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Cutting the Cord: How Will Media Companies Adapt?

Forget set-top boxes. Innovation and upstart companies are changing the way viewers consume television programming and feature films.

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There used to be a saying in the media world that "content is king." In other words, if you produced the televisions shows and feature films viewers wanted, you had competitive advantages over other companies in the sector.

Does that expression still hold? That's debatable, as the media sector has seen its fair share of innovations that have changed how millions of Americans consume programming. Indeed, no longer do households eat dinner and then watch the news and a hit show that comes on during prime time. Rather, consumers are more likely to binge watch an entire season of a favorite show in one weekend or watch a hit movie on their cellphones or tablets. Then, add in companies such as  Netflix (NFLX) and  Amazon.com (AMZN), which not only have allowed consumers to get around the traditional broadcast television model but are also developing original content.

With the media sector picture changing focus constantly, we recently sat down with Neil Macker, who covers the industry for Morningstar. His answers have been edited for length and clarity.

Can you start by giving us your read on the media sector?

Macker: When it comes to the TV ecosystem, the challenges for media companies are the "cord-cutters," "cord-shavers," and the "cord-neverers." These are the people who are no longer entering into the pay-TV ecosystem or they are exiting or cutting back the amount they are spending in that area. It is something that the mainstream media has been talking a lot about. So, what is happening in that space and what are the interesting things these companies are trying to do to combat that?

If we look at the pay-television market--there are around 93 million pay-TV subscribers in the United States. That number has come down slowly over time, and pay-TV penetration, depending on how you look at it, is around the low 80s. That is down from a high of around 90% four or five years ago. The question for the companies I cover is: Are these people that are coming out of the ecosystem permanently out of the ecosystem and is there any way to draw them back in?

There is some popular reasoning for why viewership is declining. One is lower household formations. Millennials are staying home with their parents and not forming new households. That explains some of the drop. Part of the drop is also based on affordability. If you look at what the pay-TV bundle costs nowadays, it is $70 to $90 a month compared with the content costs of the bundle, which are around $45. That is the amount a media company charges the pay-TV distributors per month on a per subscriber basis. That differential is going to the distributors. One of the things I looked at was what is a way of drawing that profit out, and how can media networks move the price of the bundle down or capture more of that bundle itself? One interesting development is the emergence of new linear over-the-top pay-TV distributors. The first ones I've seen with this are Sling, which is offered by  DISH (DISH), and PlayStation Vue, which is offered by  Sony (SNE).

Sling came out and said there are certain channels that people want to have and we are going to try to provide a subset of those channels. So, for $20 a month, Sling gives consumers access to those channels.

Sony went at it a different way. It is recreating the pay-TV bundle and moving it onto this new platform, which is a PlayStation platform. It has signed up all the major cable channels, and in some markets, it has lined up local broadcasters as well. So, for $40 a month, you can get a very robust package of cable channels plus your local broadcasters.

Now, the question over the long term is, does that value proposition hold up against just buying Netflix or Hulu or pirating it from other places? One of the ways we see piracy is not the traditional way, which is simply people going on to the Internet and downloading a show. The other part of piracy is, for lack of a better phrase, "soft piracy"--where millennials have gone out and formed their own households, but they are using somebody else's password. You are still getting the channels you want, you just aren't paying for them.

Can you go into a little more detail by what you mean by cord-cutters, cord-shavers, and cord-neverers?

Cutting the cord means a consumer no longer has pay-TV. They have decided the cost is no longer worth it. They may be replacing pay TV with Netflix, Hulu, or Amazon Prime.

Cord-neverers are generally millennials who have moved out of their parents' house, but who have never paid for cable. There is no value to them to pay for TV.

Cord-shavers have had pay TV, but they have decided to go down to a much more basic package. They may just pay for a channel like HBO, but they no longer want ESPN.

Do viewership changes depend on demographics?

What we found is a lot of the cord-cutting or cord-nevering is happening on the younger end, and as the customers get older you see a lot more cord-shaving. "I'm not getting the value out of it any more. My cable and phone and Internet bill is coming out to $200 a month. It's just too much. I don't need all these channels. Let's cut back." What is also happening is that when people bought cable TV they were buying network access, right? And that access is part of the cost. However, nowadays if you are also buying Internet from the same company, you are also paying for network access. You are paying for network access twice. So, if we move to over-the-top TV or linear TV, you are paying for network access once. We think that is a more efficient way of paying for that.

Is price the most important determinant for a cord-shaver or a cord-cutter? Or does competition matter, too?

I think it is a little of both. Price is definitely part of it. The rise of Netflix, Hulu, and Amazon Prime has made it such that consumers don't have to necessarily watch a show right when it happens.

So, this idea about a typical family eating dinner and then sitting down to watch a hit TV show during prime time doesn't exist any longer?

That has died off as a general concept. You see that in the ratings for news. Fox News does well. CNN has done well on occasion, as has CNBC. But the ratings for national newscasts have consistently come down. And those viewers who are watching tend to be older.

The way the media sector has been explained in the past is that you either control the content or you control the distribution of that content. But that argument doesn't seem as clear-cut with the rise of such firms as Netflix and Amazon. Is that right?

Yes. These guys are all partners together, too, right? They are all trying to keep that cable ecosystem together. One of the other things to think about is TV works because we all subsidize each other. ESPN costs $6 or so a month per subscriber. But if it was just the subscribers who actually wanted ESPN, it would be a lot more expensive. You hear all these arguments--the average household watches 17 channels so why do they have 200? Well, the next household might not be watching all those channels, but it works because we balance each other out.

As that concept changes, where does that profitability move to? One of the ways we think about media companies such as  Twenty-First Century Fox (FOX),  Discovery (DISCA), and  Time Warner (TWX) is that they should be opened up to whatever pay distributors are out there--Sling TV, PlayStation Vue,  Comcast (CMCSA), or  Apple (AAPL). Figure out the pricing and then be open to everybody. You want as wide  distribution as possible.

Is there resistance to that?

There has been in the past. There has been a little resistance to putting channels on Sony PlayStation Vue when it first launched. But now most companies have come around to that idea. NBC Universal is a little more resistant because it is owned by Comcast.

How do companies such as Netflix fit into the media picture?

The thing you need to remember about Netflix is that most of its content comes largely from traditional content providers. Its library of TV shows comes from  CBS (CBS), from Disney (DIS), from Fox. If you look at its famous original programming, it has financed it, but it still uses traditional movie studios to build that out. "Orange Is the New Black" comes from Lions Gate (LGF). All its Marvel shows obviously come from Disney. Dreamworks Animation does a lot of the children's animation. So, all this original content is coming from the traditional media companies. It has to have that. There is a relationship there that is built in.

Does Netflix go a different way? If you look at Amazon, obviously their back catalog still comes from traditional media companies. But when it does original content, Amazon is the studio. It is doing a lot of the work itself. That is what will be interesting to see about Netflix. Will it move that way--competing with those companies instead of working with them? As we move forward, the world is going to be mix of live and what we call SVOD, or subscription video on demand. That is the world that is out there.

Another interesting company is CBS. It has a channel called CBS All Access. It is linear streams of whatever is on CBS outside of NFL games. It has a video-on-demand library behind the channel. It is streaming the new Star Trek show. It will only be available on the All Access site. That is a really interesting model that you might see some companies migrate to over time.

Are companies such as Sony and Apple trying to control more than your viewing habits? Do they want to control all of the electronics in a given household?

If you look at the Sony PlayStation Vue service, we think it is largely selling it at cost. There is maybe a slight markup, but not a very big one. What Sony is really interested in is locking in consumers. The way to do that over time--maybe there isn't exclusive deals with channels, but there is a better interface, the thing that people have complained about with set-top boxes for years. To have that user experience, that portability of content--that is what people want.

So, that console is the heartbeat of the home.

If we are looking down the road, Apple definitely wants to do that. If you look at Amazon, its products now do smart home stuff. It used to be called the battle for the living room. I think we are seeing that come back.

When you look at the future, are you convinced which companies have the smart business models and which ones will struggle?

We think companies that have a broad amount of content with a strong production studio are the ones that are best suited. There are three media wide-moat names and then there is one wide-moat name on the cable side. Companies like Disney, Time Warner, Fox, and NBC Universal, which is owned by Comcast. We think companies with more narrow content--and maybe leveraged more to one type of content like a Discovery or a  Viacom (VIAB)--could struggle.

The other thing to remember is that SVOD is here to stay. People like Netflix. The content Netflix has primarily invested in is prestige drama and not so much on reality TV like a Discovery or a Viacom. Netflix is also doing a lot of investing into exclusive children's content. So, that might be problematic for Viacom, which is highly leveraged to that area. Viacom is competing against Disney, it is competing against Time Warner, which spent a lot of money buying "Sesame Street." Amazon Prime is also investing in that area. If you are Viacom right now, you are highly leveraged to children's content and reality programming. That is a tough spot to be in.

What about Apple and some of these other firms. Can an investor take a position in a firm like Apple based only on its TV content and distribution potential?

Not really. We are still in the early innings of this game. We will see how it plays out, but we are encouraged to see some of the innovations.

Let's finish up by talking about your coverage list. Back in December, you wrote about how the stocks you cover looked inexpensive on a price/fair value basis. Is that still the case?

Yes. There are still a couple of names that are interesting in this space. We definitely still like Disney. It has moved around a lot. It's trading in the low-$90s currently, but its fair value is $134. Going forward, the key to that name is stabilizing ESPN. Then, Disney Parks is the second piece to that. Shanghai, the park it just built, looks positive. And then obviously the "Star Wars" movies and the continued success on the studio side.

The other name that is trading at a discount that I like is Fox, but it has also has some uncertainty. It has had some things happen over the past year, the most recent being the firing of Roger Ailes at Fox News. We don't believe viewers watch that network because of Roger Ailes. He isn't a personality, but he is the driving force behind it. So, there is a longer-term story there.

The other part of that story is what happens now that the Murdoch sons are running the show. What are they going to do that is different from their father? Another concern for Fox, more so than Disney or Time Warner, is that it has a larger percentage of revenue overseas. It has taken some foreign currency hits.

Does Fox have a Warren Buffett problem, where there is uncertainty around a well-known CEO retiring and who will take over?

It has done a better job with the Murdoch sons and defining roles for them. James Murdoch is the CEO. Lachlan Murdoch is the co-chairman. I still think there will be a hit, but Fox is better suited to weather it than a Viacom with Sumner Redstone. Because of the chaos that will happen--to be honest, it is already happening--that's one we will be watching. Viacom looks attractive on a price/fair value basis, but there is still a lot of hair on the story there. There is a lot that could still go wrong.

What are the risks investors should keep in the back of their minds if they are considering a position in one of the companies you mentioned?

The risk for all these companies is what is happening with the TV ecosystem and the cord-cutters, cord-shavers, and cord-neverers--and whether those trends accelerate. Right now, we are looking at 1 million to 2 million subscribers per year. If that accelerates to 5 million a year obviously all these stocks are going to get hit.

Another key risk: All of these stocks we talked about are a little GDP sensitive. Advertising is GDP sensitive. If we have another big worldwide recession, advertising will go down. One of the things about some of the companies like Disney, Time Warner, and Fox is that they have less than 20% of revenues from advertising globally, versus Discovery, which is about 50%, or CBS, which is above 50%. With all those names, foreign currency is a problem.

This article originally appeared in the October/November 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.

Neil Macker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.