Cable networks have been the best performing and most coveted assets across the entire media business landscape for two decades. "Old media" subgroups like radio, newspapers, broadcast television and cable television systems all saw their valuation multiples peak in the late 1990s amidst a flurry of M&A activity and subsequently drift into the mid-single-digits today (as measured by enterprise value to operating cash flow).
Cable networks continue to command premium valuations in the public markets. The competitive forces and technological threats that have flattened growth and valuations for old media assets have, to date, not negatively impacted cable networks. Indeed, unique among legacy media assets, cable networks have continued to deliver double digit revenue and OCF growth and solid value gains over the last two decades, with only a slight hiccup in the teeth of the 2009 recession.
Without question, investors have witnessed the golden age of cable networks and the value created for media companies and their shareholders. By our estimate, more than $200 billion of value has been created by this industry since 1990. Perhaps only in the context of Google (GOOG) and its $200 billion of value created since 1999, Facebook and its purported $100 billion of value created just since 2004 and, of course, the astonishing value created by Apple (AAPL) in recent years does the performance of the collective cable network industry lag.
A quick look at the economics of cable networks provides the explanation for this massive harvest. The pay TV ecosystem in the United States has nourished the cable networks (and vice versa) and delivered the platform for this growth. Today, approximately 100 million U.S. homes and businesses pay an average of $68 per month to a cable or satellite operator for about 90 channels of video programming. The pay TV providers, in turn, pay some $20 per subscriber per month to the cable networks in carriage fees that aggregates to roughly $24 billion per year. Add U.S. advertising sales of $25 billion in 2011, another billion or so for the sale of content to alternate distribution outlets and a $50 billion annual revenue industry with 40+% cash flow margins comes into focus. And that excludes the contribution from international networks that is especially significant for ESPN, CNN, MTV and the Discovery networks.
The good news for cable networks is that advertising sales trends remain strong on a demand and cost per thousand (CPM) basis such that the industry's ad revenue growth rate of 11% in 2011 is likely to meet or modestly exceed that pace in 2012, though certainly aided by a few non-recurring events like the London Olympics and the U.S. elections. And for those cable networks with a meaningful international presence, the growth rates of non-U.S. businesses has, for the first time in many cases, passed that of the domestic business.
The less good news is that while cable and satellite carriage fees are expected to rise at the healthy, but lower, rate of 7% this year on a per-subscriber basis, the days of U.S. pay TV subscriber growth are over, probably forever. That 2012 will be the first year in the 33-year history of pay TV in the U.S. that subscribers will decline from the previous year is no longer really in dispute; the question will be the magnitude and slope of the decline. The factors at play are well documented but the fact is that younger people are paying for TV at lower rates than that of previous generations. We see that downward slope of pay TV subscriptions fairly benign, but investors will be forced to think about a world in which cable networks are finally maturing assets.
With these fundamental considerations in mind, let's take a closer look at the investment opportunities in this space.
Ninety percent of the value in the cable network business is lodged in the media and entertainment conglomerates: Disney (DIS) owns 80% of the ESPN group and all of ABC Family and Disney Channel; Time Warner (TWX) owns HBO, CNN, TNT, TBS and Cartoon Network; Comcast (CMCSA) owns 51% of CNBC, USA, E!, Golf Channel, MSNBC, part of Weather Channel and various regional sports channels; Viacom (VIA) owns MTV, Nickelodeon, VH1, Comedy Central, BET and Spike TV; News Corporation owns Fox News, Fox Business, FX and Speed Channel and Liberty Media (LMCA) owns Encore and Starz. Investors are forced to calculate implied valuation multiples for the substantial cable network assets within these media and entertainment giants, no simple task considering the range of assets, varying levels of disclosure and minority interest deductions (for DIS and CMCSA).
The valuation exercise is much more straightforward and revealing for the publicly traded pure plays that represent about 10% of the industry's value -- Discovery Communications (DISCA), Scripps Networks Interactive (SNI), Crown Media Holdings (CRWN) and Outdoor Channel (OUTD).
DISCA is an exceptionally well-managed cash flow machine that produced $1.9 billion of OCF in 2011 (+13%) on revenues of $4.2 billion (+12%). International revenue was 34% of the total, likely the highest percentage of any family of cable networks in the industry. Perhaps the most impressive metric from DISCA is its U.S. cable network OCF margin of 57%, indicating operating leverage that may be among the most robust in all of American business. While DISCA pays no dividend, it deployed its substantial free cash flow toward $997 million of share repurchases, retiring 6.5% of its stock in 2011. Investors expect more of the same in 2012 for each of the above data points.
But with the stock up 28% YTD and up nearly 300% since the beginning of 2009, are DISCA shares still attractively priced? We would argue that they are not, especially on a relative basis. The stock trades at nearly 5x expected 2012 revenue and nearly 11x expected 2012 OCF, multiples usually associated with the fleeting fascination in small companies in the Internet, technology or biotech space. While it's hard to bet against a company hitting on all cylinders and one that's likely to return half of its $2.14 billion of OCF to shareholders this year in the form of more share repurchases, a pause in DISCA's ascent seems likely if for no other reason than its rich relative valuation.
For investors, we would argue that SNI, CRWN and OUTD each offer much better value than DISCA and come with the added benefit of potentially participating in a favorable M&A event.
Like DISCA, SNI has been an excellent stock market performer, up 13% YTD and nearly doubling over the past three years (excluding its currently 1% dividend yield). Yet investors can buy SNI's $1.1 billion of estimated 2012 OCF from Food Network, HGTV and Travel Channel for a relatively modest 7.75x. While SNI will likely grow revenue and OCF at a rate 200bps below that of DISCA going forward, there is more margin for error at SNI's much lower valuation multiple. Like DISCA, SNI repurchased 7% of its shares outstanding in 2011. Unlike DISCA, SNI pays a 48 cent annual dividend and has the financial capacity to raise it meaningfully in the near future, perhaps as soon as its earnings release on May 3.
CRWN is a stock market orphan because 91% of its shares are owned by the Hall family of Hallmark Cards and the family acquired the bulk of its stock in a controversial debt-for-equity swap a few years ago. It is a decent story operationally -- two unexceptional, family-friendly cable networks called Hallmark Channel and Hallmark Movie Channel that are growing OCF nicely, owing to solid ad sales activity.
But the reason to own this stock is that there is simply no reason for CRWN to be independent; its networks fit nicely with DIS, DISCA or even NWS, and an acquisition of CRWN at any reasonable multiple would be immediately accretive to every buyer in the industry. CRWN's valuation metrics are quite modest at 7.7x expected 2012 OCF despite the company's weak 36% cash flow margin in 2011, 20 points below that of DISCA and 14 points below SNI's domestic operations. But, perversely, we view this as only a slight negative: prospective buyers of CRWN know that they can, almost overnight, take perhaps $50 million of annual operating expenses out of CRWN's cost structure.
Attributing only half of those cost savings to CRWN shareholders (but leaving certain revenue gains to accrue to the eventual buyer: our estimate is another $25 million annually) and putting a 9x OCF takeout multiple on CRWN shares yields a price of about $3, twice the recent share price. The challenge here, of course, is that a somewhat reclusive and possibly irrational shareholder is in control and minority holders, despite their growing discontent, have zero influence.
But with the industry maturing and the prospect of higher capital gains looming in 2013, it would indeed be irrational for the controlling shareholder not to explore a sale of CRWN very soon. Our view is that the value of the CRWN assets are of maximum value now to strategic buyers, before the subscriber decline slope steepens.
As for OUTD, given its small size as the operator of a single cable network aimed at outdoor enthusiasts, it understandably trades at the lowest multiples in the industry. At just 1.5x expected 2012 revenues (compared to 4.9x for DISCA and 3.8x for SNI) and 7.3x expected 2012 OCF (and considerably lower still when looking at 2013 OCF as management has stated that it plans to invest in programming in 2012, impacting OCF), OUTD is also a stock marker orphan. It has more than $2 per share in cash on its balance sheet and is improving efficiencies in a non-core business unit that will likely boost its M&A attractiveness.
Given the low trading volumes and corresponding lack of institutional interest in this name, our view is that OUTD will be challenged to attract investors absent a sale of the company. We think that the OUTD board should simply go private with a private equity sponsor or run an auction that could yield $9.50-$10 per share from a trade buyer like NWS, CMCSA's NBC Universal or even ESPN.
The golden age of cable networks may be sunsetting, but we believe that there is a final round of investment returns, likely driven by a final round of consolidation, to be had for patient investors.