By Michael Corty
Misgivings about the role of content owners in the evolving world of pay television could eventually present investors with a buying opportunity. For the first time ever, combined video subscriptions from cable, satellite, and phone companies that we track declined in the second quarter. However, we believe concerns about "cord cutting" have been overblown, as emerging alternatives to traditional pay television still rely on offering compelling content from media firms, regardless of their medium of distribution.
Substitutes to the traditional pay television model such as offerings from Apple (NASDAQ:AAPL), Hulu, Netflix (NASDAQ:NFLX), Roku, and others have generated a substantial amount of buzz, but pay television remains a dominant industry. Roughly 90% of television households receive service from a cable, satellite, or phone company, according to Nielsen. Considering the tough economic times and high unemployment rate in the United States, pay TV subscriptions have been exceptionally resilient. Total subscribers declined just 0.1% during the second quarter and came on the heels of 0.6% growth during 2009.
The average U.S. household is consuming more television than ever, at 8.3 hours per day according to Nielsen. Therefore, we believe consumers are willing to pay for quality video entertainment and still derive significant value from current multichannel subscriptions. Based on Time Warner Cable's (TWC) second-quarter average revenue per customer, or ARPU, of about $72 per month, the hourly cost per household is approximately $0.35, much cheaper than most other alternatives such as a-la-carte streaming or purchasing from Apple when factoring in the amount of content consumed by the average U.S. household. (Netflix's unlimited streaming is much cheaper but has a very limited and dated selection of television shows.) Additionally, consumers have become accustomed to having a wide variety of content available including live news and sports programming, which most substitutes lack.
We recognize that emerging services pose a threat to the traditional pay television model. The battle for a place in America's living room is fierce, and new distribution mediums are likely to attract some pay television customers. However, a major hurdle facing these providers is obtaining enough compelling programming and the high price of content when made available. Without a large revenue base, paying for enough compelling content to compete with multichannel subscriptions will be a major challenge for these emerging platforms.
The cable network business has grown significantly over the past few decades, with overall affiliate fees paid by cable, satellite, and phone companies approaching $28 billion annually according to SNL Kagan. Both the content owners and distributors benefit greatly from this business model. Cable network owners have been careful about keeping the majority of their most valuable content within the traditional subscription model as they do not want to jeopardize risk losing the dual revenue stream of affiliate fees and advertising dollars.
Hulu is one example of media conglomerates holding back their valuable cable network programming. Companies like NBC Universal, News Corp (NASDAQ:NWSA), and Disney (NYSE:DIS) each hold equity stakes in Hulu and provide current broadcast network programming while holding back cable network content. Also, News Corp and Disney were the only media firms to initially participate in the recent Apple TV rental program for 99 cents, with mainly Fox and ABC network programming available.
Given the measured way in which cable network content has been made available, we think media companies are smart enough to manage content distribution wisely. Disney CEO Bob Iger recently commented, "We also are very mindful of what kind of products we make available in what I'll call an over-the-top experience or Internet direct experience, because on one hand we want to reach consumers more often, serve customers, and by doing so improve our bottom line. On the other hand, we want to protect the channel business that has been unbelievably valuable to us, and there's a delicate balance there."
In order to satisfy consumers, we believe content owners and distributors will come together to allow subscribers to access content on multiple devices with an authentication system. Time Warner (NYSE:TWX) was one of the early proponents of this concept, which it named TV Everywhere, and its premium HBO Go service allows subscribers to access content through its proprietary website. HBO customers will be able to stream programming on portable devices by early 2011. Included within the recently extended carriage agreement between Disney and Time Warner Cable (TWC) was access to a new authenticated service, which will eventually allow cable subscribers to view ESPN channels through broadband and mobile Internet devices.
The future direction of the pay television industry greatly affects several conglomerates on our media coverage list such as Disney, Time Warner, and News Corp, which derive over half of their operating profit from cable networks, as well as pure-play cable network firms like Viacom (VIA.B), Scripps Networks (NYSE:SNI), and Discovery Communications (NASDAQ:DISCA). We believe these firms are taking the right steps to ensure that they continue to get paid for their content, even as alternatives to the traditional pay television emerge. Overall, cable network valuations only appear mildly compelling with an industry median price/fair value ratio of 0.97, but we would encourage investors to take advantage of any unwarranted downward stock price movements. New distribution mediums may get the buzz, but ultimately it's the content providers that will dictate the direction of this sizeable industry.
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