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Starz (NASDAQ:STRZA) has attracted the attention of investors due to its apparent cheapness against other cable networks. Any relative valuation is by its nature inexact but the discount here is clear:

Investors should ask two questions: first, why does this discount exist? And second, is Starz still good value on an absolute basis after its tremendous run YTD?

Explaining the discount

Starz trades at a discount because it has an inherently weak competitive position. The structure of the industry and the company's strategy mean the company lacks negotiating leverage with customers and suppliers. The transition to original programming which this competitive position necessitates is far from riskless.

Industry Structure

Starz is the third largest premium cable network with just under 22 million subscribers. HBO, which is owned by Time Warner (NYSE:TWX), has around 28 million subscribers and Showtime which is owned by CBS (NYSE:CBS) has around 22 million. Starz is usually priced at the same level as Showtime. Both are priced at a substantial discount, as much as 40%, to HBO. Including all the other subscription units, such as Encore, does not change this position.

The structure of this category makes it hard to compete. HBO is clearly the leader and has substantial pricing power. According to Susquehanna, 90% of households that have premium cable have HBO. For distributors, premium channels are a useful source of revenue and the premium that HBO obtains is highly attractive. For the other players, distributors can always trade them off against each other. Any threat to go elsewhere from Starz is pretty weak as distributors can just offer Showtime instead. HBO's lead makes it difficult for anyone else to obtain pricing power in negotiations.

In these negotiations, distributors can choose either fixed rate or variable rate (also known as 'consignment') agreements with Starz. Under fixed rate deals, distributors pay an annual fixed license fee. Under variable deals, distributors pay for each customer. The upside under fixed rate deals is limited, although marketing expenses are lower as the onus is on the distributor to increase subscribers.

Most fixed rate deals are made with large cable MSOs that tend to grow slowly if at all. Variable rate contracts are made with growing MVPDs, such as Verizon (NYSE:VZ) or DirecTV (NASDAQ:DTV). These contracts align Starz with distributors and any upside from subscriber growth is shared. As 60% of subscribers are fixed rate, it seems that future growth is limited. Growth in variable deals has been strengthening year-over-year and recent renewals seem to have been more favorable but the number of fixed rate deals remains a headwind.

So clearly the picture here is of a company facing some headwinds with little pricing power with customers. Why? Why is HBO so far ahead?

Original Programming

The big difference with HBO and Showtime is ownership and original programming. Both HBO and Showtime can use the scale of their parents to negotiate better affiliate fees. More importantly, HBO has 77 hours of original programming, Showtime has 69, but Starz has only 38.

Ownership questions will come later. The key reason why Starz has no negotiating leverage is the lack of original programming. The majority of current programming is output deals with Disney (NYSE:DIS) and Sony (NYSE:SNE). HBO and Showtime make output deals with studios too but Starz really relies on them. Distributors view film content as replaceable. Consumers can watch the same films on DVD and they could have already seen the films at the cinema.

Again, if a distributor loses Starz, they just put in Showtime with HBO, no big deal. Output deals do not make Starz indispensable. The value of moving to original content has been demonstrated at AMC (NASDAQ:AMCX), which previously showed old movies but transitioned with series such as Mad Men and Breaking Bad. To gain pricing power, Starz needs to perform a similar transition.

Starz has been forced into making this move by the loss of the Disney output deal to Netflix (NASDAQ:NFLX). Netflix paid around $350 million, an increase of $100 million on what Starz is estimated to be paying annually. Content will only start coming off in 2017 but pressure on renewals will likely increase in the run-up without any new content. There may be pressure on a renewal with Sony too, although competitors are likely to recognize how important it is to Starz and back off, maybe not before making Starz pay though. Either way, Starz will add 40 hours of original content by 2017. If the company has not transitioned by then, it will be in trouble.

A Risky Transition

At this price, investors seem fairly confident that the company can pull this transition off. With good reason, as the company is led by Chris Albrecht, the former CEO of HBO who is credited with shows like Sex in the City and The Sopranos. My guess is that distributors like Albrecht too, which is perhaps more important. Albrecht will be essential to the success or failure of this strategy.

The transition to original programming is still a risky proposition, even with such skilled leaders. Starz does not have wide experience in the area. To mitigate this risk, Starz has adopted a "portfolio" approach to internal development using third parties to lessen the level of risk.

The Portfolio Approach to Original Programming

The most risky choice is going it alone. Spartacus was developed internally and was modestly successful running for three series, averaging six million viewers per episode in the last season (this was just about the same as the last season of Dexter on Showtime and four million less than Game of Thrones on HBO). Magic City was also developed internally and is now in its second series opening at 3.3 million viewers per episode. Starz bears most of the risk but can monetize success across multiple platforms and regions.

Da Vinci's Demons was developed through a JV with the BBC and opened at 4 million viewers. The BBC paid 33% of the development cost for international rights in the UK and Benelux. White Queen was also developed through a similar structure.

Finally, Starz has licensed from Lionsgate (NYSE:LGF) and the Weinstein Brothers utilizing this structure for Boss and Marco Polo. Neither was successful. Licensing removes the risk of cancellation costs but the upside is limited to rights within its window. Renewing a successful show will also be expensive.

How Much?

Developing an hour of content internally can cost as much as $3.5 million so sharing the cost with third parties is a wise choice. The end of the Disney contract combined with the reduction of films released by Disney and Sony in the near future should open up some margin to develop content. If the company has trouble renewing with Sony then pressure on margins may become significantly more acute.

Estimates of incremental spend needed vary. To get to 80 hours of original programming an extra $150-200 million will need to be spent. Another $50 million of margin will come back in 2017 as Disney rolls off but this is still a substantial amount. The potential rewards are even larger though.

Dropping Disney was definitely the right choice but investors should not forget that to make this strategy work, there will be a period when Starz is paying for both new content and Disney. If the company does not gain any leverage with distributors, this will weigh heavily on profits.

Where Is The Upside?

As we know already, the problem with distributors is the weight of fixed rate contracts. These fees are set to increase about 2-3% annually which will not meet the added spend on original programming alone, although changes in film output deal releases and the mix of wholly owned programming could add more margin. From this perspective, it is hard to be enthusiastic. Revenues are basically fixed while the whole cost structure is overturned. Benefits may never come, if they do it will probably be in 2017. Investors appear to have been swept up in the euphoria around the sector and two scenarios keep reappearing.

First, is a merger. When Starz was spun off, John Malone highlighted the significant synergies that could be obtained in a merger with Starz. Exactly who would be the acquirer, though, is unclear.

Time Warner and CBS own HBO and Showtime, the value of adding Starz for each of them is not clear. Disney is probably happy with the premium that it can obtain licensing to third parties. Comcast (NASDAQ:CMCSA) already owns 6% of Starz but signed a film distribution agreement with HBO for NBCU's Universal Pictures, as did Fox (NASDAQ:FOX). Viacom (NASDAQ:VIA), the owner of number four premium cable channel EPIX, seems the most likely candidate. The question there is whether a combined Viacom/Starz would have enough leverage on distributors, although there would presumably be some useful synergies. I don't know enough about the industry to really speculate on this so I don't think it is worth the risk.

Another possibility is spinning off Anchor Bay, the home-distribution arm of Starz. Anchor Bay has a strategic partnership with Weinstein to distribute DVDs and digital/streaming content. A deal here seems unlikely as Chris Albrecht suggested that Anchor Bay had a lot of distribution capacity and aims to bring in third-party product. The synergies in doing this would possibly be greater within Starz than outside.

Neither of these outcomes look particularly likely. The fashion of the day is to bet on all kinds of far out corporate restructurings, especially spin-offs, but management will rarely see things the same way. It is probably best they don't, especially in industries like media.

The real source of upside here is the company's buyback program. Given the target of 2.5 times OIBDA/Debt, I would guess the company can buy back about $200m per year. Over three years this would reduce the share count by 20%. At some point, this sort of buying will require a new program but I doubt Malone will say no. Due to buybacks, EPS will probably grow faster than the increase in programming costs.

Summary

The upside at Starz is quite tangible and compelling. The buyback adds a lot of value and management has some experience in original programming. To gain any negotiating leverage the company really needs to pull this off, this should light a fire under executives to pull this off.

My concern is that the company is under a lot of cost pressure but has limited scope to improve revenues quickly. If the strategy does not work, it will really go wrong. Negotiating leverage with customers and suppliers could disappear overnight.

For the risk, Starz is probably priced about right. If you believe in the original programming strategy, which I do, then I think Starz looks like a fair bet. Management look pretty good and the company's resources are, in my view, under-utilized. Even if you don't buy this scenario, Starz is one to watch. Transitions like this are highly complex and the road to 2017 will probably be a bit bumpy throwing up a better opportunity for investors.

Source: Starz: Betting On Original Programming