT offerings, we might actually end up not too far from where we started.  The cable bundle, is actually a very good deal for the amount of quality content you get. For a family of four paying $100 per month for content, the cost for its primary entertainment is less than a dollar per day per person and includes an amazing amount of variety and options.  Almost every other form of entertainment is much more expensive. Even those offering “skinny bundles” have begun to let their belt out in an acknowledgement that a large portion of the market still wants a wide variety of channels. Consumers who want more than just a handful of channels will likely pay more trying to build their own bundle a-la-carte.  

Changes we hope to see across the board are updated IP-based user interfaces that don’t distinguish between a TV and an iPhone.  Consumers who pay for content in a bundle should be able to access it anywhere on demand. The old model of the distributor marking up content costs by of as much as 100% must go away.  The aggregation function that distributors used to provide just isn’t worth much anymore now that customers can access content directly. Distributors would do well to seamlessly integrate 3rd party content into their platform.  We, as viewer’s, wouldn’t naturally segregate all of our content sources into the various providers’ apps.  Apple has made some early strides in doing this through its TV app, and Comcast has made similar moves in building Netflix into its Xfinity platform.    

Bear Point #2 – CBS is subscale and can’t compete with the likes of Netflix, Amazon, Hulu, Google, Apple, etc. in an OTT world

“Beyond television, we’re all watching an epic battle unfold for who will control human attention.  For who controls attention, controls its monetizing.” – John Landgraf, CEO, FX

Netflix’s success in growing subscribers for its internet offering has encouraged other internet giants to enter the fray.  At the same time, traditional media content creators and distributors are quickly consolidating in response to the shrinking universe discussed above and to have a chance to compete at scale with the internet giants.  One of the concerns we often hear is that CBS is just too small to compete in the new media world. This argument is usually backed up with a comparison of market caps between tech giants and legacy media. Much more relevant to us are metrics like content spend and hit rate of successful shows.  On this basis, CBS is still a significant player in the industry. For example, CBS’s content budget is $7 billion, producing 70 shows annually across all platforms including Netflix, Amazon and Hulu, more than double the number of shows from five years ago. This content spend produces consistently large audiences.  CBS was the most watched network in 15 of the last 16 years, and all of the last ten years. CBS had 15 of the top 30 series and more than half of the top 50.  In 2016, it had 15 series with at least 10 million viewers every week, more than all other networks combined.  Producing sought-after content is not purely a function of money; Amazon has the second highest digital content spend but few hits to show for it.  CBS’s ability to profitably produce quality content for itself and others at scale is an underappreciated strategic advantage. CBS and Showtime own more than 80% of primetime content.  Once CBS finishes a season, that show becomes a valuable library asset, which can be monetized to SVOD or international distributors. The accumulation of value in this content library should not be underestimated.  CBS generates hundreds of millions in library monetization revenue every year; this income has little to no cost associated with it. This level of content creation is quite capital intensive; yet, CBS has managed to hold margins relatively stable while growing production spend, building OTT offerings in-house, generating significant free cash flow and actively repurchasing shares.  To us, being able to achieve these is at least one important proof point of scale.

CBS’s sports rights are also important in considering the question of scale.  They include:

NFL: Sunday night AFC football through 2022

Super Bowl: 2019 and 2022

SEC football and basketball through 2023

NCAA Men’s Basketball Tournament through 2032 (shared with Turner)

PGA Tour through 2021: Masters renewed every three years

Sports rights are a multi-billion licensing commitment for CBS and allow the company to garner large audiences with higher advertising CPMs and act as a lead-in for new shows after sports events.  While there is a portion of the TV universe that does not watch sports, larger portions of broadcast TV subs would not consider a video package without sports. These rights are critical in driving CBS’s retrans fee growth.  The cost of securing sports rights has gone up significantly over the years and are partly to blame for the increase in the pay TV bundle’s cost. Many believe that with the entry of internet giants into the video space, CBS will not be able to renew its sports rights at acceptable rates.  CBS was recently outbid by Fox for Thursday Night Football (TNF). It will be interesting to see how much of a viewership hit there is.  Young Sheldon, following TNF on CBS last season, was the third most watched primetime show in 2017 with 16 million average viewers (more than double TNF viewers) and would have been a big hit with or without TNF.  

CBS has publicly stated that it lost money on TNF, but this would not include hard-to-quantify benefits like marketing other shows.  From a profit perspective, CBS may be better off relinquishing these rights over time. Having sports as lead-ins is much less valuable in an OTT world.  Management so far appears to be rational in bidding on rights.  With respect to internet companies bidding up rights, we don’t think the NFL is willing to completely migrate to a digital only feed any time soon.  This may change before CBS’s next and most significant renewal, Sunday Night Football, which comes up in 2023.  There are still just too many subscribers in the traditional ecosystem. Five years is a long time, especially in the current media environment.  Given the limited profit contribution, it is just not something that we spend much time worrying about.  We also find it unlikely that CBS will be an independent company at the time of renewal.

Importantly, CBS doesn’t have a legacy portfolio of dozens of smaller channels which need to be fed with content, so CBS can concentrate its spend on its flagship properties, CBS and Showtime, making them difficult to exclude from traditional and emerging distribution platforms.  The high rate of current content production as well as a large content library have allowed CBS to pursue a DTC strategy on its own. CBS has also maintained relative independence from distribution partners such that it can pursue multiple strategies and maintain optionality. Most peers either did not have the scale or the foresight to pursue a similar path.  On the one hand, several basic cable content peers have attempted to deepen relationships with traditional distribution partners because they cannot afford to lose the existing base of shrinking fee income. On the other, Disney is combining with Fox to increase scale to launch its own DTC products. We prefer the latter strategy, but Disney will be somewhat limited by is soon-to-be majority ownership of Hulu.  Ideally it would drop all of its content into one OTT offering.

(apologies for the dated chart, NFLX numbers will be higher now, others roughly the same)

Hulu was legacy media’s answer to the Netflix threat.  Currently owned by Disney (30%), Fox (30%), Comcast (30%), and AT&T (10%, through Time Warner), the OTT service has approximately 16 million subscribers, offering a growing slate of original series as well as licensed content from the owners and third-party companies like CBS.  While the size of its subscriber base is nothing to sneeze at, a look at its P&L still shows that it is subscale and couldn’t stand on its own:

Conveniently, Disney and the other owners can book arm’s length licensing revenue and profit above the line, while booking their share of Hulu’s losses below the line.  The above table and discussion highlights the difficulty of building a successful OTT platform without a significant owned content library. CBS had the opportunity to be an owner in Hulu but instead chose to just sell Hulu content and retain its OTT optionality.  Again, we see this as the right decision.

CBS’s nascent OTT platforms are clearly still subscale at less than 5 million subs each.  However, the company has sufficient cash flow from its other modes of distribution to grow them without cannibalizing its existing business or needing third party capital.  We see a low-risk growth path for these offerings while the traditional ecosystem and new vMVPDs are too profitable for CBS to abandon, and likely will be for the foreseeable future.  

Within premium content, we believe Showtime is an underappreciated competitor.  HBO gets all of the love from the street, but Showtime has somewhat quietly become competitive.  Outside of Game of Thrones, which is far and away the dominant show in premium cable, Showtime holds the top shows in every quarter.  CBS is investing behind that strength with Showtime targeting to put out a new premium series about every month, a level of production required to grow and retain subs in the OTT world.  Showtime’s transition to OTT has initially been fairly smooth.  Showtime OTT launched in mid-2015 and is estimated to have around 3 million subscribers today.  Along with its traditional subs, Showtime has 24 million subscribers, an all-time high. Subs have doubled over the past decade, growing at around one million per year.  As existing subs migrate from the cable bundle to OTT, CBS’s monetization should improve by eliminating the cable distribution middleman. We also believe that subscriber acquisition will be easier and cheaper OTT in that bundled subs had to pay the $100/month basic cable before having the chance to pay $10-15 extra for Showtime.  “Cord shavers” and “cord nevers” now have the opportunity to purchase Showtime a-la-carte. CBS estimates that offering Showtime OTT adds some 20 million household to its domestic addressable market. The company is also just beginning to scratch the surface of international monetization. It completed its first full Showtime-branded licensing deal with Bell Media in Canada in 2015 (previously individual pieces of content were licensed unbranded).  In 2016, Showtime completed a more significant branded licensing deal with Sky, reaching 21 million of its subscribers in the UK, Ireland, Italy, Germany and Austria. A similar deal was announced with Stan in Australia shortly after the Sky deal. These deals provide guaranteed licensing revenue for Showtime for years to come and help de-risk its growing content spend. Eventually, Showtime will be marketed directly to international consumers as the business grows and gains international brand recognition under these deals.  

The company’s strategy on All Access has been more unique. CBS made the bold move of launching All Access with the next iteration of Star Trek, what the company calls its crown jewels, as an exclusive OTT series (i.e., it was not included on the broadcast network or in any other distribution mode).  This was bold because the platform had essentially no subscribers at the time. While Star Trek would have no doubt monetized better in virtually any other distribution manner, the show jump started All Access. Again, the fact that CBS could take one of its key pieces of IP out of its traditional distribution channels without harming its financial results speaks to its scale.  CBS has continued to slowly carve-out exclusive content for All Access, with the goal of eventually having one new show premiering about every month, similar to Showtime’s cadence. Having all of its library content, current shows and sports on the platform without significant incremental licensing cost has helped grow subs, reduce churn and limit the negative margin impact of ramping the service.  Along with its related OTT news app CBSN, the number one news app on Roku, and its sports app CBS Sports HQ, All Access’s racy exclusive content is bringing a much younger demographic to the company (38 years old on average).

In addition, CBS has licensed certain All Access shows’ international rights to SVOD competitors to help pay for the growth.  For example, Netflix partnered with CBS in producing Star Trek, paying 100% of the first season’s cost in exchange for the international distribution rights.  As CEO Les Moonves stated in 2016 before the launch, “I go to bed at night a lot happier knowing that Star Trek is 100 percent paid for before it goes on our All Access service.”  The company has executed similar arrangements for other OTT shows and more broadly considers backend licensing opportunities for all its owned content. While content ownership does require more capital, ownership of these shows provides back end monetization opportunities, which are every bit as important as front-end advertising monetization in today’s ecosystem.  In the early days of broadcast production through the early 1990s when retransmission fees began, CBS would need to make its margin purely on advertising. CBS currently has some 600 episodes of hit shows that have yet to be licensed. This is roughly a $2-3 billion high margin revenue opportunity.

To date, CBS has primarily been a domestic business (only 15-20% international revenue); however, international demand for US television content is voracious.  The US is the clear leader in creating video content. In fact, the international box office for theatrical movies is almost three times the size of the domestic market.  Yet, most US media companies only derive around 1/3 of revenues abroad. The rest of the world is years behind the US in terms of pay TV proliferation: international markets have less than 50% penetration vs. 90% in the US.  The market is very large and growing rapidly though, and CBS has enjoyed increased competition for the content it makes available for international licensing from traditional media and new SVOD players around the world. CBS has only begun to effectively monetize international markets in recent years, with international revenue growing from $500 million a decade ago to $1.5 billion today.  Over half of this revenue is from multi-year output commitments similar to the Showtime deals discussed above. In these output deals, the buyer commits to programming purchases sight unseen for several years, taking some risk out of the U.S. production model. In the last couple of years, international licensing revenues have eclipsed CBS’s content sales to Netflix and Amazon combined. As CBS became more comfortable with its OTT offerings and the demand for its content abroad, it began launching All Access in international markets – so far only in Canada and Australia.  CBS specifically highlights the success that Netflix has had in scaling its existing content in international markets. In many ways, the disintermediation of distribution partners and the delivery of TV over the internet has allowed content creators with scale to expand the addressable market potentially by many multiples. We expect CBS to be a fast follower in this regard.

CBS also has more non-TV digital scale than most of its traditional media peers, with 163 million unique monthly visitors across its digital properties.  This is due in part to its acquisition of CNET in 2008 but also as a result of digital investments made to support its TV brands such as digital news property CBSN, CBS Sports HQ, a new ad supported OTT offering, Sportsline, and local news websites for its 30 owned TV stations.  Its digital knowhow allowed the company to develop its OTT platforms in-house in a relatively short amount of time. Altogether, CBS has over 100 million registered users across all of its digital properties.  These existing customer touch points act as the top of the funnel, driving them to the pay services.  CBS has struggled to monetize its non-OTT digital assets to the degree it originally had hoped. As convergence between TV and digital continues, and traffic increasingly moves to native apps, we are optimistic that CBS’s digital traffic monetization will improve.  We discuss digital advertising in detail below.

If we include internet giants like Amazon, Apple and Google in this conversation, the question of scale becomes an order of magnitude larger from both a market cap and a user base perspective.  They also have more financial resources and a willingness to support unprofitable divisions for many years. Lastly, they have direct relationships with and data on all of their users. As mentioned above, they all have large and growing content budgets, a large portion of which goes to traditional media.  It is clear these giants will participate in a meaningful way in the video ecosystem, but it is not quite clear exactly how. We should also include broadband and mobile connectivity providers like Verizon and AT&T in the list of players, the latter recently closing on its acquisition of Time Warner. As we attempt to define CBS peer group, we increasingly must draw a larger circle around distribution companies and the larger technology sector.  This landscape is consolidating quickly, both vertically and horizontally.

As AT&T CEO Randall Stephenson stated on their last conference call, “We've now assembled the key elements of a modern media company, and it all begins with owning a wide array of premium content, because we are absolutely convinced that there is nothing that drives customer engagement like high-quality premium content.  And whether it's Netflix, Amazon, Google, Disney, or Comcast, everybody is now pursuing the same thing. How do you deliver great media and entertainment experiences to our customers? And I think the recent valuations of media companies is reinforcing this point.”

We don’t know exactly how it will play out.  It is clear though that content companies like CBS are a valuable prize in the game, and there are few with the heft and quality of CBS left independent.  Taking Fox as an example, as soon as the company was in play, a bidding war between Disney and Comcast ensued. A company like CBS is especially valuable in a vertical merger, where the acquirer may not have significant content production operations.  We know AT&T considered CBS before moving forward in acquiring Time Warner. Verizon is reported to have been interested at one point but now claims to be only interested in connectivity. We could see Charter making a move into content now that Comcast and AT&T each own major content companies.  Lastly, the possibility of recombining with Viacom may come on the table again, which we discuss more below. Regardless, we believe it is highly likely that CBS is in play and becomes part of a larger digital media company at some point in the next few years. To close the loop on this section though, this will happen not because CBS is uncompetitive; it will happen because marrying content and distribution makes sense for all involved.  In the meantime, CBS will continue to execute on its low risk independent growth path.

Bear Point #3 – TV is losing share to digital.  TV advertising declines are accelerating.

One expected though troubling output of the decline in the pay TV universe is ratings declines.  Advertisers pay based on impressions, and impressions are dropping fast, by double-digits on average for many networks, including CBS.  Similar to sub count erosion, the trend of ratings declines is well established, though it has accelerated recently. This is obviously concerning as advertising is a significant piece of traditional media revenues – for broadcasters like CBS, it used to be the only form of revenue.  Today, at approximately 45% of revenue for CBS (down from 65% in 2010), it’s still is an extremely important source of income, but shrinking by the day as licensing and fee income grows. One might reasonably expect that ratings declines directly translate into advertising dollar declines of a similar magnitude.  Again though, impressions are only one of the variables in the equation. The industry in general has been able to offset ratings declines with higher pricing (CPM) for many years, leading to modest advertising revenue growth.

TV advertising is no doubt losing share to digital in the $500 billion global advertising market, and TV’s growth rate is flattening out and could decline.  Looking at TV advertising revenue dollars instead of growth rate tells a different narrative; this has been and is expected to continue to be a source of modest revenue growth.  CBS often cites the fact that its flagship network has generated approximately $4 billion in advertising revenue in recent years. Google and Facebook, and digital advertising in general, have indeed taken share from TV and became larger in absolute dollars in 2017.  However, digital advertising has grown the size of the pie and taken a bigger piece of the pie; TV’s piece of the pie may be shrinking but it still benefits from an overall larger pie.

Much of the digital advertising growth has come from expanding the addressable market to smaller advertisers who could not afford expensive TV campaigns.  90% of TV advertising dollars come from 200 companies. Facebook and Google, on the other hand, have over one million advertisers. As one would expect, at least some of digital’s share has come from print and radio for these smaller advertisers.  This is likely going to continue (see Credit Suisse chart below), with TV’s share staying relatively constant in a growing advertising market.

One of the benefits of TV advertising has always been large reach.   CBS network and local TV stations generate over one trillion ad impressions per year.  This type of advertising reach and its ability to build brand equity remain a crucial part of advertisers’ campaigns in the largest advertising market in the world.  

Ironically, the largest digital advertising and New Economy companies are also growing their TV advertising spend.  Facebook, Amazon, Apple, Netflix and Google collectively spend over $1 billion on TV ads. That spend is growing at a high 20% pace and is a testament to the value that TV advertising provides.  When Google launched YouTube TV, it chose to do so with TV advertising during the World Series. The legitimacy of this advertising medium is still second to none.

We believe that measurement issues explain a portion of the relative weakness in TV advertising.  Historically, ratings and ad impressions have been counted by Nielsen, which sampled audiences from “black boxes” placed in cable boxes.  As mentioned above, people are watching more TV content than ever and CPMs continue to rise. Of course, part of this digital viewing is on Netflix, which is not ad supported.  However, there are still many TV ad impressions that are not counted and monetized because: 1) the impression falls outside of the time window that makes money, or 2) it occurs on a device in which the technology is insufficient to properly count and monetize that impression.  In the first instance, agreements between advertisers and networks allow the network to get paid on content beyond the live linear feed, typically over the following three to seven days. As viewing increasingly occurred on a delayed basis with DVRs, this monetization window slowly expanded.  The vast majority of advertising is not time sensitive. CBS believes that at least 10% of its delayed impressions are not yet monetized. In 2000, CBS had an average of 12.5 million people watching its primetime shows. Today, that number has actually grown to 13.2 million if you include live and time-shifted viewing.  The second instance has to do with content increasingly being watched on mobile devices, which is not counted in the Nielsen system, and thus is poorly monetized. Symphony Advanced Media says 20-50% of viewing of the most popular shows occurs on smart TVs, connected devices, tablets and smartphones, depending on the particular show.  Nielsen and other measurement companies have numerous initiatives underway to capture digital and mobile viewers. CBS used the show Limitless as an example to quantify the impact of these two factors. In live plus same day viewing it generated 1.5 million viewers. Once you include DVR, VOD and other streaming viewers, the count more than doubled to 3.2 million.  Nielsen’s Total Content Ratings show a 53% viewership uplift for some CBS shows over the past year in the C-35 window.

As video viewing moves from linear to digital and OTT and engagement and user data improve, media companies have an opportunity to monetize impressions at higher rates.  TV company sponsored platforms like Open AP, which provides advertisers with access to first and third-party data to narrowly define target viewers, will give TV both reach and relevance and should increase CPMs dramatically while decreasing ad loads.  Similarly, dynamic ad insertion (DAI) allows advertisers to change the ad within a show to the most relevant ad for that particular viewer. This could be based on area, income, sex, age, purchase history, etc. Credit Suisse believes this is a $100 billion revenue opportunity for TV media companies, mostly stealing share from non-advertising marketing forms like telemarketing and direct mail.  CBS’s various digital assets provide the company with valuable data for advertisers on its over 100 million registered users. This is extremely important for advertising monetization and dynamic ad insertion. With the user information CBS has from All Access registration, for example, it can offer advertisers highly specific customer targeting characteristics, which makes for higher ROI and conversion for the advertiser and higher CPMs for CBS.  

Bear Point #4 – The board/NAI legal drama and the Moonves harassment case likely end with Moonves’s firing and a merger with Viacom, making this stock unownable

We obviously disagree with this point and see these as part of the reason CBS is sitting near 52-lows and has dramatically underperformed its peer group.  We believe the noise surrounding these cases explains a lot of the performance because financial results have been quite strong, with earnings expected to grow almost 20% this year and subscriber numbers trending better that forecasted.  We understand the market’s concern; these well-publicized stories have been among the ugliest we can remember, and it may get worse before it gets better. However, we have tried to focus on potential outcomes and what they mean for the business/stock.  The outcomes that seem to be most troublesome to the market are that Les Moonves is ousted, and the Viacom merger is back on. There is a reasonably high probability he could be out, either through the harassment scandal or the dilution case. We get that investors like Les Moonves; we do too.  He is credited with setting in motion the large retrans fee increases CBS now enjoys and is considered one of the best programmers around. He is highly competitive and has positioned the company for the next era of media decently well, especially relative to peers. We don’t believe he is irreplaceable though.  At 68 years old, this was already an eventuality that should have been considered. Even if he survives this scandal, he may not have the credibility with talent and viewers to successfully run the company. Many of the initiatives he has created are well established, and the strategy is much more about blocking and tackling at this point (e.g., hitting 2020 fee targets).  We wonder whether the next CEO shouldn’t come from the digital distribution world, or alternatively, report to Jeff Bezos (one can dream).

We have no way to handicap the outcome of the board/NAI lawsuits.  The lack of precedent and gravity of stripping control from a controlling shareholder makes us believe it is unlikely.  Regardless of the outcome, we believe CBS is or soon will be in play. We now know the Redstones’ intentions based on a recent court filing:

“Ms. Redstone discussed NAI’s long-term plans for CBS, focusing on a two-step process starting with a merger with Viacom that would strengthen both entities, and continuing thereafter with a sale or merger of the stronger combined entity, with NAI open to the possibility of relinquishing its voting control as part of that second transaction.”

This was big news to us as one of our issues with CBS in the past was our belief that the Redstones would never sell.  That is looking to not be true now. The intermediate step of merging with Viacom, which we discuss below, is not as abhorrent to us as it is to other investors.  Alternatively, If CBS is successful in diluting NAI’s control, we believe Moonves & Co. would seek to sell CBS to a large internet company or distribution partner.  This belief is more speculative but plausible given Moonves’s age, the industrial logic of such a combination and the fact that CBS’s growth through retrans step-ups begins to decelerate in a couple of years.  In addition, the closing of the AT&T/Time Warner deal should give CBS acquirers conviction that they have a high probability of passing DOJ and FCC scrutiny and closing the deal.

What if CBS merges with Viacom?

“But just owning great content is no longer sufficient. The modern media company must develop extensive direct-to-consumer relationships. And we think pure wholesale business models for media companies will be really tough to sustain over time.” – Randall Stephenson, AT&T Q2 2018 Earnings conference call

Viacom was originally a spinoff from CBS in the 1970s as a result of the FCC ruling that television networks like CBS couldn’t directly own the shows they broadcast.  Viacom announced its intent to recombine with CBS for the first time in 1999. Viacom, with Sumner Redstone at the helm, sought to marry CBS’s older broadcast viewers with the young viewers of MTV and Nickelodeon.  Sound familiar? The deal was the largest media deal in history at that time at $40 billion (more than the combined market caps of the two companies today). The two companies again split in 2006 in an attempt to garner higher valuations for each as separate stocks.  Viacom’s stock had dropped by more than half in the prior five years. Viacom was the growth company, and CBS was the high cash flow dividend payer. CBS, Showtime, the local TV stations, Simon & Schuster and other assets were spun-off to investors tax-free. Les Moonves, who was co-chief operating officer of Viacom at the time, became CBS’s CEO, while Tom Freston, the other co-COO, became Viacom’s CEO.  Both ultimately reported to Redstone, whose family retains voting control of both companies to this day. In the years following the CBS spin, Viacom’s struggled with lack of innovation and investment in content under former CEO Philippe Dauman. As cord cutting set in, it became clear to all that Viacom was poorly positioned. The company’s debt load also had become an issue. After Shari Redstone assumed power of her father’s media empire in 2016, she began to make moves to eventually reunite Viacom and CBS.  NAI filed a press release in September 2016 asking both companies’ boards to consider an all-stock transaction, saying that a merger “might offer substantial synergies that would allow the combined company to respond even more aggressively and effectively to the challenges of the changing entertainment and media landscape.” The release also cautioned that NAI “is not willing to accept or support (i) any acquisition by a third party of either company or (ii) any transaction that would result in National Amusements surrendering its controlling position in either company or not controlling the combined company.”  Moonves and the CBS team did not like the idea, and NAI basically said the timing was not right in December 2016. The Redstones pushed for a merger again late last year, with both boards engaging this time and even allegedly agreeing on price. Social issues proved to be an insurmountable roadblock for the deal as Moonves was unwilling to put Bakish in front of Joe Ianniello as his successor. After reaching an impasse and fearing being replaced by NAI, the CBS board sued NAI saying Shari Redstone breached her fiduciary duty and attempted to dilute NAI’s voting control through a non-voting stock dividend. The main example of her breach of duty appears to be her categorical rejection of a CBS buyout overture from AT&T.  As if the plot of this sh*t show were not dramatic enough, Ronan Farrow’s New Yorker article accusing Les Moonves of multiple instances of sexual harassment dropped at the end of July, complicating matters for the supposedly independent CBS board members.

We think much of the stock reaction to the Farrow article was more related to a higher probability that the Viacom deal would be back on the table if Moonves were out.  Investors seem to view the potential deal as a bailout of Viacom at the expense of CBS shareholders. Our view is much more sanguine; the deal makes sense in the strategic long game where only a small handful of very large OTT players will dominate the market, and the wholesale content business will be increasingly challenged (along the lines of Stephenson’s comment above).  Netflix is the unquestionable leader in OTT and has a multi-year head start.  One of traditional media’s greatest asset in competing with Netflix OTT is large, owned content libraries. To-date, they have only halfheartedly utilized all of this owned content in OTT offerings. Disney looks to be moving in the right direction. It has announced plans to pull back on content licensing to other SVOD players in support of its own OTT platforms. CBS’s more measured strategy of organically building All Access’s exclusive library while maintaining the overall business’s margin profile looks nice on the financial statements, but we worry it could be too slow if the goal is to be one of the OTT leaders in the next few years.  CBS has been insulated from the universe erosion so far, but they are still subscale in the OTT world.  We acknowledge that CBS All Access is not yet a good value to the consumer on a relative basis to Netflix and Hulu in terms of content you get for what you pay per month.  Adding the Viacom/Paramount library to CBS All Access would make a very attractive product to consumers.  CBS wouldn’t have to raise the price and would generate a lot more cash just from the sub growth (we guess that All Access is around break even today).  At some point, Showtime needs to be included in that offering, and you would then have a very powerful collection of content for around $15/month, very much rivaling Netflix and HBO.  CBS will still generate over $5 in EPS this year and grow earnings at a double-digit pace for the next few years without Viacom or anyone else.  But, longer-term they need more content that they control to add to their DTC offerings.   Viacom has a lot of complementary content to CBS and young, non-sports related audiences.  CBS also lacks an important movie studio like Paramount. Movie and TV show libraries are incredibly important for reducing churn, which is estimated to be as high as 30% for many OTT offerings. 7Park Data estimates that 80% of streams on Netflix are licensed (i.e., non-Netflix originals). Paramount has a 1,000-title library including Transformers, Star Trek, Ninja Turtles, G.I. Joe, SpongeBob, Tom Clancy / Jack Ryan, Indiana Jones, Jack Reacher, Mission Impossible and lots of other kids content.  Viacom also has much better international distribution assets than CBS, including its interest in Viacom 18 and its 600 million subscribers in India as well as important channels in the UK and South America. As discussed above, a direct relationship with international subs at scale is key to success the OTT world.

Looking at the deal another way, Viacom can be used as a cheap financing mechanism for CBS’s OTT buildout, in other words paying for Viacom’s content with its own cash flow.  Viacom still delivers 14% of US cable viewership and will throw off substantial cash flow for the next several years. CEO Bob Bakish has executed an impressive turnaround after years of mismanagement under Dauman.  Similar to Disney, subscriber erosion has improved at Viacom as they have been included in vMVPD offerings. Bakish mentioned that subscriber erosion is currently at 1-2% per year. Viacom guided to affiliate fee growth next year after resetting fees lower with distributors over the last two years.  While the market views Viacom as a melting ice cube at 7x earnings, we believe the VIAB earnings stream will be fairly steady over the next couple of years. It is important to note that these earnings estimates include losses from Paramount, which looks to have stabilized at breakeven in recent quarters.  Paramount losses have been as much as a $2/share earnings swing for Viacom. Many estimate that cost synergies in the deal will be in excess of $1 billion annually (>$1/share pro forma).  It is interesting that most of the Street notes we have read on the deal expect very large accretion from an all stock deal, reducing CBS’s EV/EBITDA by more than a turn pro forma.  However, many of these notes also expect the pro forma multiple to compress down to Viacom’s multiple. This makes no sense to us. How could the combined company not be better off than Viacom alone? CBS would almost certainly trade down if a Viacom deal were to be announced; however, we would view that selloff as a wonderful opportunity to buy a growing OTT leader at a seven P/E.  

Basic Model and Valuation

CBS does not provide this level of granularity into its business lines.  The assumptions here are based on company filings, management comments and review of sell side models.  A few assumptions to point out:

• Advertising declines at a 2% CAGR.  We believe this is below management and street expectations.

• Fee income and international growth basically in line with management expectations.  Domestic licensing revenue more than offset with SVOD/international licensing.

• CBS All Access subs/revenue captured in Interactive.

• Margins held flat across all divisions.  CBS believes that margins will scale as fee income becomes a larger percentage of revenue.  We are holding flat to capture increased technology and talent cost as well as higher content spend.

• Initial working capital drag of $750 million to capture content spend in excess of amortization.  This drops to $250 million by 2021.

• Dividend grows at 20% CAGR.  All remaining free cash flow used to repurchase shares at $65 per share.  

Transaction Comps

The table above illustrates a valuation range for CBS in a takeout.  We believe TWX and FOXA are the most appropriate comps. Taking the 12x multiple from Fox gets to a share price range of $80-120 depending on what year.  This obviously seems quite far away from the current trading price, but we think $100 is a reasonable expectation for where CBS could trade in a takeout scenario.

Showtime

If Showtime were a standalone publicly-traded entity, we believe it would be valued at half of CBS’s current enterprise value, yet Showtime only represents about 1/3 of total EBITDA.  Prior to the AT&T acquisition, many discussed the premium multiple HBO would receive if it were to be independent from Time Warner. We believe that AT&T’s acquisition of Time Warner hinged on getting access to HBO, and it is clear they plan to chase Netflix and replicate its business model.  Netflix says HBO is its primary long-term competitor. We acknowledge that Showtime deserves a lower multiple than HBO, but it possesses much of the same appeal. HBO has around 50 million traditional domestic subscribers and 5 million OTT subs, as compared to an estimated 21 million traditional and 3 million OTT subs for Showtime.  In terms of original content as discussed above, Showtime is quickly catching up to HBO. If Showtime were to be spun or sold, we believe that a 15x EBITDA multiple would be achievable, implying a roughly $15 billion value. This compares to CBS’s total enterprise value of $30 billion. One of the reasons that Comcast and Disney/Fox bid up Sky to 17x EBITDA is its emerging OTT service.  Lionsgate, which owns Starz, is valued at approximately 12x EBITDA.

Valuing OTT

We have seen a few analyses attempting to value CBS’s OTT businesses separately.  This interesting but flawed. For one, comparing per sub values for Netflix at 130 million subs to CBS’s 4-5 million subs is irrelevant.  Subs at scale are worth a lot more than subscale subs. We believe that CBS has as good of a shot as any content creator at achieving scale OTT.  If the market wants to give CBS that credit early, we won’t argue too much. If CBS can hit its 16 million OTT sub target by 2022, a $4 billion valuation for OTT is quite reasonable.   

Hidden / Other Assets:

Television City worth up to $900 million.  Received a bid this year, so hired firm to look into sale.  Some shows filmed there but no longer needed for operations and likely worth more repurposed.  

Spectrum – non-CBS owned and operated stations.  Can monetize spectrum through government auctions.  Large buyers of spectrum include wireless carriers that need more spectrum due to growth in mobile data consumption.  Non-earning.

Risks

Accelerating declines in advertising beyond our and the market’s expectations.  CBS is still among the most exposed to advertising as a percent of revenue.  Our base case calls for a modest 2% secular decline in advertising, which we view as conservative.  The TV industry’s deceleration in advertising revenue is particularly concerning given the strength of the economy and where we are in the economic cycle.    Some studies show TV advertising declined in 2017.  As we are late in the economic cycle, a cyclical downturn and the corresponding decline in advertising could put pressure on earnings beyond our expectations.  Advertising flow through is 85%, so a recessionary decline will hurt.  A 15% advertising decline translates into a $1 per share earnings hit.  As an aside, it is interesting that we rarely hear a discussion of cyclical advertising risk for Google or Facebook.  Granted, the secular trends of digital advertising so far have overwhelmed any cyclicality.  However, one of the benefits of CBS’s business model is that its fee income should be more steady in a recession, as consumers historically have not dropped pay TV subscriptions at higher rates during tough economic times. 

Accelerating erosion of the legacy TV bundle.  The ability to achieve CBS’s retrans/reverse comp guidance, the largest growth driver for CBS, relies on clawing an increasing amount income from a smaller pool of fees.  Broadcast retrans fees are already the largest line item in distributors’ content budgets.  On the reverse comp side, CBS receives a fixed fee from its station affiliates (i.e., not on a per subscriber basis).  If sub erosion accelerates, local stations may not be able to afford their reverse comp fees.  We are comfortable with this risk because CBS is still underpaid for the viewership it delivers and is more than offsetting traditional subscriber erosion with OTT subs. 

Customers increasingly access CBS Network through antennas or new digital technologies.  CBS’s broadcast content has always been available free over-the-air with an antenna.  Walmart, for example, has a program that helps customers set up digital antennas as a part of its cord cutters program.  We also recently saw a new non-profit app that takes CBS’s broadcast signal and streams it digitally to subscribers for free.  If customers can easily go around traditional and digital distributors to access CBS’s content, it could put CBS’s retrans guidance at risk.   

Prolonged legal battle between board and NAI.  Apparently, the case will be decided by October and could obviously be settled before then.  However, we do not rule out the possibility that the case drags on longer.  The stock could be dead money until we have some resolution. 

Viacom execution risk.  In the event that CBS merges with Viacom, the short and medium-term outlook becomes more uncertain.  Viacom today is more tied to the legacy pay TV universe than CBS.  It’s revenue growth rate is lower, and results will be more unpredictable with Paramount’s lumpy/volatile income.   This, of course, assumes no OTT revenue synergies, which we believe are substantial and make the execution risks worth taking.  

Just too many shows on TV.  There are over 400 scripted series available today on broadcast, basic cable, premium cable and streaming services.  If CBS is unable to continue to attract viewers either through lack of access to proper distribution modes or its production exaction fades, CBS could lose relevance among consumers and have a difficult time in growing and retaining subscribers. 

Catalyst

Lawsuit resolution

Continued execution on growth plans

Continued OTT sub growth

Industry consolidation