Description

Starz (STRZA) – Long

Stock Price: $35

Price Target $45

Market Cap: $3.8 b

ADV: $35 mm

Thesis

Starz (STRZA) is a long because it is currently under-earning due to being burdened with extraneous programming costs that will begin rolling off in 2017, stepping up EBITDA and EPS by 20% and 30% respectively. STRZA is also a likely take-out target in a media industry we believe will see significant consolidation activity over the next few years. In either scenario, we see ~30% upside to a 12-month price target of $45/share.

Business Description

Starz is 1 of 3 premium channel networks with 23 mm subs (in line with CBS’s Showtime, smaller than HBO at 32 mm). A premium channel is advertising-free and is purchased by the consumer as an add-on to their pay TV bundle. A consumer will pay an average of $8-$10/month for Starz, often as part of a bundle with some or all of Showtime/HBO/EPIX for ~$15-25/month. Starz nets $4-$5/month as their affiliate fee with the distributor partner keeping the rest as compensation for distributing and promoting the channel. Consumers subscribe to Starz for their original series (Outlander, Power, Black Sails, Da Vinci’s Demons). Starz runs ~80 original episodes annually with theatrical library content (syndicated movies) supplementing the rest of the lineup. Subscribers have been stable and growing at a LSD rate for years.

We believe the above economic model provides Starz with a stable recurring revenue model with zero exposure to the secular concerns about advertising. We also believe Starz is well-positioned as the video ecosystem evolves to less and smaller bundles and more over the top consumption as they can launch their own OTT streaming product much like HBO and Showtime have done this year. Because consumers are used to paying a premium for the channel, there is no bundle of basic channels or advertising revenue to protect, the premium channels are uniquely positioned to continue to grow their businesses even with the backdrop of a slowly declining pay TV ecosystem.

Management

Chris Albrecht has run Starz since early 2012 after having tremendous success at HBO developing original series and has begun to have some traction with his slate at Starz. We believe he is the right person to be leading the company’s transition away from syndicated theatrical content and to exclusive original TV series.

John Malone is a major shareholder owning $200 mm of stock (4% of the economics) and 32% of the vote through his ownership of the high-vote “B” shares. Greg Maffei is Chairman and owns $60 mm of stock. Decision-making to maximize shareholder value is excellent here.

Industry Backdrop

Changing TV Landscape - The television industry is going through important changes. The rise of alternative ways to watch video outside of the increasingly expensive traditional pay TV bundle (NFLX, YouTube, HULU) has driven two important changes in behavior in the US 1) new entrants have taken eyeball share driving ratings for traditional TV down and pressuring advertising revenues  2) millennials are growing up with good enough video outside of Pay TV and are not subscribing to the bundle (“cord-nevering”) resulting in overall pay TV subscribers declining 70-80 bps y/y over the last two quarters. The result of these pressures is reflected in the fully-penetrated basic programmers (CBS, FOXA, DISCA, SNI, VIAB, ESPN) taking down advertising and affiliate revenue estimates and multiple compression. The more exposed stocks are down 10-30% YTD.

Premiums are Different - The premium channels (HBO, Showtime, Starz) positioning is different than the basic channels from the above pressures for two key reasons 1) they are ad-free thus they have no advertising revenue that could be pressured from worse ratings  2) premium channels are sold as an add-on to the bundle and are 25-35% penetrated rather than 100% which means that the people that are subscribing made an active decision that they wanted to pay more for the channel. Subs are slightly growing 2015 YTD for the premiums vs. down 1-3% for the basic channels.

Premium OTT Launches - Because of the lack of dependency on the basic bundle and linear advertising the premium channels are well equipped to launch their own OTT products that the consumer can buy directly rather than being forced to subscribe to a big bundle before having the option to add a premium tier. HBO and Showtime have each launched their own OTT product this year at $15 and $11 per month respectively. Starz has signaled that they will launch an OTT product before the end of this year as well. While it’s still early days, there are 10 mm HH that have broadband but don’t subscribe to the bundle (of which 5 mm of those HH are NFLX subscribers) that could be ideal subscribers for the OTT premiums. Over time, should cord cutting accelerate, that 10 mm TAM will grow which offers a hedge to the premiums to maintain their subscriber base.

The above leads us to believe that the premium channels such as Starz are better positioned than basic channels for the future although by no means are they immune should cord cutting accelerate.

Recent History

Starz Programming Transition – In 2012 Chris Albrecht was hired and Starz accelerated their transition from sole reliance on syndicated movie content from their output deals with Sony (ends 2022) and Disney (ends 2017) to an original programming strategy that has proven so successful for HBO and Showtime. 3-4 years later Starz has ramped up their original programming to ~80 episodes across 6-8 series annually at a cost of ~$200 mm per year. Several shows including Outlander and Power have garnered critical acclaim and impressive viewership ratings. During this transition to a focus on original series Starz has continued to carry both movie output deals with Sony and Disney at a cost of ~$330 mm annually. This transition is on the verge of completion however as Disney begins to roll off in 2016 and will be done by early 2017, saving STRZA ~$150 mm from 2016 levels, partially offset by $60 mm of expense from the Sony output extension, ultimately resulting in what we think will be a net $60 mm of programming cost savings for 2017 with the remainder realized in 2018. Management has guided to these net cost savings falling to the bottom line unless their investment opportunity set changes in the near term.

Rumored Failed Sales Process of STRZA – From September-December of 2014 there were multiple rumors that STRZA had hired bankers to sell the company, culminating with a 12/4/14 Bloomberg article suggesting that none of the likely suitors (including LGF, AMCX, FOX, and CBS) put forth a bid. This news sent the stock from

$34 to $28.   

John Malone & Media Consolidation – On February 11th this year John Malone swapped a portion of his STRZA stock for Lions Gate (LGF) stock and took a seat on the LGF board. Soon after, Malone began publicly evangelizing the strategic importance of content production that drives network and distributor differentiation, and the need for media companies to consolidate and get scale to better compete within an increasingly consolidated distribution industry, and to better pursue international growth. Malone has said that LGF is a natural vehicle to pursue consolidation given their tax-advantaged Canadian domicile.  Then on November 10th LGF announced that both Malone-affiliated Discovery (DISCA) and Liberty Global (LBTYA) were taking ~3% stakes in LGF and David Zaslav and Mike Fries would join the board of LGF along with Malone. We believe this is confirmation of Malone’s scale thesis and a pre-cursor to LGF doing additional M&A.

Starz Operating Trends – Q4 14 and Q1 15 subscriber growth of 800k and 300k accelerated meaningfully which along with renewed M&A speculation post Malone/LGF helped drive the stock from the high $30 to $45. Since then, Q2 15 and Q3 15 saw disappointing sub results of growth of 100k and then a decline of 200k, and Q4 programming cost guidance was higher than expected, sending the stock back down to its current $35 price.

Summarizing the Opportunity

Recent Pullback is an Attractive Entry Price - The market over-reacted on the move up earlier this year on better subs and it's over-reacted on the way down recently on worse than expected subs. While quarterly sub results can be volatile depending on what promotions are being run in the market, note over a longer period of time the trend is higher; subs today are 1 mm higher than they were 12 months ago which is 4% growth in a pay TV ecosystem that shrunk by 80 bps over the same period of time. The higher programming expense in Q4 is mainly a timing issue of when their original series air and are therefore amortized particularly as it relates to their expensive original "Flesh and Bones" that was planned as a multi-season series but was so costly to produce (in NYC) that they cut it short and will air it as a mini-series in Q4.

2017 Programming Expense Step Down - Starz is burdened with carrying a double film studio output deal but this will begin to unwind as Disney rolls off in 2017, providing a meaningful uplift to EBITDA and EPS.

Potential take out - we believe there is a decent chance that a Malone-encouraged LGF acquires STRZA in 2016. There is also rumors that AMCX, CBS, and FOXA looked at STRZA at the end of last year at similar prices to where STRZA is trading today albeit with another year of building out the original programming  slate and getting one year closer to Disney rolling off.

Valuation

Due to the programming expense step down in 2017 our OIBDA goes from $474 mm in 2015 to $573 mm in 2017 and our goes from $2.25 in 2015 to $3.00 in 2017. This puts STRZA trading at 8.7x OIBDA  and 12x EPS. Given the stability of the business, modest growth, and efficient balance sheet and capital allocation we think a market multiple of 15x EPS is warranted yielding a $45 price target at year end 2016.

Conversely, we run a merger model assuming LGF and STRZA merge in a nil-premium all stock deal which is 30% accretive to LGF 2016 EPS, LGF trades to 20x EPS given the excitement around it's consolidator position in media, which results in a target price of $45 per STRZA share.

Catalysts

• Uncertainty in the step-up in 2017 EBITDA decreases as we get closer to 2017.

• Albrecht finds a hit that drives subscriber growth.

• Launch of a OTT direct to consumer product in the US before year end.

• Take-out by a strategic such as Lions Gate.

Risks

• Original programming flops and Starz subscribers stagnate/decline.

• More content spending is required which pressure margins.

• Potential OTT launch costs significant opex and doesn’t generate incremental subs.

• DTV renewal is in Q3 16 and could act as an overhang on the stock and ultimately result in a lower affiliate fee on DTV's ~6 mm Starz subs (25% of Starz's sub base). To sensitize, every 100 bps of rate card compression is 2-3 cents of EPS.

Catalyst

Uncertainty in the step-up in 2017 EBITDA decreases as we get closer to 2017.

• Albrecht finds a hit that drives subscriber growth.

• Launch of a OTT direct to consumer product in the US before year end.

• Take-out by a strategic such as Lions Gate.