Fox Builds Moat With Content

Similar to Disney, management discussed the changing media landscape and its impact on the company's channels. Fox president Chase Carey's remarks concerning Verizon's skinny bundles--offering fewer channels at a lower price--mirrored those made by his counterpart at Disney; Fox believes the current carriage agreement precludes a skinny bundle without its channels. Carey said a change in method of packaging or bundling would require a significantly different pricing structure in terms of affiliate fees. Management also addressed the position of regional sports networks in a potential over-the-top/skinny bundle situation. While Fox remains positive on regional sports networks, we believe they may suffer much more than national sports networks in an OTT/skinny bundle world as they typically appeal to a much narrower slice of the market and charge relatively high affiliate fees.

Excluding the sold direct broadcast satellite business, quarterly revenue grew 2% versus the year-ago period, driven by increases in cable programming (up 14%) and filmed entertainment (up 5%). The broadcast segment disappointed with negative revenue growth (down 22%) even when accounting for the Super Bowl boost in the year-ago quarter. The Fox network continued to suffer from lower prime-time ratings, leading to a 7% decline in advertising revenue. EBITDA decreased to $1.7 billion, down 3% year over year and slightly below our expectations, as the Super Bowl-related declines at the broadcast division offset the gains at the cable network and filmed entertainment divisions.

Global Networks, Growing Content Library Fox's Best Assets 21st Century Fox possesses a vast array of media enterprises worldwide. We believe the company enjoys strong competitive advantages based on its worldwide cable networks, along with its film and television studios.

The filmed entertainment segment generates a number of hit television programs and movies annually. 20th Century Fox owns robust film franchises and a strong television production studio, both of which are important, given our premise that the value of quality content will increase. Its studios currently produce 70% of the prime-time slate on Fox and the majority of the original programming on its cable channels, while also creating programs for other networks, such as Modern Family on ABC. The critical acclaim for the studio's content, along with its willingness to place shows on the right outlet, creates a virtuous cycle that retains the creators of the studio's hit shows and attracts new creators to the platform.

Consumers still consume news and sports programming in real time, not time-shifted on a DVR--a trend that advertisers value. Fox News remains the market leader in news, and its recent growth has turned it into one of the 10 most-watched cable channels. As distributors cannot afford to black out popular channels, we expect Fox to leverage this position into earning higher affiliate fees over the next several years.

The Fox broadcast network provides the company with an important platform for showcasing content, as broadcasters are the only outlet to reach almost all 116 million households in the United States. The network holds the rights for the NFL, college football, MLB, and other sports. We believe the combination of original programming and exclusive sports rights will allow Fox to sharply increase its revenue from retransmission fees and reverse compensation in the near future.

Fox also has a large international cable channel segment, with more than 300 channels reaching 1.4 billion households. Pay television penetration remains below 50% in many emerging countries. While penetration in these countries may never approach the 90% level of the U.S., we believe it will continue to expand in the near future.

Positioned to Benefit From Increasing Content Value We assign 21st Century Fox a wide moat rating. Our guiding premise in media is that the value of video content continues to increase even as the distribution markets mutate. Following the split from News Corp., Fox now operates a global entertainment company that is well situated to capitalize on increasing content value.

The cable networks segment contains a number of outstanding franchises, including Fox News, FX, and a number of regional sports networks. Fox News continues to outpace CNN and MSNBC to remain the number-one cable news channel and one of the 10 most-watched cable channels overall. FX and its new spin-off channel FXX have created a platform for critically acclaimed original scripted shows, most of which are generated and owned by the company. Fox's regional sports networks are in markets across the U.S. and own exclusive local broadcast rights for multiple teams.

Outside the U.S., Fox owns channels in a number of markets. While pay TV penetration in the U.S. appears to have peaked at around 90%, penetration in many markets such as Brazil remains below 50%. While we don't believe penetration will reach the levels of the U.S., we expect Fox, with its established channels, to reap the benefits of increased penetration in emerging markets.

Fox owns one of four major U.S. national broadcast networks and affiliated TV stations in 18 markets (including 9 of the top 10 markets). While network ratings have declined over the past decade, the broadcast networks are the only outlet to reach almost all of the 116 million households in the U.S. Network ratings still outpace cable ratings and provide advertisers with one of the only remaining methods for reaching a large number of consumers.

The broadcast and cable networks also provide multiple outlets for the filmed entertainment segment, which has generated a number of hit television programs and movies. The company currently produces or coproduces 70% of the prime-time slate on Fox. Its studios also produce many programs shown on other broadcast and cable networks, such as Modern Family on ABC, Burn Notice on USA, and Homeland on Showtime. The critical acclaim of its studio-produced content along with the studio's willingness to sell shows to the right distributor creates a virtuous cycle in which the creators of its hit shows have an incentive to launch new shows with the studio and the strong ratings attract other creators to the platform.

While there are a number of bidders for original programming--including NBC Universal and USA (Comcast), TBS and TNT (Time Warner), CBS (CBS), and ABC (Disney)--the revenue and profits for all of these players increased over the past decade. Demand for content remains the driver for revenue and profit growth, as the average adult spends over five-and-a-half hours a day watching TV, according to Nielsen.

Demand for Content Continues to Grow While the media environment is highly competitive, the demand for content continues to grow. Live sport remains the one programming category largely immune to DVR/time-shifted viewing and continues to draw adult males ages 18-49, a key advertising demographic.

We believe the popularity of NFL and college football will continue to increase and their importance to advertisers will also increase, given their live nature. The company's regional sports networks generally stagger the expiration dates for sports rights deals to make entry by a new competitor difficult and expensive.

Given its broad and historically successful production pipeline, we expect Fox to continue to generate hits in both television and filmed entertainment. The growth of OTT and international syndication increases the value of wholly owning content. Despite the growth of viral and other short-form Internet video, we expect Americans to continue to consume original long-form content, making the studios that can generate high-quality content increasingly valuable.

Also helping buoy Fox's growth is the increase in the retransmission fees from cable operators. The company's slate of hit programming and sports programming (such as NFL) helps keep retransmission fee disputes to a minimum. Even if the pay TV industry consolidates, we believe the breadth and popularity of the NFL programming slate will insulate Fox from potential decreases in retransmission fees.

Risks Include Flagging Viewership, Costlier Sports Rights The new business models proliferating throughout the media sector could diminish Fox's revenue growth or profitability. Viewership of its programs could fall below expectations, and advertisers could pull back on their spending, both of which could drag on advertising sales growth. The cost of sports rights may continue to skyrocket, putting pressure on margins. The company may overpay if chairman and CEO Rupert Murdoch makes another bid for Time Warner.

Some observers see the potential combination of multichannel distributors as an attempt to gain leverage with media companies such as Fox. However, we believe any leverage gained by distributors by merging would be minimal against the large media companies, since the distributors still need must-have content, especially from major content owners/creators such as Fox. We have been unable to find an example of one of the major media companies not getting an increase in affiliate or retransmission fees. Additionally, any potential synergies from a merger may also be outweighed by the potential for problems arising from culture clashes and from managing an enormous company.