Description

Introduction:

Well….here I go.  I am about to enter the debate that has already begun in earnest on this site about the future of media.  Further, I am about to enter the debate with one of the companies most vulnerable to a future where the cable networks see their economic moats crumble, as they are replaced by among others three members of the all-powerful FANG (Netflix, Google (YouTube sub), and Amazon).  What am I thinking….

Well, I am thinking mostly about valuation.  I am thinking this stock is so cheap that in if its earning power dwindles, I don’t lose too much money.  However, if the future is a bit more rosy than currently assumed for cable networks (and I think it will be), then I might have a once in a lifetime opportunity to purchase a great company at a very cheap price.  I am presenting Viacom as a heads I win, tails I don’t lose so much investment.  

Company Overview:

Viacom (“the “Company”, or “VIAB”) is a cable network that owns such iconic stations as Nickelodeon, MTV, BET, and Comedy Central.  It is estimated that 11% of American’s tune into stations owned by Viacom and that Viacom stations comprise ~20% of viewership.  Its stations are targeted at critical demographics for advertisers and cable.  The Company also owns Paramount studios.  95% of operating income comes from the cable networks.

Sumner Redstone owns ~10% of the Company valued at ~$1.6bn keeping him very aligned with shareholders.  Management has done an excellent job of returning capital to shareholders, returning over 100% of cash flow to shareholders over the past three, five, and 10 years through stock buybacks and dividends.  By the way, I don’t think the ongoing Sumner Redstone saga with his ex-whatever doesn’t matter all that much.  If the lawsuit is right and we are about to go into a protracted court proceeding regarding his stakes in CBS and Viacom, I believe that actually presents a positive catalyst for the stock as that scenario likely results in Viacom being sold.  I doubt that will be the case.  

Within the cable networks, the Company makes money from advertising, affiliate fees (paid for by cable companies in order to offer Viacom’s channels on its stations), and ancillary revenue (merchandise sales, etc.).  

Typically, affiliate fees grow in the mid-single digits during their contract terms and multi-year contracts.  There is a lot of attention being paid to the upcoming Dish renewal. I think a deal with DISH gets done.  In fact, Chairman and CEO of DISH Network Charlie Ergen recently stated that "it would take a lot for us not to do a deal with [Viacom]. but they have to be realistic that their ratings have deteriorated over the last three or four years, in some cases in a material way, and that the world has changed somewhat."

Cable companies are fairly captive to the cable networks due to long-term contracts and the need to provide a comprehensive suite of channels to its customers on a cost-effective basis.  It is very difficult for a cable or satellite company to cancel a large cable network, because users will switch based on whether or not a cable company or satellite provider has a specific channel they like.  Viacom’s channel’s and viewership makes it difficult to cancel them.  Viacom gains additional leverage, because refusing one Viacom station could result in an elimination of all Viacom stations. Viacom’s channel’s represent ~20% of viewership for the cable companies.

Further, the cable networks benefit from large economies of scale primarily in SG&A, which enables them to invest more in content creation.  SG&A as a % of sales is a full 10% lower for the large cable networks compared to the smaller ones.    Content as a % of sales is 6% higher, as the large networks invest more in content both in terms of % of sales and on content per subscriber.  The larger cable networks earn 4% more EBIT margin than the smaller ones.  

Therefore, the large cable networks are able to invest more in content than the smaller guys, which in turn increases their value to the end subscriber making it more difficult for the cable companies to cancel their contracts.  Further, the suppliers of content (studios, production companies, etc.) want to go to the larger networks with their content, because they have the bigger audiences allowing the larger networks to pay top dollar for their content.    

The Threat:

OK, so if everyone believed the industry structure wasn’t going to change, then Viacom wouldn’t be selling for a 9x PE.  The bears would say that the problem with everything I have said above is that it appears that the end consumers of the cable companies aren’t that happy with what they are getting and dropping their cable subscriptions.  Importantly, people aren’t watching less TV.  They are watching it via other methods, like Netflix, Hulu, YouTube, etc, but content consumption has not declined.  Also, the bears would say that because of technological improvements like DVRs, it is easier to watch programming without watching the advertising, making a key source of revenue very vulnerable.  Let’s turn to each of these factors separately.

Cord Cutting

In 2013 and 2014 pay TV lost subscribers at a rate of 0.2% per year and about 1% YoY for the YTD through Q3 2015.  Most customers cutting the cord cite economic reasons and only a minority state that they are actually switching from cable to Hulu or Netflix.  In my opinion, the reason that customers aren’t cutting the cord and switching to these offerings is because these substitutes are more suited towards those who watch less TV than most Americans.  By the way, I think this is one reason why Wall Street is so concerned about cord-cutting, because they probably consume much less TV than the average American and the lower priced substitutes make perfect sense for them.  But it is hard to consume 30 + hours of TV on Netflix each week on a sustained basis.  So why are people leaving cable TV?  Is it that the marginal customers (those consumer much less content) are leaving?   Possibly, but survey data suggests that is only the minority of cord cutters.  The vast majority (~70%) appear to be reacting to the fact that cable bills have been rising at over triple inflation rates for 5 – 10 years.  If the cable companies continue losing 1% of customers per year but raising prices 5% - 6%, then the cable companies will actually be better positioned to continue paying affiliate fees and keep the virtuous circle going.  In other words, the cable companies are pricing their service to where they will lose customers, but gain revenue.  

Also (and importantly), most cord cutters appear to be keeping their internet connections provided by the cable companies.  Remember, Hulu, YouTube, et al primarily rely on the cable providers to actually get into your home.  Cable companies are protecting their turf by increasing the internet portion of the bill much faster than the cable portion of the bill.  I believe they are doing this rather than overtly tying cable and internet into a bundle to avoid the ire of regulators, but the impact will be the same – soon the difference between buying internet + cable will be near the cost of buying internet + Netflix or Hulu or Sling Box.  Eventually, the ~30% of cord cutters who are switching to save a bit of money will be coming back to cable as the arbitrage disappears.

The below is an illustrative example of what I am talking about above.  I am assuming someone is purchasing Hulu for the network shows, sling for ESPN, and Netflix.  It assumes the average all in cable bill continues to grow at 7% per year, but only by raising internet prices.  It assumes Hulu, Sling and Netflix all have to increase their prices in order to invest in content at the rate that the cable networks are investing.  I think you might be able to consume the average 30+ hours of TV in this package.  However, I think most people would still prefer cable to the hodgepodge of other offerings (more content and simpler to access).   Plus, you would likely want to add HBO too, which would erode all of the value saved by switching.  

Advertising

Perhaps the more concerning part of the cable network story is advertising revenue.  Due to DVRs more and more people are skipping commercials.  Advertising is almost 50% of Viacom’s revenue.  The bears raise the question good question - how can a company survive selling ads that the consumers of their programming never watch!  Further, this dynamic is complicated by the fact that while I believe the concerns over cord cutting are overblown, they may not be.  Let’s explore the possible outcomes in both a scenario where cord cutting is increasing prevalent and one where it is not.

Cord Cutting Concerns Overblown

DVR penetration has reached 76% and I think it is safe to say that the impact of this technology on advertising revenues has already been felt.  Further, Viacom was definitely underinvesting in content and I believe a combination of those two factors plus the teenage / kids demographic being more on the leading edge of watching content on Netflix, YouTube etc. has resulted in the advertising declines Viacom has faced.  Interestingly, we are beginning to see those investments in content bear fruit as VH1 and Nickelodeon are actually trending positive and others are trending in the right direction. Advertising revenue actually increased by 1% last year despite all the ratings headwinds the Company has faced.

Looking out further, people’s desire to watch more television does not appear to be changing, and they still are requiring high quality (costly) content.  I think cable companies are going to have to offer video-on-demand for all channels eventually and will likely have packages with ads and without ads (that will cost more).  In other words, I think the end consumer will have to eventually pay more to watch shows without ads.

Cord Cutting is a Problem

If the cable companies are disintermediated, I actually think a decline in advertising revenue is not a foregone conclusion.  I think services like Netflix will be buying content from folks like Viacom, much like the cable companies do today.  I think we will see more tiered pricing structures where consumers choose whether or not to pay a higher price for no ads or watch the ads.  Much of that revenue will be passed along to the cable networks, as they will have similar bargaining power to what they have now with the cable companies.  Netflix, Hulu, et al will be competing for the same customers the cable companies have now and will still face the dilemma of not carrying Viacom content that the cable and satellite companies currently face.

While I don’t know how this will exactly shake out for the cable networks, I believe the relative bargaining power lies with them over the end consumer who is demanding more and more content, but doesn’t want to watch the ads.  In other words, the consumer will in the end have to pay for the privilege of not watching ads.  

Valuation Scenarios:

Permanent Shift in Industry Dynamic

OK, so clearly I don’t think that the cable networks are going the way of the buggy whip.  But, as my wife can confirm, I have been wrong before.  

So, right now cable subscribers are declining at 1% per year.  Let’s assume cost of equity capital is 10%, that would imply that a 9x multiple is appropriate which is a little higher than where Viacom currently trades.  Even if that accelerates to a 5% decline, then we are talking about a 6.7x P/E ratio 8.7x today or a 23% decline in the stock price from here.  Bear in mind that historically the Company has returned 100%+ of cash flow back to shareholders, further de-risking your investment.    

At this point, I am guessing the bears will say that this will all be over in 5 – 10 years, and as the decline in subscribers will result in an inflection point where the cable networks go away.  Five years seems unrealistic to me given that the affiliate contracts are normally 5 year contracts.  Perhaps a more realistic scenario is that the decline in advertising will be rapid and not replaced with increased affiliate fees.  Perhaps that advertising declines will accelerate to 10% per year.  Assuming the Company continues to aggressively spend on content, profitability would only decline 2% per year.  Assuming a WACC of 10% (it is lower right now due to low cost debt, but I am assuming it would increase over time), then an 8x EBIT multiple should be applied in 2020 resulting in a stock price decline of 28%.

Current Industry Dynamic Continues

If the current industry dynamic continues, then I think Viacom will return to its average 3, 5, and 10 year EBIT multiple of 10x representing a stock price of $68 compared to $41 today or 66% upside.  

Conclusion:

Below, I have assigned probabilities to the valuation scenarios above.  My conclusion is that this represents an attractive upside / downside and that the odds skew to the upside, and that you are buying at a 30% discount to intrinsic value assuming the probabilities below.

Catalyst

- Dish renewal

- Cable networks prove to be more resilient than previously thought