In Large Cap Media Space, Fox Looks Undervalued

One of the things I try to do with this blog is highlight attractively priced securities that I might not have room for presently in client portfolios, but that warrant attention for value-oriented investors. As I have been active in media stocks in recent years, and many content providers are trading at meager valuations due to fears over cord cutting and increasing competition in content creation more generally, I don't really have a lot of room for more media and entertainment exposure at the present time. However, if I did and I was looking for well established blue chips names in the sector to allocate investment dollars, recently slimmed down Fox Corporation (FOX) would be near the top of the list.

Not too long ago, 20th Century Fox was a large, diversified media company. The recent deal to combine much of that legacy business with Disney (DIS) has left behind a more focused Fox, which trades for $35 per share and sports an enterprise value of $25 billion.

The new company is focused on cable news, live sports networks, and Fox broadcast stations. They have essentially sold the higher cost, riskier, production and creative content creation business and kept the simpler, lower cost stations that focus on live programming and have less competition. The company is using free cash flow to also make small, strategic acquisitions to boost growth, such as a 5% stake in The Stars Group (TSG), which will partner with Fox Sports on sports wagering, and a 5% stake in streaming platform operator Roku (ROKU).

Fox recently reported their latest fiscal year results and booked revenue north of $11 billion, EBITDA above $2.6 billion, and free cash flow per share of $3.69. On an EV/EBITDA basis Fox trades for ~9.4x cash flow.

Given their dominant position in live news and sports, coupled with a strong balance sheet and superb cash flow generation potential, it appears that FOx shares at $35 each can offer investors an attractive, low risk opportunity to benefit from multiple avenues of value creation over time. While this is not a high growth, high return situation, paying less than 10x EBITDA for the franchise, which does not factor in assets such as the Roku stake (worth $750 million and rising) or operational upside from any of the company's strategic investments, seems like a bargain.

From a capital allocation standpoint, Fox pays a 1.3% dividend (which is likely to increase over time), and free cash flow north of $2 billion annually will allow for a material reduction in share count over time. As a result, free cash flow per share should grow in the mid to high singles digits long term. With rising per-share cash flow and the potential for multiple expansion (why can't this company trade for 10-12x EV/EBITDA?), there appears to be an attractive risk/reward opportunity here, though I understand it is far from a sexy pick in a climate where money-losing, high revenue growth entities are leading the way. If you like somewhat boring cash cows that are well positioned to maintain their franchises, Fox looks like a good bet.

Wynn Resorts Analyst Day Confirms Upside Scenario

Back in May I outlined a fair value range for gaming operator Wynn Resorts (WYNN) that suggested upside to at least $155 per share, if not 10-20% higher. That thesis was predicated on a 12-13x EV/EBITDA multiple and $2 billion of EBITDA in 2020.

Last week the company hosted an analyst day at its recently opened Encore Boston Harbor property and took analysts through a more than 75- slide Powerpoint deck that included projected company-wide growth between now and 2021. Overall, I was pleased with the guidance they provided, as their internal forecast for 2021 EBITDA is roughly $2.3 billion, which equates to 28% growth versus the current trailing 12-month figure of ~$1.8 billion.

It is quite common for companies to issue rosy guidance that factors in most of what could go right and little of what could go wrong, so the 2021 projection is far from assured. Still, I felt good about my $2 billion 2020 number beforehand and management's presentation did nothing to shake that confidence.

That said, I am looking to trim my WYNN position around $145 per share, which is less than 7% from the low end of my fair value estimate. There have been several great opportunities to buy WYNN materially below current prices over the last couple of years and I have built up some fairly large positions in the name. With the stock on yet another upswing, I am hoping to pare it back as a source of funds.

Why not sell it all? Well, I can certainly assign a reasonable probability that WYNN does reach its $2.3 billion EBITDA target over the next 2-3 years. Using my 12-13x EV/EBITDA fair value multiple, the stock would reach $200 per share at the midpoint ($190-$210), which is enough upside potential for me to keep WYNN in client portfolios. However, since that scenario assumes no unexpected outcomes in Vegas, Macau, or Boston, and the stock has rallied around 40% in 2019 so far, an outsized position is getting less attractive.

Gaming Update: Wynn Set for Boston Opening and Why Penn Looks Dirt Cheap

A lot has been going on with Wynn Resorts (WYNN) since my last post about six months ago so I figured it was time for an update. In addition, I recently significantly increased long holdings in regional gaming operator Penn National (PENN) and will share some brief thoughts there.

Shares of WYNN have continued in seesaw fashion, as the Massachusetts Gaming authorities held hearings to determine if it would allow the company to keep its gaming license in the state and open its Encore Boston Harbor property on schedule this summer. After a lot of tough talk, WYNN was fined $35 million for how it handled its former CEO amid inexcusable behavior, but got the green light for the Boston resort, and the stock has firmed up with the uncertainty cleared up.

It will take some time before we know exactly how profitable the new property will be, but I have been sticking with my $2 billion EBITDA target for 2020 throughout my holding period, and there is no reason to think that figure will be materially off base at this point.

If we apply an EV/EBITDA multiple of between 12x and 13x on that cash flow number, fair value for WYNN shares would be in the $155-$175 range, compared with the current price in the 130's. On a free cash flow basis, a 15-18x multiple on my $1.1 billion estimate (once Boston has stabilized), gets us to a fair value range of $154-$185 per share.

As a result, the stock is still well priced for longs, but given that it moves up and down a lot quite quickly, there could be an exit point approaching near the bottom end of that range if one can find other opportunities with even more upside.

On that front, I really like shares of Penn National Gaming and have been buying a lot more at $18 and change this week. PENN is the nation's leading operator of regional casinos, with more than 40 properties in nearly 20 states. Competition is typically intense, as jurisdictions often grant additional licenses in order to try and maximize tax revenue, but PENN has proven to be as solid an operator as they come, and does not shy away from accretive M&A deals when given the chance.

PENN shares have been cut in half from their 52-week highs despite a highly accretive merger with one of its largest peers (Pinnacle), and continued single property acquisitions - such as Greektown in Detroit.

The stock has been crushed lately and in the high teens fetches an EV/EBITDA multiple in the mid 6's. The free cash flow multiple is even more extreme at sub-6 times. With sports betting now legal, the company should benefit over the long term, as more and more states pave the way for taking bets. While the margins on betting won't be huge (the house takes a 10% cut and then gives a nice chunk to the state via taxes), it should be an incremental positive, and ancillary revenue such as food/beverage and hotel stays should get a nice bump as well.

Regional gaming assets typically fetch around 8x EV/EBITDA in private transactions and I see no reason a diversified operator like PENN, with a long track record of impressive capital allocation on behalf of shareholders, should not trade at a similar multiple, if not a slight premium. The market does not agree at the moment, but there is a great chance that at some point in the next couple of years that sentiment will change.

If we assume further deleveraging in 2019 and into 2020, my financial model shows a per-share fair value as high as $30 per share, assuming a valuation of 8x EV/EBITDA and a net leverage ratio of 2.5x excluding lease obligations.

The Dizzying Ride That Is Wynn Resorts Stock Is Not Slowing Down

Since I first wrote about gaming and hospitality company Wynn Resorts (WYNN) three and a half years ago the stock performance has been nothing short of an intense roller coaster. For a large cap company with a relatively simple business, you are unlikely to see more volatility in the equity markets. Such wide gyrations are great for investors, especially those willing to be contrarian and buy when things look the bleakest, but the exercise can admittedly become tiring while also predictable.

Fast forward from May 2015 to today and I am still a rider on this roller coaster. Although I bought stock at low prices and sold much of it at high prices, I failed to sell everything near the top and we are now stuck in a down cycle for the shares, despite the fact that the company is doing just fine.

Below is a five-year chart of Wynn Resorts shares that shows just how dizzying the ride has been:

I was buying the stock in 2015 after the prodigious collapse from the 2014 highs and began trimming positions in late 2017 and well into 2018, but the long-term outlook (still very bright in my view) caused me to hold onto to a smaller position even as the stock reached the $200 level. And now we are left with an interesting question; what to do now?

Given the stock chart above, you would probably guess that Wynn's business is in trouble, but you would be wrong. In fact, company EBITDA this year is likely to come in right around their previous best two years ($1.68 billion in 2013 and $1.61 billion in 2017) and could even reach $1.7 billion, a new company record. As is usually the case, the financial markets extrapolate current results and value the business based on those  near-term figures, ignoring both longer term historical track records and the future outlook a year or two down the road.

That trend is playing out now, as Wynn's business has gotten soft in recent months and is unlikely to bounce back quickly in the near term. Never mind that their Boston property will open in June 2019 and offset weakness seen elsewhere in their property portfolio. Never mind that the company is in the process of designing new additions to their properties in both Las Vegas and Macau that will grow profits over time.

What happens when near-term stock valuations are based mostly on near-term financial results is that prices and investor reactions overshoot in both directions. When things are great, the stock reflects that and analysts have high estimates for future profits and use high valuation metrics due to those rosy outlooks. The opposite is seen as well. This week, as near-term profit expectations come down for WYNN, the multiples used to determine Wall Street price targets will also come down, undoubtedly justified in their minds "to reflect the near-term weakness of the business."

From a valuation perspective, the value of a dollar of profit should not change based on near-term trends. The notion that WYNN should be valued at 15x EBITDA one quarter and 12x the next makes little sense, if indeed we believe that the stock should reflect the discounted present value of all future profits in perpetuity.

To illustrate this phenomenon, let's look at Wynn's stock price and financial results since 2013. The 2018 revenue and EBITDA figures shown are my firm's internal estimates.

As you can see, the stock price reacts far more violently, in both directions, than the actual financial results of the business. In each and every year, the stock move is more aggressive than the year-over-year (yoy) change  in sales and profit. Interestingly, the stock today is 50% below the level of year-end 2013, even though EBITDA is roughly the same.

Generally speaking, this is why it makes sense to many of us in the industry to have a portion of one's investment portfolio allocated to active managers; to try and take advantage of such mispricings in an inefficient marketplace.

In hindsight, it would have been nice to sell every share earlier this year and buy back each of those shares today. In actually, I am quite pleased that I bought it low and sold a portion when I did. While the roller coaster ride that is Wynn Resorts stock can be frustrating at times, there is no reason to jump off now. If my investment thesis is right (the Boston property does well and the legacy resorts in Las Vegas and Macau grow revenue and profits over the long term, despite short-term bumps along the way) then investors will surely get another chance to sell at a fair price in the future, just as they get chances to buy at attractive prices periodically.

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

Many Gaming Related Companies Are On Sale

I have written enough about Wynn Resorts (WYNN) in recent years that much more in the way of commentary is likely unnecessary. Investors are once again getting a unique buying opportunity with the shares down a stunning 30 percent on very little news:

Even if they wind up selling their under-construction Boston property prior to opening, the haircut for shareholders would likely be less than $5 per share (a 20% gain on the $2.5B cost is just $500M). Although Macau revenue growth is slowing, the August figures are still well into the double digits.

Other leading gaming related stocks are also selling off and warrant special attention. Two notable ones are lottery and slot machine giant International Game Technology (IGT) and video game behemoth Electronic Arts (EA). 

IGT is a global leader and despite low single digit revenue growth (most markets are mature), the business is minimally cyclical and the company's valuation seems extremely reasonable at 10 times 2019 earnings estimates and a dividend yield north of 4 percent.

EA has been riding the coattails of a transition from packaged software sales to cloud-based digital sales, and the higher gross margins such a distribution model affords. A recent profit warning, due in large part to a delay in the upcoming release Battlefield 5, has helped the stock fall about 25% from its highs. While not dirt cheap (low 20's multiple to earnings), continued revenue growth, margin expansion (digital sales still represent less than 70% of the total, which could reach 90% over time), and a stellar balance sheet should be accretive to shareholder value over the intermediate term.

No matter your investing style, and despite the market near all-time highs, there are plenty of gaming investments worthy of consideration right now.

Sports Betting Will Help Many Gaming Companies On The Margins, But Impact Will Likely Be Tempered

Some investors might have thought that last week's Supreme Court decision that paves the way for legal sports betting in all 50 states would have resulted in skyrocketing stock prices of the largest perceived beneficiaries. And yet, the market reaction thus far has been fairly tame.

Consider Penn National Gaming (PENN), whose pending merger with Pinnacle Entertainment (PNK) will make it the largest regional casino operator in the United States. It stands to reason that from a customer destination perspective, they should benefit immensely from sports bets being taken outside of Nevada. And yet, PENN shares have moved up only marginally (less than 5%) since the ruling was announced:

So why isn't Penn stock soaring? Won't there be millions of bets placed at their casino resorts annually once the infrastructure is put into place? Probably, but it is important to keep in mind how much revenue these bets will likely generate for the sportsbooks (hint: it might be less than one thinks).

Americans wager about $5 billion in Nevada sportsbooks each year. It is not crazy to think that the market will be increased by many multiples of that if a dozen or two dozen states take steps to accept bets. With over 200 million Americans of betting age, it is not crazy to think the market could swell by a factor of 10. Annual wagers of $50 billion in total equates to about $200 from each and every American age 21 and over.

However, we must keep in mind that the $50 billion is a gross figure (the "handle" for the betting inclined). In Nevada, the historical hold percentage is around 5%, which is the amount the sportsbooks net after paying out winning bets. As a result, $50 billion of gross bets will generate revenue of just $2.5 billion. Still a hefty sum, but there's more to consider...

Many states, like New Jersey (which spearheaded the lawsuit that set this entire process in motion), are chomping at the bit to allow sports betting because they see it as a revenue generator. States typically tax casinos heavily in exchange for granting licenses to operate facilities that many constituents would prefer not exist. Those taxes are usually assessed on adjusted gross proceeds (total bets placed less winnings paid out), which eat into casino profit margins quickly. According to this article, while New Jersey taxes casino at just over 9% (among the lowest), most neighboring states charge far more, with New York at 31-41% and Pennsylvania at 16-55%.

So let's imagine that state legislators decide to tax sports betting revenue at an average of 30%. Now we have gone from $50 billion in "handle" to $2.5 billion of "pre-tax revenue" to just $1.75 billion of "after-tax revenue." With more than 500 casinos in the country (a Penn/Pinnacle combination would own 40 alone), each stands to generate some incremental revenue ($3.5 million per year, on average), but it will by no means be life-altering for shareholders. Perhaps that explains why Penn National stock is up only a few percentage points since the news hit.

Now, this of course only considers actual gaming revenue from the bets themselves. Resort operators will surely try their best to attract customers to visit frequently and spend some money on food, drinks, and perhaps some slot or table game play while they are there. The tricky part about that strategy, however, is that technology is likely going to play a huge role in nationwide sports betting.

Movie theaters and restaurants are already trying to figure out how to coax customers out to their properties when Netflix and food delivery services are just a few clicks away. The same will be true for the sports betting industry. MGM already has a mobile app for Nevada residents that allows in-state players to place bets from home (or anywhere else). Such capabilities will surely expand to other states now, so why not just watch from your couch and bet on your smartphone?

What is probably a slam dunk, though, is that engagement with sports teams should increase. That is good news for Disney (DIS), whose stock has firmed up lately despite worries about cord cutting and ESPN subscriber losses. ESPN viewership should increase (as can ad rates) as regular games have more importance to the average fan who might throw down twenty bucks on the outcome.

With engagement set to rise, there will be more money attached to these teams and franchise values should continue to rise, perhaps even faster than currently (if that is possible). In addition to Disney, stocks like Madison Square Garden (MSG), which owns the Knicks (NBA) and Rangers (NHL), could see increased investor interest.

All in all, this is an interesting time to be sports fan and market watcher. While there will be billions of dollars generated from legalized sports betting, it is likely that with so many players in the industry set to split the pot, outsized winners are less likely in my view. As a result, there might be very few pure plays from a stock market perspective. Instead, take a company like DIS or PENN or MSG, all of which have dominant franchises already, and assume that sport betting will help them at the margins increase shareholder value over the long term.

Charter and Comcast Shares Fall on Hard Times, Look Ripe for Rebound

It has been about five months since I outlined the valuation disconnect between the two leading consumer telecommunications providers in the United States in a post entitled Is the Enthusiasm for Charter Communications Getting Overdone? Charter (CHTR) and Comcast (CMCSA) together provide nearly half of the country's households with cable, broadband, and phone service. A lot has happened since then, so I thought it would be interesting to revisit the situation.

It turns out that my post last August roughly marked the short-term peak, and shares have fallen about 30% since:

Whereas the shares near $400 seemed very overpriced compared with the likes of Comcast (11.5x EV/EBITDA vs 8.6x), they now appear closer to fair value at around 8.8x my 2018 EBITDA estimate. Comcast has also hit a rough patch in terms of stock performance, on the heels of its bid for UK's Sky Plc, which would further entrench them into the pay television world. While CHTR has fallen 30%, CMCSA has dropped 20%, and now fetches $32 per share, or just 7x my estimate of 2018 EBITDA.

In my mind, Comcast looks very cheap and Charter appears to be reasonably priced, without factoring in any upside they could see from increasing prices on broadband services (they are priced well below Comcast currently), or from their upcoming cellular phone service offering, which promises to look very similar to Comcast's recently launched and fast-growing Xfinity Mobile service.

My wife recently switched from Sprint to Xfinity Mobile and is paying $12 for every 1 GB of data usage, with no additional charges other than the phone payment itself. Having switched to Google Fi from Sprint earlier this year, I had planned on adding her to my plan upon the termination of her contract, but Xfinity Mobile is actually an even better deal because Google Fi pairs a $15 plan charge along with a $10 per GB data rate. You can add family members for just $10 more )rather than another $15), but it would have cost $20 to add my wife to my plan, whereas Xfinity charges just $12.

With such a compelling price (using Verizon's network), it is no wonder that Comcast last quarter added more post-paid mobile subscribers than AT&T and Verizon combined. Charter is set to launch a similar service later this year, also using Verizon's network (pricing not yet available), and I would suspect they will see quite a bit of traction at that point. In fact, with Comcast and Charter in attack mode, it is easier to see why Spring and T-Mobile might think they can get regulators to bless their merger. The big cable companies, along with Google, are truly strong competitors in the marketplace.

And there is the constant merger talk involving Charter, whether they be the buyer or the target. Talks with Verizon and Sprint supposedly did not progress too far last year, but as a large triple play operator without a dedicated mobile or content business, it is not hard to understand why Charter could continue to be a player in the M&A market (thus far they have simply rolled up a bunch of regional cable companies).

Simply put, Comcast would fetch $40 per share if it just traded at 15 times annual free cash flow, and they have a fairly diverse business as it stands, even without buying Sky. Investors are worried about them overpaying in the M&A world, but the current price seems to account for those fears already. And with Charter stock now trading at a fair price, the risk-reward appears very favorable given that they have optionality in terms of their mobile offering, broadband pricing, and continued M&A activity.  For the intermediate to longer term, I do not see material downside for either stock, and 20% gains would not surprise me.

Investors should also take a look at T-Mobile, now that they are going to try to get a Sprint deal done officially. The stock initially bounced well above $60 on the news, but has faded back into the mid 50's. They are performing best in the mobile world right now and the stock is not expensive. It looks like it could be a case of "heads, we win" (continued strong operating performance going at it alone, and "tails we win big" (the deal with Sprint has massive synergies) situation.

Full Disclosure: Certain clients of PCM were long CHTR, GOOG, TMUS, VZ, and Sprint debt at the time of writing, but positions may change at any time without notice

New CEO Moving Quickly To Stabilize Wynn Resorts Shares

In the three months since my last post on Wynn Resorts (WYNN) a lot has happened. Steve Wynn has resigned as CEO and Chairman of the Board amid sexual misconduct allegations, long-time executive Matt Maddox has taken over the CEO role, two other directors of the company have vacated their positions, the board increased the annual common stock dividend by 50% (to $3.00 per share), and the company announced a settlement agreement to bring to a close a long-time litigation.

As you can see from the chart below, WYNN shares have found some support and are in the midst of climbing back, as Mr. Maddox settles into his new role and tries to turn the page:

In what turns out to be fortuitous timing, I began to trim back my WYNN positions in late January (around $195) as the stock approached my conservative $200 fair value estimate. Just days later the Steve Wynn news broke, which complicated matters with what to do with the rest of the shares.

Since then I have been sitting tight, waiting for more clarity as to the company's next steps. Recent days has brought some insight on that front, but two big questions remain in my mind. One, how are Wynn Las Vegas bookings shaping up in the weeks since the news reports made national headlines? And two, what is the fate of the under construction Boston Harbor project?

Although I do not think the company's Macau business will be impacted, the U.S. market is a different story. As long as Steve Wynn's name is on the door, even if he is no longer with the company, I could see convention business contract materially, as well as tourist bookings. As far as Boston goes, it would be surprising to me if they put the Wynn name on that property when it opens in the middle of next year. So that begs the question, will they sell it, or get to keep their gaming license and simply rebrand the property?

The answers to these questions are likely to take several quarters to be crystallized. Wynn reported 2017 free cash flow of $942 million, which included roughly $650 million of construction costs for the Boston project. If the company can really generate free cash flow of $1.6 billion from its existing three properties, the stock today remains a great value ($19.3 billion equity value) and could easily fetch $230 per share (15x normalized free cash flow). And that does not even include Boston (the worst case scenario there would probably be them having to offload it at cost). Of course, that assumes that the Las Vegas business stays strong despite the negative headlines, which is a big unknown. I will be watching the data closely on that front in the coming quarters.

There has been speculation that the company may be up for sale, or that Steve Wynn might try to take it private. I think it really depends on whether he plans on holding onto his shares or not. He is 76 years old and could very well decide to retire from the business. If he was open to selling his shares I think the company would look to maximize value for shareholders and auction off the entire business to the highest bidder (and there would be plenty of interest).

If Mr. Wynn wants to hold onto the stock, then Mr. Maddox will have to figure out how to preserve the business value. That would possibly mean taking the Wynn name off of the door (if business does suffer here in the U.S.), or maybe even a more bold move (selling the U.S. assets and focusing on Macau and future growth opportunities like Japan).

In either case it looks like there are plenty of levers for the company to pull to realize full intrinsic value for the business. In that scenario, holding the stock and waiting for even more clarity will probably work out quite nicely. Heads we win (the company is sold and the resorts rebranded), tails we win (they rebrand it themselves with Steve Wynn nowhere to be seen).

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

Not All Media Companies Are Created Equal: A Closer Look at Charter, Comcast, and Disney

A client reached out to me after reading my past post regarding the media industry landscape to point out that Comcast and Charter, while both in the business of providing video, data, and voice services to customers, are far from equal when it comes to revenue diversification.

This is a point that is certainly true. I probably should have been more specific in my prior post that my comments were meant to be focused on the TV business. With Comcast's NBC Universal acquisition about eight years ago, the company became far more than just a cable company offering triple play packages to mostly residential customers.

Along those lines, Charter is a far more one-sided investment bet than Comcast is these days, and would be more susceptible to people who are cancelling their cable service and instead opting for Netflix and/or Prime Video.

Since these companies, along with Disney, have various business segments, I thought it would be helpful to illustrate where each gets its revenue from. The answers are a bit surprising.

Below is a chart that shows the percentage of total revenue that each media company gets from various businesses. Since Disney's 2017 fiscal year is already over, I am showing data for their latest 12 months. For Comcast and Charter, only the first nine months results for 2017 are publicly available.       

In my mind, there are a few notable things about this data:

1. Disney is the most diversified of the three, as one might expect. More than 55% of their revenue comes from sources other than television.

2. 40% of Charter's subscriber revenue comes from TV packages. This is comparable to, but lower than, Comcast's non-NBCU division (44%).

3. Because of Disney's large parks/resorts segment (33% of revenue), they have less exposure to cable despite owning ESPN. Still, it is a large portion of the company at roughly 30%.

4. If you want to play increased broadband adoption and higher speeds/prices over the longer term, Charter is actually the best option, as 34% of their subscriber revenue comes from high-speed internet services. The comparable figure for Comcast is just 17% (28% if you exclude the NBCU division).

As with any publicly traded security, price should play a material role in drawing conclusions about the merits of an investment. When I look at the valuations, Charter trades at a similar level to Disney, despite having no content library or dominant consumer franchises. Comcast trades at roughly a 10-20% discount to them, even though one might expect it to trade at a premium to Charter given the diversification of their revenue stream in an uncertain and ever-changing media landscape.

As a result, my personal rankings considering valuation, revenue diversification, and franchise positioning, would be 1) Disney, 2) Comcast, 3) Charter. If I was into the paired trade strategy, long Comcast/short Charter would look interesting over a multi-year period. Of course, the big question is whether Charter will make a play for a content business, or wireless provider, or something else to expand their horizons. In that scenario, the outlook would really depend on who they bought and how much they paid, not surprisingly.

Content Providers Take Leadership Role in "Unbundling" of Cable

As we head into 2018, one of more interesting sectors among those I watch closely would have to be the media space. This year has seen a huge amount of deal activity (both discussed and completed), as well as a continued secular shift in the way content is distributed and purchased.

For years consumers and industry watchers contemplated if and how the cable bundle would come undone. The idea of paying for 100 or 200 channels, while only actually watching a dozen or so, seemed like an obvious target for disrupters, but for a long time nothing changed. The cable and satellite pay-TV providers would have been obvious candidates to initiate a change in how content is sold, which easily could have increased satisfaction scores and retention rates among consumers, but they balked at potentially bringing down their "monthly ARPU" (monthly average revenue per user). Now with so-called "cord-cutting" becoming a reality, it appears that perhaps that lack of action was a mistake.

The blossoming of Netflix shows just how much "unbundling" was the right move. It turns out that the content players have now taken a leadership role in doing away with the expensive, voluminous TV bundle. If you think about the Netflix service it really is just "a skinny bundle." Rather than pay $75 or $100 for 100-200 channels, Netflix provides enough content for consumers to be happy (I am just guessing, but perhaps 5-10 traditional cable channels worth of content library?) for $10-$12 per month. Given what industry watchers have been predicting for what seems like decades, it should not be surprising that Netflix has been a runaway success, Amazon Prime Video was created, and HBO is flourishing with its over-the-top streaming service despite more competition.

What is surprising is that the cable and satellite companies have been so slow to react. Leaders like Comcast and Charter have yet to answer with their own competing products. DirecTV did launch a $35 streaming service featuring a more limited channel line-up, so we'll give them credit for taking the plunge.

The big question is how the Comcasts and Charters of the world are going to compete as the content companies try and eliminate them as middlemen. HBO, Netflix, and Prime Video are sold direct to consumer and other content producers are now accelerating M&A activity to gain scale in content. I recently made a list of 60 top TV channels to see exactly how the concentration of ownership has been shifting lately, especially after three recent deals were announced; Discovery buying Scripps, AT&T buying Time Warner, and Disney buying much of 21st Century Fox. Assuming all of those deals close, below is the breakdown:

Disney/Fox: 12 channels

Comcast/NBC: 11 channels

Discovery/Scripps: 10 channels

AT&T/Time Warner: 8 channels

Out of 60 channels, it is entirely possible that just 4 owners will control a whopping 42, or 70% of them, within the next 12 months.

And more deals could be ahead. A remarriage of CBS and Viacom has been long-rumored and combined they own another 9 channels. A company I am invested in, AMC Networks, owns 3 channels on my list.

To me is seems pretty clear what is going on here. The infrastructure players have been slow to adapt to suit consumers' needs. The legacy content companies see Netflix and Amazon spending billions on content and realize that if they are not careful, those two companies could offer so much programming that households might no longer need to watch any of their shows. So rather than stand by and watch, they are getting bigger through M&A and will have enough selection to offer their own streaming service, cutting out the cable and satellite providers completely, while also becoming increasingly crucial for those who stick with a bigger bundle. Disney specifically is going to be in great shape given that they also have an unmatched movie collection that can be offered alongside TV programs.

If this is the internal corporate strategy, we can expect more M&A to be announced in 2018. From an investor standpoint, there are attractive opportunities outside of the profitless Netflix and e-commerce juggernaut Amazon.

AMC Networks trades at about 10x free cash flow, 8x EBITDA, and has been buying stock aggressively. In an age of scale mattering, they would seem to be a logical M&A participant. The post-merger Discovery trades at less than 10x free cash flow, has plenty of synergies to exploit with Scripps, and is internationally diversified. Their focus on non-scripted reality shows keeps production costs low and profit margins high. Disney is building a Goliath in the space and is probably the most likely candidate to create a service that can become as valued as Netflix or Prime Video in many households. At roughly 20x free cash flow and 11x EBITDA, the stock no longer trades at a premium to the market (based on ESPN viewership issues), but arguably should given their unmatched franchises.

The media space is not without investor fears, and it certainly is not a popular group for the current bull market, but there are plenty of strong, cash flow generating machines in the public markets whose share prices are quite attractive due to concerns that Netflix and Amazon will crush everyone and that young people simply don't watch TV. The financial results from these companies in recent years, even as all of this industry change has been afoot, disproves those theories. Additionally, further M&A will only serve to boost competitive positions and generate accretive returns for shareholders.

Full Disclosure: Long shares of Amazon, AMC Networks, AT&T, Discovery, Disney, and Time Warner (hedged with covered calls) at the time of writing, but positions may change at any time