What a wonderful 30-year run! Cable system operators and networks have for this long time lived in the best of all business climates for growth and prosperity. This is unlike the airlines, for example, which have experienced violent ups and downs in profitability over this time (see "The Justice Department Flies in the Wrong Direction"). It's unlike the situation for Microsoft (MSFT) and Intel (INTC) and Dell (DELL), who all rode the desktop boom and then faded to shadows in Apple's (AAPL) sunlight. Of late, even Apple has lost considerable luster. Business history is filled with corporate ghosts from their previous dominantly-positioned pasts. But the cable industry has instead been able to power ahead with only a few bumps and scratches over an unusually long stretch of time.
For cable networks and distributors, first admire the long-term pricing power for cable services (shown in the chart below). Price increases have far exceeded the rate of gain of the Consumer Price Index (CPI) for decades and thereby supported the stock prices and earnings growth of the entire industry (even though some companies such as Charter (CHTR) stumbled into bankruptcy even with this pricing wind at their backs).
Source: U.S. Bureau of Labor Statistics.
The post-housing boom collapse in 2007 was the first sign of impending change as most investors had up to then taken it as a given that people in difficult economic circumstances would rather eat dog food than give up their cable subscriptions. Only since 2007 has it become clear to industry cheerleaders that if your home is foreclosed, there's no one at the address to watch the shows and pay the monthly bills.
Moreover, in the lackluster economic growth environment of the last four years, it is becoming much more difficult to continue raising cable service prices notably above the CPI's rate of gain. There are several reasons for this. First, many young people, just after completing their loan-burdened educations, are finding it difficult to find jobs and/or form new households of their own. This is part of a much broader economic and social problem that cannot be remedied quickly and on which the cable industry has no influence, but from which its growth prospects are diminished.
In addition, the great natural monopoly of program delivery via coaxial cable is fracturing; you can cut the cord and now watch free-to-air Aereo for a minor monthly fee or see favorite programs online on Netflix (NFLX), Amazon (AMZN), and others ("over-the-top" or OTT in industry jargon). OTT distribution will be the dominant video delivery system in ten years and maybe a lot sooner - and thereby render much of the legacy cable infrastructure obsolete.
Moreover, the industry is no longer about video signal distribution. It's becoming more about provision of Internet broadband - quite a different business with significant capital costs similar to those in video but with much more competition and a dependency on wireless-service affiliates for an increasingly important side of the business that cable cannot itself provide without breaking its bank. More competition, such as from Google's (GOOG) Kansas City roll-out of ultra-fast (1Gbps) low-priced broadband and dependency on the kindness of mobile-phone strangers (Verizon (VZ), AT&T (T), Sprint (S)) signals an important, tectonic-type of shift in the relative competitive position of MSOs.
Cable networks have also long been on winning streak - indeed one that has been fostering average cash flow margins of around twice that garnered by the MSOs. Yet, even in the favorable recent growth recovery phase of the economy in 2010-12, the industry has not in the aggregate expanded margins. By and large, for both MSOs and programming networks, cash flow margins have been flat for the past three years. And this is prior to the headwinds that are just beginning to blow. Cable networks used to regularly sport operating margins north of 40% and be able to grow subscribers like lawn weeds. But subscriber growth has now stalled and households are already expressing much greater and growing interest in "cutting the cord."
Aggregate Cable Industry Revenues (in $billions) and Operating Cash Flow Margins (%), Selected Representative Companies, 2010-2012.*
Total Cash Flow
*Includes AMC (AMCX), Cablevision (CVC), Charter, Comcast Cable (CMCSA) and networks, Discovery (DISCA), Disney (DIS) cable networks, Time Warner Cable (TWC) and cable networks, Viacom (VIAB) networks.
Because of the high and still rising prices charged to cable-viewing households, there is also now some pressure, in the form of legislation introduced ("TV Consumer Freedom Act of 2013") by Arizona Senator John McCain, to move to à la carte channel selections. The likelihood of any immediate enacted legislation in this area is still remote, but not zero as cable subscribers are becoming more adamant and politically vociferous about being forced to pay for a bundle of 50 channels that they never watch. Most households max out at maybe a dozen or so channels regularly viewed and the other 100 are then irrelevant.
Sure, avid sports fans don't mind indirectly paying the freight for the approximately $5.50 a month that the ESPN package costs MSOs. But why should all of the many non-sports fans have to pay too? Economic studies have shown that in any industry a higher overall profit can be extracted by bundled than by à la carte pricing. Unbundling, even should it be only partially implemented for political expediency, will simply mean that many low-rated networks will be dropped, that popular large networks will have fewer households passed on which to base their advertising rates, and that profitability will be reduced.
Sports rights costs are now more than ever in an exalted league of their own because live sports is the only programming that is "must see, right now." Cable networks have no choice but to pay up. There's no way to get around the prices for rights that are commanded by the NFL or MLB, for examples. Prices for such rights are forecast to continue trending higher by an average of at least 5% to 7% a year for the next several years.
The squeeze on cable network margins will also continue to intensify because there are now not only too many networks but also too many distractions arriving by each addictive moment from mobile device games, shopping-aid and advisory apps, and time spent on Facebook-type conveniences. In the most desirable 18-34 viewing demographic, it's possible to Yelp and Tweet all day long and never find the time to tune into cable's programming, no matter how many networks are made available.
And then there's the thorny retransmission-consent issue that delights broadcast networks and their local affiliates. As the recent nasty spat between CBS (CBS) and Time Warner Cable has illustrated, MSOs - being more immediately and intimately linked by billing and marketing to viewers than are broadcasters - must either pay up or bear most of the wrath of consumers. Fifty cents to a dollar a month per sub to retransmit a broadcast network's signal is nowadays not that unusual and provides the old stodgy broadcasters with an important second revenue source in addition to advertising. (Unofficial estimates have it that within five years, CBS will be receiving $2 per month per sub from Time Warner and others.)
For sure, cable networks and system operators will continue to bounteously generate cash and to possibly continue to massively repurchase shares and/or pay higher dividends. But in my view, the great 30-year run is gradually nearing the end as growth prospects and pricing power dissipates, program acquisition costs rise faster, and margins thus compress. Market history has shown that once industry-wide margin compression begins, it takes a long time (if ever) to reverse. Eventually, some of these pressures may ease if and when the domestic economy starts growing more rapidly (e.g., generating more household formations), and if and when prices for Internet infrastructure services rise.
Such a rise would be good news for MSOs and telecom companies because it would allow pricing to be based directly on how much data consumers use. But it is a mixed bag in the sense that online video providers such as Netflix, Google, and Amazon would likely see their operating costs notably increased. What happens will largely hinge on whether Verizon wins its current challenge to the FCC on "net neutrality." Recent reports (e.g., "Appeals Court Voices Concern About FCC Rule") suggest that Verizon might prevail. If so - and we won't know the outcome for several months - cable MSO shares might then rally on the news.
But in all, given my relatively pessimistic view of macro economic growth prospects going into 2014 (see "The Fed's Twinkie Defense") and the major fundamental shifts that I've described, I don't see how or why industry P/E or cash-flow multiples should or will expand over the next year. Although multiple compressions don't necessarily mean that share prices can't rise further, gains then become far less probable and the risks of holding on increase. For now, after 30 great years, I think that it's game over and I'd rather be a seller than a buyer.
My suggestion is to reduce exposure in Time Warner Cable, Viacom, Discovery, Cablevision, and Comcast - with Comcast being the most diversified and best of the bunch fundamentally and having the most potential to at least hold margins near current levels.