Description

STRZA owns three premium pay TV networks (Starz, Encore, Movieplex), a DVD distribution business, and an animation studio. However, Starz and Encore consistently account for ~95% or more of STRZA EBITDA, with Starz the more profitable network. Starz/Encore pay for film rights and develop their own content, and then sell the Starz/Encore channels to distributors, such as CMCSA, TWC, DISH, etc. and collect revenues, known as affiliate fees, from their distributors, priced with a mix of fixed and per subscriber metrics. Starz and Encore have approximately 24MM and 32MM subscribers, respectively, which compares to 23MM Showtime subs, 31MM HBO, 15MM Cinemax, and 100MM pay TV households in the US.

Thesis

Starz/Encore is one of three premium pay TV networks in the USA. Importantly, TWX owns HBO/Cinemax and CBS owns Showtime, and both companies are unlikely to part with these networks. This leaves STRZA as the only “for sale” premium pay TV asset in the USA. While people wonder the future of Starz with Netflix and EPIX both growing and offering a similar “movie” option, STRZA has a sticky subscriber base, 35% EBITDA margins, and a ~20% ROA. To recreate STRZA’s business would take years and hundreds of millions of dollars, all bet without any certain outcome (like what NFLX has done/is doing).  While growth has been a modest 1-3% annually over the last few years, Starz is a relatively recession resistant model – no ad exposure and at home entertainment often benefits from recessions as consumers stay in more often. Starz grew subscribers through the last downturn.

Most importantly, Starz is for sale. While this has been rumored in the past, LGF filed a 13-D saying they plan to engage STRZA in merger talks and several media outlets reported Malone wanted to wait three years from STRZA’s spin to sell. LGF is the most obvious acquirer, given its Canadian tax rate, opportunity to combine Starz/Encore with EPIX, and a combined less volatile (for LGF), higher growth (for STRZA) business. However, I believe numerous other media companies could be interested. In particular, any studio would value STRZA’s recurring revenues and ability to self-distribute, while any media company looking to increase scale would be a potential bidder.

Valuation

STRZA has two separate valuations: risk arb and fundamental.

Risk Arb

·        LGF Takeover – STRZA and LGF are engaged in discussions to merge. Assuming a 100% equity deal at current market prices, 10% G&A synergies, and a 20% tax rate, I reach PF EPS of $2.65 per STRZA share ($2.20 per LGF). A 15x multiple would yield $40.

o   While modestly dilutive per STRZA share, the combination would add tremendous value. STRZA would immediately bolster its original programming development, and LGF would have access to predictable recurring revenues, insulating the studio from box office volatility.

§  STRZA would also gain access to LGF’s lower Canadian tax rate.

o   I believe STRZA will see a modest premium if a merger is proposed

·        Non-LGF Takeover – If a second bidder for STRZA emerges, I believe the stock is worth at least 11x run rate EBITDA of ~$500MM, which implies a $45. While a 50% premium may seem high, STRZA was trading in the mid-$40s last summer, 11x is a mere one turn premium to large cap media peers, and any acquirer would have significant synergies.

o   There are 20-30 different companies who could conceivably acquire STRZA, from cable network companies (DISCA, FOXA, CBS, TWX, AMCX, etc.), to studios (LGF, SNE, DIS), to cable/fiber companies (T, VZ, CHTR), to “odd balls” (international players like VIV FP, technology companies like GOOG, streaming businesses like NFLX and Hulu).

o   I’d be modestly surprised if a second bidder emerged for STRZA, given the lack of news leaks indicating any other serious bidder. AMCX, CBS, etc. were rumored to have passed. However, should one emerge, STRZA has the right combination of “rare,” “strategic,” and “optionality” to fetch a high price.

Fundamental

·        Due to the timing of amortization expense from the DIS contract wind down while STRZA original programming ramps, sellside estimates for STRZA are all over the place. However, I believe assuming just a modest incremental savings from the end of the DIS contract (>$200MM expense) yields $500MM in 2017 EBITDA versus guidance of ~$450MM this year, which yields ~$3 per share in FCF. I believe STRZA should trade at least 13x, yielding $39, inline with large cap media names.

o   STRZA has several fundamental catalysts for multiple expansion, notably subscriber growth as STRZA rolls out on Amazon and the T/DTC and TWC/CHTR deals normalize, better understanding of the DIS savings, and my general belief that “TV levered” media names are generally cheap and will rally as the “imminent Pay TV ecosystem implosion” worries die down

Risks/“The Bear Case”

·        Subscriber Declines – As a subscription based service, the number one risk to STRZA’s model is the subscribers begin to decline. Bears see NFLX and Hulu growing with a similar subscription movie/TV offering. They see EPIX, which is a similar pay TV movie channel started by Viacom/MGM/LGF, growing and offering a similar experience to Starz/Encore. However:

o   Starz has grown subs every quarter as a public company and, while Encore has had negative 3-5% sub growth the last few quarters, those subs losses were related to distributor repackaging and have much lower revenue contribution than Starz.

o   Even if subs turn negative, unless declines are massive (>10%), it will only have a minimal impact on revenues/EBITDA as subs are on a mix of consignment/fixed prices and STRZA could cut costs as subs decline

§  Even magazines and newspapers are declining at a modest pace

o   Fundamentally, if you watch movies/premium pay TV content (shows with nudity/you can curse), Starz/Encore are a very good deal. A night at the movies is $75+ for a family of four. Starz/Encore are typically $10 for an entire month. NFLX streaming has grown from zero in 2008 to 36mm today, yet STRZA has grown subs every year in that time. EPIX has gone from zero in 2009 to 10MM today, yet STRZA has grown subs in that time. STRZA is a good deal for consumers and a highly profitable channel for distributors. I think there’s room for all… particularly if STRZA can make the shift towards originals.

o   Essentially, I think the risk here is overblown and would take years to play out.

§  Plus Malone runs it, so he’ll hit a bid or run for cash if he thinks things are looking bad.

·        Loss of Distributors – If a distributor (such as CMCSA, CHTR, etc.) were to stop offering Starz/Encore, STRZA would experience a large drop in subscribers. However, Starz/Encore are sold “a la carte” to subscribers and are exceptionally high margin for distributors, so despite bear fears of STRZA being dropped, I believe this is exceptionally unlikely.

o   For instance, Time Warner Cable sells Starz as a $10 per month add-on to a cable package. They likely are paying Starz $2-$4 per subscriber, so TWC makes $6-$8 of profit per sub. If 20% of TWC’s 11MM subscribers order Starz at $10 per month, that means Starz directly contributes ~$185MM in profit to TWC (~$7/month/sub x 12 months x 20% penetration x 11MM subs). If TWC drops Starz, they will immediately lose that $185MM in annual gross profits which had minimal additional opex needs (literally maybe you need a handful more customer service reps, some servers, that’s it). They are highly incentivized to not only keep STRZA but to grow sub count.

o   This contrasts with basic cable channels. Time Warner Cable pays SNI about $0.25 per month for The Food Network. However, it is sold as part of a large bundle (i.e. – “$50 per month for 100 basic cable channels”), so TWC’s profits are not directly tied to offering The Food Network (TFN). Thus when SNI and TWC sit down and discuss that $0.25 affiliate fee, it is largely a zero sum game. In this theoretical example, if TWC thinks they can drop TFN and not see churn greater than 50bps as a result, then TWC would cut TFN.

o   Note: This is why it is so important for the various cable network companies to have scale and own many networks. When SNI and TWC sit down to discuss fees, SNI doesn’t just negotiate TFN. They negotiate TFN, HGTV, DIY Network, The Travel Channel, etc., which makes TWC less able to threaten to turn SNI’s channels off because it will piss off too many customers.

§  Also note: This is exactly why different cable network companies (DISCA, TWX, SNI, etc.) may be interested in buying STRZA – to gain scale and have the ability to push back against distributors.

·        Rising Content Costs – With Amazon and Netflix buying up content, the price of film rights has increased. Essentially, for its non-original content (which is almost all movies), STRZA goes out and acquires the right to show films on its various channels and pays content producers (SNE, DIS, Lions Gate, Universal, etc.) for that right over a period of time. Further, STRZA is increasing its original content, which typically costs more than acquiring others content. It also has more revenue potential long term than acquiring content. With more people bidding for content and more originals, bears are worried STRZA will see margins compress. However:

o   STRZA does not expect licensed content price increases to impact margins in the near future and they have excellent visibility. STRZA knows its licensed content costs years in advance. These are long term contracts largely at a fixed rate (can go up or down depending upon how certain movies do at the box office, but that is a minor part).

o   Where STRZA could see declining margins is if management decides to increase upfront spending on originals above their currently expected pace. Essentially, they could only miss on costs if management decided to miss on costs.

o   HOWEVER, this is where owning a Malone company is easy. Management has said, through a variety of financing options (partnership, co-producing, pre-selling international streaming rights, etc.), that margins should be stable as they increase original content. Management gets paid for EBITDA growth, and Malone is a “by the pennies” kind of owner. If Malone is telling people “don’t blow up on margins as you expand original content,” the management team won’t blow up on margins because they’ll get fired if they do. This is not some company with a captive board that cares more about keeping their and managements’ jobs than shareholder returns.

·        STRZA Could Be “Cut Out” as the Middle Man in an Over-the-Top (OTT) World – Ignoring STRZA’s originals, all STRZA does is acquire rights to films and distribute them on its TV channels. As the world heads towards OTT, there is a risk that the film producers distribute their films directly to consumers without the need for Starz/Encore, and STRZA subs wither away with the content declines. However:

o   At worst, this will take a very long period of time

o   More realistically, STRZA already has the subscriber base, revenues, and customer relationship to pivot from purely linear to linear + OTT

§  Management is not blind to this risk and is gradually repositioning STRZA by an improved app and adding Amazon Prime as a distribution partner

o   Further, STRZA management acknowledged the need for original content several years ago, hired Albrecht, and has significantly expanded owned content. If STRZA establishes itself as viable HBO/Showtime competitor, STRZA can’t be “cut out” because they will control their content.

§  A merger with LGF or another large studio could significantly enhance STRZA’s original content strategy

o   Further, if STRZA subs start to turn and content doesn’t work, Malone will cut the originals budget to preserve cash flow/margin and hit the bid and sell to someone at a price lower than he’d demand today.

Catalysts

·        Takeout News – Enough said.

·        Subscriber Growth – In December, STRZA announced it was partnering with Amazon to distribute Starz via Prime, which adds 10MM broadband only homes to Starz’s addressable market. Starz also aims to grow internationally, which is an untapped market for Starz at present.

·        Further Hit Shows – STRZA is starting to ramp originals from 20-30 hours a year to 80-90 hours. CEO Albrecht has finally had enough time to build a team and all the new shows are his picks. Some, like Outlander, Power, and Black Sails, have had decent ratings. If any breaks out and becomes “a hit,” it will have a significant benefit to STRZA stock, as the market will “believe” the STRZA story.

·        Disney Savings Better Understood – Management has been tongue in cheek about how much of the DIS savings will drop to the bottom line. However, management has indicated significantly more will begin dropping down in 2017 and into 2018 and that managements plan is to reinvest some, but not all, of the DIS savings. As the earnings picture becomes clearer, I believe STRZA shares can rerate.

Strategic Value – All Companies

·        Direct Subscriber Model

o   I believe the single most under-appreciated feature of Starz, as well as other premium TV options, is the significant value in a large subscriber base voluntarily paying directly for your product

§  Predictable revenue streams are hard to come by, and are of particular value in television/film content where there is significant demand for big budget productions but the risk of a miss in a non-presold fashion can mean disaster

o   Simply put, it is very difficult to reach 24MM monthly subscribers, or about one in five US households

§  For instance, Time Magazine’s peak subscription was 4.6MM households

§  I can only think of nine companies with a US subscriber base in excess of 24MM paying >$5/month directly for a product – the four large phone companies (T, VZ, TMUS, S), Netflix, HBO, Comcast, Costco, Amazon

o   We can squabble over how direct the consumer/Starz relationship really is, but there is tremendous value in STRZA’s subscriber base, particularly to anyone with a film/television studio

·        “The Next HBO”

o   STRZA management is essentially trying to create Starz in the HBO/Showtime mold of original, cutting edge, high production value original content

§  There’s a place on TV for long for serialized shows with cursing, nudity, adult topics, etc., etc.

o   As STRZA has yet to have a hit show (though Outlander close), many bears doubt STRZA’s ability to execute on developing hit content. It’s fair point and I have little push back.

o   However, STRZA is not valued like a hit making content factory, either.

§  If the market believed STRZA was the next HBO, it’d trade >20x EPS

o   CEO Albrecht has a strong pedigree, having developed numerous hit shows at HBO, such as The Sopranos, Game of Thrones, Band of Brothers, Sex and the City, Entourage…

o   Any acquirer who would like to acquire a talented production team “on the cheap” could be interested in STRZA

§  For example - SNE, LGF, DIS, FOXA, and others with studio/production currently or an interest in getting into content production (VIV FP?, NFLX?, Softbank?)

·        No Ad Dollars

o   While the fear had died down lately, a significant concern facing cable network companies is the risk ad dollars shift from TV to digital

o   STRZA has zero exposure to ads and is 100% subscription based

o   Any cable net who wants to lower their overall exposure to advertising could be interested in STRZA

§  For example – DISCA, FOXA, TWX, SNI, etc.

·        Scale

o   As the distributors are consolidating (CMCSA/TWC/CHTR, T/DTV), many cable networks fear that larger distributors will demand lower affiliate fees going forward

o   The cable networks are seeking scale to combat this (for instance, FOXA trying to buy TWX)

o   In particular, the smaller cable nets (AMCX, SNI come to mind) are in a particularly dangerous situation and likely need to combine

o   Further, if STRZA were combined with a strong cable network collection (TWX, CBS, DISCA, etc.) at the bargaining table STRZA could almost certainly demand higher affiliate fees, which would be probable, pure margin revenue synergies

o   I believe almost anyone with a cable network business would be interested, on some level, in buying STRZA simply for scale

§  DISCA, FOXA, TWX, SNI, AMCX, DIS, VIA, CBS…

·        Captive Distribution

o   Many content producers would like to directly distribute content and “cut the middle man out”

o   SNE, for instance, licenses its first run films to STRZA. They could purchase STRZA and have control over their distribution.

o   I think any media conglomerate, and potentially any large studio, could be interested

§  LGF, SNE, DIS, Universal (CMCSA), etc.

·        Distributors

o   The more content a distributor owns, the more relevant they are in the overall “media world”

o   TWX used to own TWC, Comcast owns NBC and Universal, etc., etc.

o   VZ, T, CMCSA, CHTR, etc. are all potential buyers

LGF Merger

·        In my opinion, the three largest drivers of an LGF merger are tax savings, a potential combination with EPIX, and fundamentals

·        Tax Savings

o   Simply enough, this would be an inversion. The tax rate on the combined company isn’t clear, but it will almost inevitably be somewhat lower, the wildcard of government rule changes notwithstanding

o   Additionally, should a combined LGF/STRZA become a platform for Malone to acquire additional assets, the tax rate could be key

·        EPIX

o   EPIX and Starz/Encore are similar “movie channels,” and both suffer from fears of being ignored/cut out as TV goes OTT

o   LGF owns 31% of EPX, with Viacom (Paramount) owning 49.7% and MGM the rest

o   If Starz merges with EPIX, LGF/STRZA could create a very strong film offering and position EPIX/Starz as a wide variety premium film plus Starz originals offering

o   I consider this “upside optionality”

·        Fundamentals

o   The biggest flaw to the studio business model is that studios take upfront risk on new content, where success is difficult to predict. The biggest flaw in Starz’s business model is that people wonder about their place in the ecosystem if their new content strategy fails.

o   By combining, LGF gets access to a predictable stream of cash flows that can significantly reduce the volatility inherent in their studio business, particularly the theatrical studio. STRZA on the other hand significantly increases its owned content library, could benefit from first look on LGF television businesses, and wouldn’t be so “at risk” every time a major film deal comes up, like SNE will in 2022.

o   Starz gets a clearer picture of its place in the ecosystem, and LGF gets less volatile, which should allow both to trade at a higher multiple

o   Further, STRZA and LGF could allow investors “dream the dream” of a self-distributing film and TV studio with domestic and international growth potential