US Cable Industry
How I Learned To Stop Worrying About Cable And Love OTT
What’s New: The biggest controversy impacting cable equities centers on the evolution of the pay-tv market. Whether it is cord cutting and the emergence of over-the-top providers or the move towards “skinny bundles” and “a la carte,” investors are worried. We think these concerns are misplaced: we think the value of a Cable MSO may actually increase with every pay-tv sub they lose. The real challenge for Cable is not dealing with the OTT threat but changing the pricing model for pay-tv and broadband. If they succeed, there could be far reaching implications for the Communications Services industry broadly, but also for the Media industry.
Analysis: Our work suggests Cable companies have mispriced their pay-tv and broadband services. Over the last decade the value of broadband to a household has increased tremendously while the value of pay-tv has waned; yet broadband ARPU has barely changed while pay-tv ARPU has
increased by more than 50%. If ARPU was reallocated based on the real value of the service, cable companies would lose money on pay-tv today. Three pieces of analysis inform this view: 1) a framework to determine the “real” value of each service; 2) a cost allocation model that disaggregates truly variable broadband and pay-tv costs; 3) a simple model that shows what a cable business would look like if broadband was priced appropriately and pay-tv was priced as a pass-through. The analysis suggests Cable would be worth more post re-pricing.
Regulatory Considerations: A potential regulatory reaction could pose a significant challenge to broadband re-pricing. Under Title II the FCC has the authority to police retail rates. Regulators shouldn’t object to a re-pricing of broadband for three reasons: first, it is the best shot we have of driving facilities-based broadband competition; second, the total bill would not change for the vast majority of households (and those negatively affected could be “grandfathered”); third, it should lead to improved pay-tv choices and lower content prices for consumers over time.
Thesis Impact: Cable companies are really broadband infrastructure companies, with the best set of infrastructure assets in the vast majority of the markets they serve. Investors are
underestimating the revenue and free cash flow these companies will generate by selling
broadband, both wired and wireless, into the consumer and enterprise markets. If the companies re-price broadband services as we think they should, the disconnect between expectations and reality will be even greater. Finally, we believe these assets are mispriced: infrastructure assets tend to trade at a minimum of 10-12x EBITDA in any market globally compared to US Cable at ~7x (interestingly, European investors seem to have it right). One of the main factors holding Cable valuations back is fear of over-the-top. We think this fear is misplaced for two reasons: first, we think cable will grow pay-tv subs over the next few years by taking share in a gradually declining market; second, and much more importantly, we think all of the future value of these businesses is in broadband. If Cable can re-price its products, DBS businesses would be challenged, and the broader Media Industry may also be challenged (although we don’t cover Media).
Company Note Jonathan Chaplin +1 212 921 9876 [email protected] Spencer Kurn +1 212 921 2067 [email protected] Zach Monsma +1 212 921 7729 [email protected] Vivek Stalam +1 212 921 2079 [email protected]
Cable Companies Lose Money On Pay-TV
Most households purchase pay-tv, broadband and wired voice in a bundle at a single price. The cable companies then allocate revenues to the individual components of the bundle. We think the
allocation decisions have everything to do with how the industry evolved and nothing to do with the value of each service to households. If the services were priced according to the value a household places on them, the cable industry would lose money on pay-tv. If cable companies were able to re-price their services, over-the-top would cease to be a threat (the value of a cable business would rise with every customer that “cut the cord”). We will argue in later sections that they can re-price the products, despite the regulatory overhangs.
It Is About The Communications Services Bundle
Most households purchase broadband and pay-tv together in a bundle at a set price. The prices of the individual components aren’t generally broken out; there is a headline price for a double or triple-play, with additional fees for higher broadband speeds or more content. In other words, 65% of households have no idea what they are paying for broadband or pay-tv specifically; the ARPU that the cable companies report for these products is based on an allocation decision.
Exhibit 1: Households Purchasing Two Or More Services From A Single Provider
% of relationships
Source: New Street Research, Company Data
Broadband Utility Has Sky Rocketed While Pay-TV Has Been Stagnant
Over the last decade the utility of broadband has increased dramatically, while the utility of pay-tv has declined. Intuitively, it seems obvious that households rely on broadband connectivity at home far more than they did a decade ago. In the meantime, time spent and content consumed online has sapped at least some of the value that households received from pay-tv. There is some data that bears this out. First, time spent watching TV appears to have peaked and is now in decline (Exhibit
2). The trend for linear TV is even starker; this peaked in 20081. By contrast, the time spent using
broadband at home has increased more than 2.5x over the last decade; average broadband speeds have increased more than 20x (Exhibit 3); the average data consumed at home has increased 220x (Exhibit 4), and; the functions performed over a broadband connection have become increasingly important to the average household (Exhibit 5).
Exhibit 2: Comparison Of Hours Watched
Hours per day
Source: New Street Research, Nielsen
Exhibit 3: Average Broadband Speeds
MB per second
Source: New Street Research, Ookla, FCC
1 Much of the time spent watching non-linear TV is likely spent consuming content like VOD that is delivered over a broadband connection
Exhibit 4: Average Data Consumed
Monthly GB per user
Source: New Street Research, US Telecom, Cisco VNI, ITU
Exhibit 5: Use Of Internet At Home
% of time spent on the internet
Source: New Street Research, IAB, WSJ
However The Trend In Revenue Attribution Has Been The Opposite
Over the last decade pay-tv ARPU has increased by 56% (Exhibit 6), while broadband ARPU has increased just 10%. The trend in ARPU couldn’t be more different from the trend in the utility of each service to a household. Looked at another way, the cost per hour of pay-tv consumed has almost doubled since 2000, while the cost per hour of broadband consumed has almost halved (Exhibit 7). If you measure broadband based on data consumed rather than time consumed, the
trend is even starker: the cost per GB consumed has fallen by 99% (Exhibit 8)2. Remember, that
ARPU is really just an accounting decision on the part of the cable company roughly 65% of the time. Cable MSOs will argue that the price they allocate to each service in a bundle has to bear some relation to the standalone price of the product, but we will argue that the standalone products are also mispriced.
Exhibit 6: Comparison Of ARPU
$ per month
Source: New Street Research, SNL Kagan, Company Data
Exhibit 7: Comparison Of ARPU Per Hour Of Use
$ per hour
Source: New Street Research, Nielsen, US Census, SNL Kagan, Company Data
2 The metric of hours spent online likely understates the increase in utility of broadband service to households: the time spent online has
Exhibit 8: Price Per GB Of Data Consumed At Home
Monthly price per GB
Source: New Street Research, SNL Kagan, Nielsen, US Census, Company Data
Priced Properly, Pay-TV Loses Money
We are pretty confident that from a consumer value perspective the products are mispriced3;
however, determining the correct price is no easy feat. One possible approach would be to hold the price per hour engaged for pay-tv flat from 2000 onwards, with pay-tv ARPU rising and falling with hours consumed.4 If this holds, the “true value” of pay-tv is perhaps $45 vs. the $81 attributed to
the average household today (Exhibit 9) and the “true value” of broadband is perhaps more like $81 vs. the reported average of $44 (Exhibit 10). At $45 in ARPU, pay-tv would barely cover the cost of content and, once you factor in the other subscriber driven costs that are specific to the pay-tv service, the service would generate an EBITDA loss and an even greater loss in cash flow (Exhibit 13). It appears that the industry has subsidized a money-losing pay-tv business with high-margin revenue from broadband. We will offer a theory for why they have done this in due course.
3 In this section we work with the assumption that the average household has hit its limit on what it can spend on pay-tv and broadband and
that any increase in broadband pricing has to be funded by a reduction in video pricing. In reality it may not be a zero sum game; there may be an opportunity to increase the entire bill. Cable companies will have better data on this than we will; we have taken the most conservative approach here. In addition, it has been pointed out to us that pay-tv can’t be mispriced because 34MM households take a standalone pay-tv product from a DBS company at current prices. While true, we think they can spend what they do on pay-tv because broadband pricing is low; if broadband pricing were higher, assuming their total spend can’t increase, we think they would spend less on pay-tv.
4 This approach for estimating the appropriate pricing for the services is really just for illustrative purposes (cable companies will have real
data on what the market will bear). However, there is some basis for this approach in that the cost per hour of pay-tv consumed was relatively stagnant at $0.12 in the 4-5 years before broadband started to take off and it accelerated quite dramatically as broadband penetration grew. To put this in context, in the decade before the advent of broadband (1990-2000) the cost per hour of TV increased at an average annual rate of 2.5%; between 2000 and 2014 the rate of increase was double that. In fact, from 1990-2000 the cost per hour did not keep pace with inflation (real annual decline of 20bps) while during the subsequent period it grew at 2.5x the rate of inflation.
Exhibit 9: Reported Pay-TV ARPU Vs. Utility-Adjusted Pay-TV ARPU
$ per month
Source: New Street Research, Nielsen, US Census, SNL Kagan, Company Data
Exhibit 10: Reported Broadband ARPU Vs. Utility-Adjusted Broadband ARPU
$ per month
Exhibit 11: Drivers Of Pay-TV Profitability5
Cable Industry (2014); $ per month per pay-tv subscriber
Source: New Street Research, Company Data
Fix the Problem: Re-price Broadband & Pay-TV
The purpose of this section is to demonstrate how the economics of the cable business would change if broadband and pay-tv are re-priced. We reflect an extreme scenario where pay-tv is priced at the cost of content - it is essentially just a pass through. Revenue and EBITDA start at exactly the same point under the current pricing model and our re-pricing scenario (it is just a revenue reallocation exercise at the outset); however, EBITDA and FCF grow at a much faster rate in the re-pricing
scenario. In the following section we will argue that the improved margins and returns will warrant a higher multiple (a double benefit: higher cash flow plus a higher multiple).
In reality, the companies will have good data on demand elasticity and competitive offerings, and pricing will likely fall somewhere between the current model and the re-pricing scenario we reflect here. Nevertheless, the conclusion should be clear: the Cable Companies should consider re-pricing their products and they should do so quickly and dramatically. Our analysis presupposes that regulators won’t oppose the re-pricing (we think they won’t; we will lay out our case in a later section).
The Thought Experiment
We have constructed a simplified version of Charter, for the purposes of laying out our case (we used CHTR because they provide the best disclosure on revenues and costs). We start by simplifying reported revenues into three categories: Broadband, Pay-TV and Other. We then reallocate ARPU by assuming that pay-tv is priced as a pass-through and residual pay-tv revenue is allocated to
Broadband. The resulting ARPU will be different from the “Utility-Adjusted ARPU” that we arrived at in the prior section because we are applying it to a specific company (the prior analysis was based on industry ARPU) and because we wanted a starting point that kept revenue and EBITDA constant. We assume pricing for all of the broadband only and pay-tv only subs are frozen at current levels. Pay-TV-only subs would only be entitled to the lower price points if they take Broadband, and
5 We have built a cost allocation model for each product based on a bottom up analysis of product-driven cost drivers such as installs,
repairs, calls to care, etc. The cost model is still very much a work in progress, so we haven’t published the details here. For the time being, we would treat these costs as illustrative. The point should be pretty clear though; even if non-programming costs are half of what we have estimated, the companies would still make a loss on pay-tv at the lower ARPU.
only subs would be entitled to keep their price until they change their terms of service. With this as a starting point, we run through analyses of how the model would change as pay-tv penetration declines and broadband penetration grows.
Cable Revenues Reconstituted
For the purposes of this exercise we allocate residential pay-tv to Pay-TV and internet and voice to Broadband (voice is just an application that rides over a broadband connection; it is not really a discrete product). We disaggregate commercial revenue into Pay-TV, Broadband, and Other, relying on feedback from the company and TWC disclosure. Finally, we allocate advertising and other
revenues to Other. We assume that advertising revenue tracks total relationships in the scenarios we lay out below; we include it in Other ARPU because it is not paid by the household.
Exhibit 12: Cable Revenues Reconstituted: Old Vs. New Allocation
Charter (2014); $ in millions
Source: New Street Research, Company Data
A Brave New Pricing Model
We assume the Cable Industry re-prices its products, much as the Wireless Industry did when they moved from a regime of variable pricing for voice, text and fixed pricing for data to a fixed price for access (with unlimited voice and text included) and variable pricing for data. The industry will likely have to give households some incremental value, as Wireless did, to smooth the transition. We assume that they can do this without giving up ARPU (as Wireless did). Our reconstituted Cable Revenues would imply ARPU of $65 for Broadband and $88 for Pay-TV at the outset. We then
reallocate revenue with pay-tv priced at $556, which is the cost of content plus the amortized cost of
the set-top-box. The residual revenue is attributed to Broadband resulting in a broadband price of $95 (Exhibit 14). The reallocation or revenue would not impact total EBITDA; however, pay-tv would lose money and broadband would have a margin of 82% (Exhibit 14).
6 We think there is logic in making equipment subsidies explicit, much as the wireless industry has done. We would like households to be
indifferent as to whether they purchase content or a set-top-box from the cable company or some other source. We like the simplicity of a model where all of the value is gleaned from a product with growing utility and that can’t be replicated or replaced - broadband.
Exhibit 13: Cable Revenues Reconstituted7
Charter (2014); $ in millions
Source: New Street Research, Company Data
Exhibit 14: Cable ARPU Reconstituted8
Charter (2014); $ per month per subscriber
Source: New Street Research, Company Data
Impact of Cord Cutting (And Shaving)
In the scenario we have imagined, when a broadband subscriber drops pay-tv service, double-play ARPU would fall from $149 to $95, but EBITDA would rise from $58 to $74. In other words, the value of a cable business would rise with every broadband subscriber that cut the cord (this is how I learned to stop worrying and love OTT!). If 100% of pay-tv customers abandoned CHTR’s pay-tv packages and adopted Apple TV, CHTR’s revenue would fall by $2.8BN (-31%), but their EBITDA would rise by $0.9BN (27%) and FCF would rise by $1.2BN (51%). We haven’t done the analysis on this yet, but we would bet that they would be able to streamline the plant tremendously resulting in lower capex, higher FCF and much higher returns on invested capital. If this proves correct, they would surely garner a higher multiple (more on this later).
7 We adjusted Charter’s CPE Capex by ~$325MM to adjust for one-time all-digital upgrade capex.
8 We attempt to show the economics of the pay-tv and broadband businesses under what we believe to be the correct product pricings.
“Other costs” consists of technical & product support for pay-tv & broadband, customer service split between pay-tv & broadband, advertising, pay-tv franchise fees, and other costs. Due to differing subscriber levels across the pay-tv, broadband, and other segments, the per subscriber figures do not sum to the total.
Exhibit 15: P&L Under New Allocation With And Without Cord Cutting9
Charter (2014); $ in millions
Source: New Street Research, Company Data
Impact of Broadband Penetration Gains
Broadband penetration at Charter is 38% today and it is growing about 250bps annually. With higher broadband pricing, EBITDA and FCF are significantly higher in the Brave New Model than in the current model. A 500bps increase in penetration would generate an 18% increase in EBITDA in the Brave New Model compared to just 11% in the old model. We always thought the cable industry should be able to get penetration to 65% over time, but even at 50% this is a pretty attractive business with $34 / share in UFCF. At 15x UFCF the equity would be worth $316 / share.
Exhibit 16: P&L Under Old And New Model At Different Broadband Penetration Levels10
Charter (2014); $ in millions
Source: New Street Research, Company Data
9 See footnote 7. 10 See footnote 7.
Impact on Consumer Perception (And on Politics)
Cable companies would be the champions of consumer choice and the great enabler of OTT (a nice change from their current image as the price gouging monopolist [I am only partly joking]). Cable companies would be in favor of consumers getting any content they want in any format they want from whomever they want – whether it is one channel or 1,000 channels from one aggregator or dozens of individual content companies. The media companies would be the gatekeepers of how content is bundled and priced (as they are today), and to the extent that consumers are frustrated with their choices or the price they pay, this would have nothing to do with their broadband provider.
The Market Should Bear the Re-pricing
When we present cable executives with our hypothesis they commonly retort that pricing is a
function of competition in the market, but it can’t be (at least not entirely). Where cable operates, almost every household has at least three choices for pay-tv and 45% of households have four choices (Exhibit 17).11 Competition in pay-tv is increasing further with the advent of over-the-top offerings
(Exhibit 18). Most of these are not perfect substitutes for most households yet; but they will increasingly be substitutes as OTT offerings get richer and viewing habits of households continue to change. By contrast, 95% of households have only two broadband choices and only 3% have three (you would be hard pressed to find a market with four) (Exhibit 17).12 Cable companies have taken
up price in the more competitive market and kept prices low in the less competitive market. Again, we attribute this to the competition for content.
Exhibit 17: Comparing Number Of Pay-TV Competitors & Broadband Competitors
% of households with a given number of competitors
Source: New Street Research, FCC, Company Data
11 The FCC’s 16th Video Competition Report estimates that 100% of homes had access to at least two DBS MVPDs in 2013. Additionally, the
same report indicates that Cable’s footprint comprises ~99% of the all homes in the country. We maintain these same assumptions in our analysis. The FCC also estimated that 35% of homes had access to at least four MVPDs in 2013. Our analysis has been updated for Q1 2015, and includes several telecom providers that were not included in the FCC’s original analysis, which raises our estimates for homes with access to at least four MVPDs.
12 The FCC’s 2015 Broadband Progress Report indicated that 3% of households did not have access to 3 Mbps / 768 Kbps speeds in 2013. We
assume that ISPs have increased their speeds since then, and all cable and telecom companies are capable of 3 Mbps+ broadband speeds. We also maintain the FCC’s estimate that cable and telecom each pass 99% of all the homes in the country. Additionally, we estimate cable over builders pass 4.4M homes. We use 3 Mbps+ as the cut off to mirror the FCC’s reporting methodology. Form 477 data is also reported with using this threshold.
Exhibit 18: Over-The-Top Offerings
Source: New Street Research, Company Data
Life in the Real World (Getting From Here to There)
It won’t be easy. First, the industry has a significant number of broadband only subscribers whose pricing they can’t change so easily. To avoid a consumer backlash that might result in regulatory and brand problems, cable companies might choose to allow these households to keep their pricing for a period of time at least. Pricing for these subscribers would likely rise over time until they close the gap with “value-based” pricing. Cable companies could accelerate this process by luring households onto higher speed products with low introductory pricing.
Second, they have a significant number of pay-tv only subscribers who would be delighted to see their bill cut in half; however, doing so would lower EBITDA and FCF. Cable companies could restrict the lower pay-tv pricing to customers that take a bundle. They may lose some customers who are angry that they are not entitled to the lower pricing on a standalone product; however, this might be more than offset by customers that elect to take broadband. Again, cable companies could facilitate this transition with low-priced introductory offers.
Third, the cable companies will be well served by offering a low-priced broadband product to households that can’t afford the higher pricing. It will be important to regulators that broadband penetration not decline as a consequence of the re-pricing. Setting a price and speed for low income households that would not cannibalize the opportunity among high income households might be a challenge, but it is one that can be solved.
These are all difficult transition issues that need to be managed; however, we think they are all manageable (the industry has figured out tougher transition issues than this in the past). The wireless industry managed an equally complicated pricing transition deftly, with no loss of revenues or EBITDA and no backlash from consumers or regulators (see Page 20 for more detailed discussion). The companies will figure these issues out because the businesses are worth more once they get to the other side. We think they should implement the re-pricing quickly, much as wireless did – the longer they wait the more standalone broadband subs they will have to deal with. Getting regulators on board will also be a challenge; we deal with this next.
Regulators Should Love This
“Our challenge – and by “our” I mean both industry and government – is to do everything in our power to ensure that the United States has the world’s most dynamic and competitive broadband ecosystem with a virtuous cycle of new investment, new innovations, and new services. It is a lofty goal. But I have no doubt this is achievable.”
“That future is built on high-speed, competitive broadband choice for both consumers and
companies. By all our actions – again, both industry and government – we must demonstrate that we
all are dedicated to that purpose.” FCC Chairman, Tom Wheeler, September 4th 2014
A big roadblock to the cable industry re-pricing its products is the potential reaction from regulators. Investors seem to think that the FCC would oppose the change and, with Title II authority over
broadband, the Commission can theoretically act to prevent such a move. We are not convinced they would oppose it and we are not convinced that Title II gives them the ability to do it all that easily even if they wanted to. We won’t debate the second point in this report13, but we will provide some
thoughts on why the FCC might not be as opposed to the re-pricing as some apparently think.14 First,
the bill won’t change for the vast majority of households; all that changes are revenue allocation within the cable P&L (those that would be affected could be allowed to keep their current pricing for a period of time or until they change their terms of service). Second, the re-pricing should lead to more pay-tv choice and lower content prices for consumers over time. Third, it should facilitate more investment in infrastructure – facilities-based competition – that would in turn feed innovation and economic growth. Who is not in favor of innovation and economic growth?
Cable Embraces Over-The-Top
The FCC and the DOJ opposed the Comcast / TWC deal because they feared that Comcast would use their increased market power in broadband to favor their own pay-tv business against over-the-top competitors. In the Brave New Model cable is no longer in the pay-tv aggregation business; they are the consumer friendly champions of infinite choice. This is good for the cable industry and it should be good for consumers too. It should improve choice and flexibility in pay-tv and we strongly suspect it will lead to lower content prices for consumers over time. Content companies might not love it, but they will have a hard time articulating a consumer-oriented reason for opposing it.
Re-pricing Broadband Will Drive Facilities-Based Broadband Competition
Tom Wheeler, the FCC Chairman, keeps reiterating that the country needs more competition in broadband. This is about more than just securing more choice and lower prices for consumers; it is about driving investment in the infrastructure that feeds the modern economy. The only active over-builder at present is Google and they have built fiber to an amazing… 600,000 homes. One could argue that their impact has been bigger because it has prompted AT&T, CenturyLink, and others to deploy fiber more broadly, but even with this the overall impact has been on a low-single-digit percentage of households. Fiber deployment costs have fallen but not by enough for Verizon to materially expand their FiOS project from the 15MM homes they first targeted in 2004 (and we doubt
13 It is worth noting that the FCC, in pushing for the Title II reclassification, have gone out of their way to say that they would not regulate
retail rates. Seeking to do so in the context of re-pricing broadband would create both legal and political challenges.
14 Some of the reasons are noted in a piece we did on “Analyzing the Odds of Retail Rate Regulation”, on February 17 (LINK). As noted in
they have earned a return on that investment ten years later). If falling fiber deployment costs aren’t going to drive deployment then the biggest thing that will change the economics of fiber deployment is charging more for the service. We don’t know how much of the country Google and others can afford to cover at current prices, but it would certainly be more if the price increased materially.15
There is an offset: as noted below, the re-pricing will likely hurt the DBS providers, potentially reducing pay-tv competition; however, with the new and steadily improving OTT offering coming to market from the likes of Apple and Google, we think reduced competition from traditional MVPDs may be an acceptable cost. In addition, given the shifting utility of the two services, if regulators had to choose between preserving traditional MVPD options and more facilities-based broadband competition, we suspect they would take more broadband competition in a heartbeat.
More Competition & Higher Pricing Is Better For Cable Than The Status Quo
Cable has to consider whether they prefer a monopoly with service priced at $50 or a duopoly priced at $100. Or more specifically, they have to consider whether they prefer real competition in 20% of their markets with ARPU of $50 vs. real competition in perhaps 50% of their markets with ARPU of $100. We think their businesses are worth substantially more in the $100 ARPU scenario as long as they can capture at least half of the market in the competitive markets. Moreover, once cable gets out of the pay-tv business and everything goes over-the-top they will easily be able to match
Google’s 1Gbps. Given their massive head start and their kick-ass plant with its lower cost structure, it would be surprising if they didn’t keep at least half of the market.
Multiples: Cable Revalued
Cable isn’t a pay-tv business; it is an infrastructure business. Infrastructure businesses, virtually anywhere on the planet, tend to be valued at 10-12x EBITDA at a minimum and, in some cases, at 20-25x EBITDA. Why would a cable business be worth any less than metro-fiber businesses that all trade at 12-14x EBITDA (Zayo; Cogent; Level3), or data centers that trade at 10-15x EBITDA (Exhibit 21). We would argue that they have higher barriers to entry than either of these industries. They may have lower barriers to entry than towers and so deserve a lower multiple, but that is the range: 10x to 20x EBITDA, as opposed to the lowly 7x they trade at today. European investors appear to have figured this out: the public cable companies trade at about 9x and private cable companies tend to trade hands at 10-12x (Exhibit 20). Wireless / cable consolidation may help cable valuations in Europe, but the fact that broadband makes up the bulk of cable revenue in Europe probably doesn’t hurt (Exhibit 19).
15
Google has stated that the single biggest barrier to rolling out fiber to more places more quickly is the disadvantage it faces in
purchasing pay-tv content. The cable industry re-pricing its products may be the Chairman’s only path to more facilities-based competition. See “Here’s The Single Biggest Thing Holding Google Fiber Back.” The Washington Post, October 6, 2014 (LINK)
Exhibit 19: United States vs. Europe Cable Revenue Allocation
% of combined pay-tv and broadband revenue
Source: New Street Research, Company Data
Exhibit 20: United States vs. Europe Cable Multiples16
Based on 2015 consensus estimates
Source: New Street Research, Company Data, Bloomberg
Exhibit 21: Infrastructure Multiples
Based on consensus estimates
Source: New Street Research, Bloomberg, Company Data
Collateral Damage: What Happens To DBS & Media
Media: Negotiating Leverage Might Shift; Content Pricing Could be At Risk
It will be fascinating to see whether the content companies can maintain anywhere near the pricing power they have today if they are negotiating directly with consumers. The prevailing view is that if all content was sold direct-to-consumer that good content would go up in value; bad content would go down in value; the overall pie would remain about the same size. We know just enough about media to be dangerous; however, if our theory that the pricing of content has been disconnected from the value of content is correct, it is entirely possible that the entire pie today is wildly inflated and content in general is overearning. In other words, this might not just be bad for Viacom; it might be bad for Disney also.
DBS: Re-pricing Content Could Pressure These Businesses
If cable is pricing a full suite of pay-tv content at cost, it will be tough for the DBS providers to charge much more. And since they don’t have much of a programming cost advantage, it is tough to see how they remain viable over the long term. DBS was able to take share from entrenched cable incumbents for two reasons: first, they had the lowest cost of distribution that allowed them to price competitively from the outset. There is now a competitor with a lower cost of distribution – OTT. Second, DBS had a better product (more channels; all digital). They have lost this advantage also with the advent of VOD and switched digital.
Some OTT Business May Still Flourish
We think most content will ultimately be sold direct to consumer. Content aggregation businesses will have a hard time remaining viable unless they generate value through some means other than a markup on the content. They will need to be able to deliver the content at a very low-cost (in other words over-the-top). A business like Netflix might continue to flourish as they have: unique,
high-value content of their own that they effectively sell direct to consumer, a low cost of delivery platform with scale, rights to a huge library of content, and algorithms and data that allow it to predict the programming that individual customers will find sufficiently interesting to keep paying the monthly charge.
Appendix
Content Cost Increases Have Crushed Cable Pay-TV Margins
Over the past decade content costs have doubled and the cost to the cable company per hour of content consumed by households has increased by ~125% (Exhibit 22). The industry hasn’t been able to recoup the cost of content despite a 56% increase in ARPU; pay-tv gross margins have fallen dramatically from 65% to 47% (Exhibit 24). How have the content companies managed to exert pricing power of this magnitude at cable’s expense?
Exhibit 22: Average Content Cost Per HH
$ per month
Source: New Street Research, SNL Kagan, Company Data
Exhibit 23: Pay-TV ARPU & Content Cost Per Hour
$ per hour
Exhibit 24: Pay-TV Gross Margins
% of pay-tv revenue
Source: New Street Research, Company Data
The Wireless Case Study
The wireless industry faced a similar challenge when voice and texts started going over-the-top, threatening their largest source of revenues. Data revenue growth was outpacing voice declines, but there was clearly a risk that it wouldn’t keep pace for ever. The industry stopped pricing per unit for voice and text – they introduced a flat “access charge” of around $40 that included unlimited voice and text. They then charged for data based on consumption. Instead of going into decline, as it did in many markets in Europe where carriers failed to make this switch, ARPU accelerated (and neither the FCC nor consumers complained). More recently, the wireless industry has made another move that cable companies could learn from – they stopped subsidizing equipment.
Exhibit 25: Wireless Voice Minutes Of Use
Monthly voice minutes per subscriber
Source: New Street Research, Company Data
Exhibit 26: Wireless Retail Service ARPU
$ per month per subscriber
Exhibit 27: Growth Of Wireless Retail Service ARPU
Growth rate (%) of retail service arpu
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