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Stock Strategist

Let's Go to the Video

Fox's cable networks and film studio are outstanding businesses with long-lasting competitive advantages.

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 Twenty-First Century Fox (FOX)/(FOXA) posted good overall results for its fiscal third quarter, and the media conglomerate is on pace to meet our full-year expectations. Although the firm continues its planned investments in film and television, profitability this quarter was steady, and management reiterated its stretch goal of achieving $9 billion of EBITDA in fiscal 2016. Our base-case model assumes a slightly more conservative path over the next few years.

Fox generated top-line growth of 12% growth versus the year-ago period, and gains in cable programming (up 11%) and television (up 27%) were relative standouts. We were encouraged by the 8% increase in domestic performance (advertising and affiliate revenue up 8% and 12%, respectively), but there were also reported foreign exchange headwinds in the quarter that obscured some of the underlying operational gains. Filmed entertainment was the only segment to post a revenue decline (off 3%) though we expect improvements owing to the April release of Rio 2 and continued monetization of television content via subscription video on demand. We continue to watch the firm's broadcast network performance as an indication of not only changing viewer trends but also Fox's ability to monetize its quality content around the year (and via different platforms).

Adjusted operating income came in just shy of $1.8 billion, up 11% year over year, reflective of management's seemingly aggressive (yet necessary) investments and steady operational execution. Adjusted earnings per share for the fiscal third quarter were $0.47, up $0.15 over the prior period. Fox is still a firm that generates $4 billion in annualized free cash flow, and we believe it has carved out a wide economic moat over the years. The current valuation doesn't appear terribly compelling, but this is a solid diversified enterprise that remains on our watchlist.

Pay TV Businesses Continue to Fuel Growth
After its spin-off from News Corporation (NWS)/(NWSA), 21st Century Fox is a pure-play entertainment company with an impressive cable network business that spans the globe. Fox will benefit from our overriding premise in media that quality video content continues to increase in value. We believe the company has a strong competitive advantage based on its global cable network business as well as a film studio that generates TV and movie content and owns a vast library of programming.

News and sports programming tend to be consumed in real time, which makes them less vulnerable to digital video recorders that can skip commercials--a fact not lost on advertisers. Fox's regional sports networks are spread across U.S. markets and benefit from holding local broadcasting rights for college sports, pro baseball, and pro basketball teams. This provides some barriers to entry, as the economics work only if rights to all or most of the local teams are secured. The regional networks space out content contracts with local teams so they are renewed in various years, making it extremely difficult for a competitor to come in and acquire all the rights at the same time. Fox also holds a large international cable channel portfolio that spans the globe and generates more than 15% of the cable segment's operating profit. We think there is plenty of room for pay television subscriber growth in foreign countries during the next decade.

The Fox filmed entertainment studio (about 20% of operating profit) benefits from the conglomerate's worldwide distribution as well as increased demand for quality video content. We believe the high demand for quality television content from the broadcast and cable networks ensures a steady stream of cash flow for the television side of the studio. The TV studio feeds most of its content to its Fox broadcast network, but also places hits on other networks, such as Modern Family on ABC. Also, the studio will benefit from firms like Netflix (NFLX) and Amazon (AMZN) licensing dated programming for their services. We expect capital allocation to consist mostly of share repurchases, and we assume potential acquisitions will mostly complement the current portfolio of pay TV assets.

Quality Video Content Is Key
Last year we increased our Morningstar Economic Moat Rating for 21st Century Fox to wide from narrow. Our overriding premise in media is that quality video content continues to increase in value. We've always viewed Fox as a great company, but uncertainty about the duration of its intangible asset competitive advantage beyond 10 years prevented us from placing it into the wide-moat bucket. As a vertically integrated content company that owns domestic and international channels and much of the content on those channels, Fox should be able to withstand any disruption to its business models over the next 20 years. While there is plenty of debate regarding the long-term viability of the current pay TV ecosystem, we believe content and channel owners like Fox are well equipped to adapt to changes.

Intangible assets are the most common source of moats for entertainment firms like Fox. Most often video (television) content is a core asset of an entertainment firm, and in most countries this intellectual property is protected by copyright laws, which allows owners to license it at their discretion. In markets where copyright laws are not enforced, global firms usually choose to do minimal business. With advances in technology, content is distributed is multiple ways and content owners can choose to license programming to multiple distributors and countries.

We view Fox's cable networks and filmed entertainment studio (about 75% of operating profit) as outstanding businesses with long-lasting competitive advantages. The combination of its television production studios and national broadcast network provides the firm with a sustainable competitive advantage in creating video content. We also think the firm's dominant cable networks are well positioned.

We think replicating the company's large studio and generating consistent hit programs on an annual basis is much harder than people may assume at first glance, even with the emergence of other possible distribution outside of traditional pay TV. Fox offers individual content creators (producers, writers) great platforms for monetizing television shows.

We don't see the cycle of the best content flowing through these channels changing anytime soon, and we think the main existing studios would maintain competitive advantage even with some new entrants. Television content creation and distribution is not a winner-take-all market. Deep-pocketed companies like Apple (AAPL) and Google (GOOG) are often cited as potential threats to video content-generating firms.

Theoretically, it can't be ruled out, but building from scratch is much more challenging than it may seem. For example, Google's YouTube initial business plan for 100 channels has stumbled out of the gate. Also, Google seems more open to working with the media owners through its ChromeCast platform than entering the content-generating industry as a competitor. We see much more competition among the various emerging and existing distributors than among the companies that own the content and the channels. We don’t see Netflix paying for complete ownership of programming (it typically only has the licensing rights for the first two to three years on its originals) as a material threat to content owners as a direct competitor for creating content.

Fox’s cable channels are outstanding franchises. Fox News continues to gain market share relative to its main competition, CNN, and we think there is plenty of room for two cable news networks in the U.S. market. News Corp.'s regional sports networks benefit from holding local broadcast rights for college sports, pro baseball, and pro basketball teams, creating a must-have channel for pay TV distributors in local markets. This provides barriers to entry as the economics only work if you have all or most of the local teams. FX has emerged as a channel with excellent original programming, with most of the content coming directly from the Fox studio.

The company also has a large international cable channel business that spans the globe and generates more than 15% of the cable segment's operating profit. Pay TV penetration is well below 50% in countries such as Brazil and Australia. While pay TV penetration in these countries will never approach the 85%-90% level of the United States, we think there is plenty of growth in foreign countries during the next decade. We think having established channels in foreign markets gives News Corp. a huge competitive advantage and growth runway, as starting a new network can be even harder to get off the ground than in the U.S.

A few risks do exist. New technologies are challenging business models throughout the media sector and could diminish 21st Century Fox's profitability more than we expect. Or the company may increase its exposure to new media; a large acquisition could destroy significant value if the firm were to overpay.

Peter Wahlstrom has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.