Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Media stocks have been under pressure recently as concerns about cord-cutting continue to pop up. I'm here with Matt Coffina--he is the editor of Morningstar StockInvestor newsletter--for a look at the sector.
Thanks for joining me, Matt.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's talk about these fears about cord-cutting. Do you think these are legitimate? Do you think there really is this secular shift away from these bundled packages to people purchasing more a la carte?
Coffina: I think the fears are definitely well founded. I think there is some very real risk here, but I also think that it's easy to overstate the pace of change in this industry. Anybody who has used Netflix (NFLX) knows what a great customer experience they provide. There is no advertising. The service is way cheaper than a cable bundle: You're talking $10 a month instead of $50 to $80 a month. You're able to choose entire seasons on-demand, watch straight from beginning to end. It's given rise to this idea of binge watching. Increasingly, Netflix has some great original programming, so you really do have to wonder, from the consumer's perspective, why people need cable subscriptions going forward.
On the other hand, I think investors ought to keep in mind that the average American watches somewhere around five hours of television per day, so this really is our primary leisure activity. People are devoting a huge chunk of their time to watching television. And for most people, Netflix, Amazon Prime, Hulu, and similar services are just add-ons to their traditional cable bundle. Most people are not actively today cutting their cable subscriptions. This is starting to change. In the past couple of quarters, for the first time ever, we've seen total cable subscribership in the U.S. start to decline; but it's still only declining at maybe 0.5% or 1% a year, and it's quite possible that it will accelerate as you get more and better streaming options available. But for most people, they want a lot of content, and they are willing to pay up for the content. As much as they gripe about their cable bills, their actions show that they are willing to pay for content, and it's really up to the traditional media firms to react to the great user experience that Netflix is providing and make sure that they maintain their relevance.
Glaser: So, how different are the economics for media firms in a streaming world? Will they have to make big changes?
Coffina: I think if you just look at the price differential, you can see that if people drop their $50 to $80 cable subscription and just go with a $10 monthly Netflix subscription instead, that's really going to be trouble for the media companies. No matter how they split up that pie, the pie is going to shrink dramatically. As I said, this hasn't really been happening historically. If anything, Netflix has just been an add-on to traditional cable bundles. The majority of Netflix subscribers or Amazon Prime subscribers also have a traditional cable bundle. So, it's really just been adding to the pie so far, but we do need to be concerned about what happens if people decide that Netflix is enough. It really could disrupt the economics of the business model.
So, by investing in media companies--and, in particular, wide-moat content companies, which is where our focus has been--you need to have a certain amount of faith that people are going to continue to want and desire a traditional cable subscription, and I think that the form of that is going to evolve over time. So, I think you're going to see more on-demand content; you're going to see less advertising and more targeted advertising. But in some form or another, people still need to be paying $50 to $80 a month for a cable subscription--maybe that comes down a little bit to $40 a month. Maybe some companies are cut out of the bundle; maybe you take some economics away from the distributors. But either way, the vast majority of people need to continue paying those sorts of prices for something similar to the traditional cable subscription for the media stocks to work over the long run.
Glaser: So, which of the firms in the media landscape are going to be the best positioned?
Coffina: I would say, first of all, the companies that are worst positioned would probably the satellite companies. They don't really have the technological capabilities to deliver high-quality high-speed Internet. It's just not feasible through a satellite connection, so I think you're seeing companies like DISH (DISH) focus on owning wireless spectrum. They have their Sling TV streaming offering. They are trying to move away from that core satellite linear TV business. DirecTV sold out to AT&T (T), and I think they are going to have to make some strategic changes as well to remain relevant.
The traditional cable companies--the Comcasts (CMCSA) and Time Warner Cables (TWC) of the world--will probably do OK. There's certainly some gross profits to be lost on the video subscribers if you see a more serious erosion of video subscribers--either people just cutting the cord or, in my view, more likely people adopting some new alternatives that are likely to come out over the next five years, whether they are from Apple (AAPL) or Google (GOOGL) or whomever. I think that the traditional distributors haven't innovated enough to remain relevant and they could be squeezed. But on the plus side, those cable companies are very well positioned to deliver high-speed Internet. And to the extent that people drop their cable subscriptions or they drop their triple-play bundles, they just end up jacking up the prices on the broadband side of things. That's actually a more profitable business for them since they don't have to pay content owners for the channels. It probably comes out as more or less a wash for the cable companies.
The media companies, I would say, are really the big uncertainty here. Do people continue to need some kind of bundle? And if they do need a bundle and if that bundle is evolving--especially if it's shrinking--what kinds of companies are going to be included in that? I would say that we're highly confident that the wide-moat media companies will be included in that bundle. That would be companies like Disney (DIS), Twenty-First Century Fox (FOX), and Time Warner. They have really valuable content, some of the most-watched channels. They are backed by very large studios that own huge libraries of content. So, anyone who comes out with some kind of new bundle is going to want to work with those wide-moat media companies.
I think you can have a lot less confidence in a media firm without a moat or with a narrow moat--somebody like Viacom (VIAB) that owns no top-10 networks and a lot of marginal channels. I think it's going to be much easier to exclude a firm like that from a narrow channel bundle. They could really struggle over time.
Another aspect that I would look at is the exposure to advertising. Regardless of what the bundle of the future looks like, I think it's going to be difficult to maintain the market share of television advertising that it's enjoyed historically, and you have some media companies that are deriving 50% or more of their revenue from advertising. On the other hand, you have someone like Time Warner that only derives about 16% of revenue from advertising. So, I would much rather own those companies with less exposure to advertising. They can still maintain the economics of their model--maybe focusing a little more on the subscription revenue and a little less on the advertising revenue.
Glaser: So, from a valuation perspective, are any of these attractive today?
Coffina: Yeah, our analyst likes a number of them. Probably Disney, Twenty-First Century Fox, and Timer Warner (TWX) would be the three that I would look at, given the wide moats and given that they are also trading below fair value. The one we own in our Hare portfolio is Time Warner. I really like that they have the HBO business. I think that's very well positioned to go direct to consumers. They're insulated from the streaming threat in terms of their traditional business but also potentially a very large growth opportunity, especially internationally as they start going direct to consumers. And any consumer with an Internet connection can get an HBO subscription. Depending on the demographic you are looking at, they own two to three top-five networks, so it's going to be very difficult to exclude them from a narrow channel bundle. They also own some exclusive sports rights, NBA and MLB, which makes it very hard to exclude them from a narrow channel bundle.
So, regardless of what the bundle of the future looks like, if there is a bundle, I think that Time Warner will be involved and will be able to maintain its economics. The real threat there--and with any of these companies--is that the whole bundle goes away. Our take is that, as of now, it's not likely, given the cord cutting that we've seen to date and given the fact that people spend so much time on television and that they really want the best and most content. As long as the bundle itself survives, I think that those three companies will do well, and Time Warner in particular.
Glaser: Matt, thanks for joining me today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.