Media Earnings Pretty Solid and Future Still Bright

Over the past two weeks, most of the major media companies have reported second quarter results. This summary will take a look at the entertainment companies held by Northlake clients. These companies are primarily content producers. A separate blog post will review the cable companies that provide the pipes through which we consume the content.

Current entertainment companies held by Northlake clients include CBS Corporation (CBS), Disney (DIS), Liberty Media (LMCA), and Starz (STRZA). Direct competitors including AMC Networks, 21st Century Fox, Time Warner, Scripps Networks, and Viacom also reported so we have a pretty good idea on the state of the TV advertising market and TV network business heading into the new fall TV season that commences after Labor Day.

Overall, the industry seems to be in good shape. Advertising trends, probably the best measurement of industry and investor sentiment generally met or exceeded expectations in the second quarter. Management commentary indicated that strength continues in the third quarter, particularly after backing out the impact of 2012’s heavy political advertising and the distorting impact of last year’s Summer Olympics. The TV networks are also in good shape on retransmission and affiliate fees paid by cable, telco, and satellite companies. This revenue stream has been front and center recently, as CBS and Time Warner Cable, two industry heavyweights, are currently in nasty negotiations with Time Warner Cable customers blacked out from CBS TV programming. This revenue stream is growing mid-single digits to low double digits at most TV networks with no signs of letting up. Retransmission and affiliate fees are extremely high margin and the primary driver of healthy industry fundamentals on a financial basis.

There are a couple of thorns in the outlook for TV networks and their parents. First, ratings for the broadcasters (NBC, CBS, ABC, and FOX) were quite weak as a group last TV season. Cable networks saw ratings growth but across the universe there was mixed performance. Short-term broadcasters are losing market share to cable networks while cable networks face fragmentation of audience. Long-term, all networks face a challenge from online video, both access to their own programming and competition from the likes of Netflix, Amazon, and YouTube.

Second, programming costs are rising as networks compete more aggressively and produce better quality TV shows to improve ratings and justify the rising retransmission and affiliate fees with better programming. Although not alone, huge success by AMC Networks with Mad Men, Breaking Bad, and Walking Dead has had a significant impact on the industry. Other networks see the unique programming and step up their games. That means more original productions and often more expensive original productions, together driving programming cost inflation in the high single digits. This cost growth in well in excess of industry ad growth and pressures an otherwise positive margin outlook.

Within Northlake’s current holdings, CBS and Starz had positive earnings surprises and saw their stock prices rise. Disney beat its earnings forecast but mostly on timing differences and has its shares have fallen since the report. Liberty Media is an asset play but is primary content business, 53% ownership of Sirius XM Satellite Radio, continues to perform very well adding new subscribers and producing free cash flow. Here is a brief recap of each earnings report:

CBS reported very modest growth against tough comparisons but once again exceeded Wall Street expectations. Overall, the company should grow revenue and operating cash flow by high single digits to low double digits in 2013, an excellent result in a generally sluggish environment for large corporations. EPS should grow faster as the company continues to aggressively repurchase shares including another big bump in the authorization last month. Ad trends should pick up over the second half of the year as the company recoups ad time devoted last year to Presidential debates and political conventions and does not face Summer Olympics on NBC. Another catalyst is coming next year with the divestiture of the Outdoor business and another increase in the share buyback. The primary risk is a poor ratings performance at CBS in the upcoming TV season. I thik the shares can reach the low $60s, another 20% upside, based on a P-E of 17 times 2014 earnings of $3.60.

Disney results were in line with estimates on revenue and ahead on operating profits and earnings per share but the stock has sold off on lower guidance for the September quarter related mostly to timing issues and a write-off on The Lone Ranger. Disney will grow revenues and earnings mid to high single digits this year. I anticipate acceleration over the next few years as the company exits a period of heavy investment in programming, acquisitions, theme parks, and cruise ships. The story really accelerates in 2015 when Star Wars films comeback to theaters. Free cash flow is et to grow rapidly and eventually DIS will accelerate its already meaningful share buyback program. It may take a little patience but DIS has the most potential of its peers looking out several years.

Starz easily beat Wall Street expectations but most of the upside came from its home video division and accounting catch up related to its recent renewal with Time Warner Cable. The core business of Starz and Encore pay TV channels was mostly on target with modest subscriber growth. Share buybacks are ahead of schedule and remain a major part of the story as the company remains under its debt leverage target. Starz is doing a good job of finding low cost replacements for its 2016 loss of Disney films having recently signed agreements for catalog titles from 20th Century Fox and MGM. The pay TV business needs some big new program hits to really juice the story but share buybacks and the possibility the company is sold or merged provides upside to the stock.

Liberty Media has seen the underlying value of its assets soar as 53% owned Sirius XM and 27% owned Charter Communications perform well. LMCA still trades at 10-15% below asset value and has numerous avenues for creating additional value by restructuring its ownership of Sirius or driving cable industry consolidation through Charter. Although a much smaller investment for LMCa, the company’s almost 30% stake in Live Nation Ticketmaster is paying off big time as LYV shares have almost double this year. I was also pleased to see the company execute a forward purchase contract for $380 million of its own shares. This represents an acceleration of the company’s recent pace of share repurchase and provides a nice boost to net asset value for continuing shareholders. Continued growth in its portfolio companies, restructuring actions, share buybacks, and the discount to net asset value create plenty of additional upside in LMCA shares.

CBS, Disney, Liberty Media, and Starz are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. CBS, Disney, Liberty Media, and Starz are net long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

2013 Outlooks Bullish for CBS and Discovery Communications

CBS and Discovery Communications (DISCK) each reported mixed 4Q12 results compared to expectations but provided positive guidance for 2013. I think both stocks offer further upside with the caveat being that each company’s results are sensitive to consumer spending trends via their exposure to advertising. With worries about the consumer on the rise due to the payroll tax increase and potential budget cuts due to sequestration, the stocks may pause. Should the economy weather the austerity storm, CBS has upside to the low $50s and DISCK could reach the mid-$70s. I plan to hold both stocks in Northlake client accounts.

CBS reported 2% revenue growth and 6% EBITDA growth. Both figures were slightly below expectations. The EBITDA figure was below expectations for about 10% growth with margins at local TV and radio stations coming in a little below expectations. Despite the slight miss, management softened the blow by announcing an incremental and accelerated share repurchase for $1 billion to be completed in the first quarter. This almost doubles the already aggressive share repurchase plan. Listening to management comments on the conference call, it is not surprising that they see value in their own shares. Advertising trends, particularly at the CBs Network, remain firm, even with early season ratings struggles. Rising non-cyclical advertising streams from Showtime and retransmission consent are driving margins higher and reducing CBS’s exposure to the economy. Management also indicated that it plans to return even more cash to shareholders after the conversion of its Outdoor business to a REIT, hopefully at the start of 2014. The story here remains very positive with great management, rising margins, less cyclicality, more consistent and higher growth, and most shareholder friendly capital allocation policy in the media industry. I think 2014 EPS estimates could prove 5-10% too low, maybe more if the REIT conversion happens in its most aggressive form. Given CBS recent history, I think it is worth holding on for the bull case which would be the low $50s based on a 15 P-E in 2014.

DISCK reported among the fastest growth of all media stocks in the fourth quarter with revenue up 9%, EBITDA up 11%, EPS up 30%, and advertising up 11%. These results were widely expected. IF anything, the company could have reported a little better results but there is little to complain about. The outlook for 2013 was in line with street estimates but hard to interpret as they include about nine months of the company’s recently announced acquisitions in Europe. Continued high levels of share repurchase despite the acquisitions is good news. Strong ratings for DISCK’s stable of networks and the beginning of a new round of affiliate fee increases seems to set the stage for more industry leading growth in 2013. The primary risk I see to the story are that the stock has the highest valuation among media companies (well-earned for sure!) and the new acquisitions are a little outside of the core competency in non-fiction programming. Assuming that cable network ratings remain solid, I think the stock can hold its current P-E of 19 times as focus shifts to 2014 results later this year. This would get the shares to the mid-$70s.

CBS and Discovery Communications are widely held by clients of Northlake Capital Management, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Filings can be found at www.sec.gov. CBS and Discovery Communications are net long positions in the Entermedia Funds. Steve is the portfolio manager of the Entermedia Funds, owns a majority stake in the Funds investment management company, and has personal monies invested in the Funds.

Media Stock Earnings on the Mark

During the seocnd half of February, most major media stocks reported December quarter results and gave a look ahead to early 2012 business trends. In general, the results and outlook were good. This was definitely the case at CBS, Discovery Communications, Charter Communications, and Liberty Media, each of which is held in most Northlake client portfolios.

The big picture for media is dominated by two themes. First, after an unexpected and abrupt slowdown in national TV advertising demand around Thanksgiving, business has picked back up. Visibility is low but the first half of 2012 presently look like a return to moderate growth with networks producing good ratings set up for double digit gains. Second, despite constant headlines, there is little sign of cord cutting or cord shaving in the cable and satellite TV industry. The total number of households receiving multichannel TV is growing again despite worries about Netflix and other online video viewing. Stabilization of multichannel video subscribers is positive for cable and satellite and providers and the networks they carry on their systems. Charter Communications gets a boost from improved sentiment toward cable stocks as a result of better subscriber trends.

Here is a brief, closer look at each of the Northlake holdings latest earnings reports.

CBS had another good quarter driven by continued expansion of profit margins. Advertising trends were a bit below expectations driven by the late year slowdown. However, management was extremely confident in a 2012 pickup with good reason given CBS excellent ratings performance this season. CBS is diversifying away from advertising as it adds more subscription revenue. Good rating performance is also keeping programming expenditures in check. 2012 is setting up well for CBS and the stock still has 20% upside even after the huge gains since mid-2009.

Discovery Communications led the industry with 17% advertising growth as almost all of its large networks including Discovery Channel Investigation ID, Animal Planet, and TLC have positive ratings growth. Management indicated trends were continuing in 2012. Discovery is another stock that has made a giant move since 2009. The company remains best positioned of TV network owners due to its international growth profile as non-fiction programming translates well overseas. The stock is nearing my initial target and could be a candidate for a trim in the days ahead.

Charter Communications reported solid results driven by growth in broadband internet subscribers. Cable TV subs continue to stabilize removing a primary risk to the Charter story. New CEO Tom Rutledge, a cable industry star, participated in his first conference call with the company in late February. He sounded optimistic and outlined opportunities to sustain modest operating income growth and keep the free cash glowing at a double digit pace. Charter is a free cash flow story as it pays down debt to benefit shareholders.

Liberty Media is an asset play. The stock trades at ab 20-30% discount to the value of the assets it owns. By far the largest asset is a 40% stake in Sirius XM Satellite Radio. The primary issue at Liberty now is that its standstill agreement with Sirius expires this week allowing Liberty to increase its stake. It is very difficult what will happen next but Liberty will be a much stronger position to undertake a transaction that closes the gap between its stock the value of its assets. Management has a multi-decade of doing just that leaving Liberty shareholders with plenty of upside.

Disclosure: CBS, Liberty Media, Charter Communications, and Discovery Communications are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. All four stocks are also long positions in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds.

Where I Stand on Media Stocks

Media stocks finally caught a bid late last week coinciding with the final set of earnings reports from the group. Viacom, AMC Networks, and Disney each reported solid results and indicated current, positive trends remained largely intact. The Street remains very worried about the advertising outlook despite the positive tone of management comments. It seems as though analysts are more skeptical than investors at this point. That is probably because the stocks likely found a level at which the concerns were priced in from the perspective of portfolio managers. Equally encouraging for bulls is that the gains have held so far this week against some Europe related market selling pressure. It is still too soon to say the coast is clear. Only clarity on 2012 advertising and macroeconomics will do that.

Coming out of the quarter, I have greater respect for the concerns about the national TV ad market. I still think the ad market is going to hold at a solid growth rate for 2012 but there is no doubt that advertising has softened somewhat. Where I differ is that I think it is normal softening after the bounce off the cyclical low of 2009 has run its course. The 2011 Upfront marked the culmination of the normalization of the national TV ad market as prices fully caught up to trend. Today, trends are still positive but with upfront prices higher and the economic outlook still uncertain, scatter price premiums and volumes have eased. I see that as normal but others think it is the first sign of trouble.

Given my view, I am sticking with Northlake's exposure to traditional ad supported media stocks. CBS and Discovery Communications (DISCK) appear to have the best near-term fundamentals so I am making no changes to current positions in these holdings. However, given some uncertainty about the outlook for advertising I have been looking for new ideas away from traditional media. The recent purchase of EMC Corporation (EMC) as outlined in the latest monthly email reflects this shift in focus.

Disclosure: VIA.B, AMCX, DISCK, and CBS are net long positions in the Entermedia Funds. The Entermedia Funds are long/short equity hedge funds focused on media, entertainment, communications, and related technologies. Steve is co-portfolio manager of Entermedia, owns a stake in Entermedia’s investment management company, and has personal monies invested in the Funds. EMC, CBS and DISCK are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.

Market Rally and Media Stocks

The stock market continued to move steadily higher over the past week as investors seem to no longer be worried about an imminent double dip recession. The drop from the yearly highs in the spring was largely about steadily deteriorating economic data. The data did not suggest the recovery had been aborted and growth was negative but it indicate a significant loss of upward momentum. The analogy I drew with clients was a plane losing speed. The plane's forward motion can only slow so much before it begins to point down. The weak summer action in the stock market was created by a fear that the economy was slowing so much that it was inevitable a double dip recession would be shortly at hand. The fear was heightened by May's Flash Crash, which seriously undercut investor confidence.

More recently the economic data has stabilized. The figures still are not great. The data says GDP growth in the second half of 2010 will be slower than the first half of the year and slower than most prognosticators expected as recently as Spring.

But takeaway the fear of the double dip and combine it with extremely pessimistic investor sentiment in late August and the setup for a rally was in place. The strength and persistency of the September rally has surprised most everyone. The fact that most investors were leaning the wrong way entering the month has helped fuel the rally as lots of people were underinvested and are stepping up to buy any dips.

What happens next is always the question most investors want answered. Today's conclusion of the Federal Reserve meeting and fresh statement will likely control the near-term. Higher stock prices have raised expectations going into the meeting. An announcement that at least confirms the possibility of more easing is probably necessary to prevent some backing and filling of recent gains.

For media stocks, the stock market action continues to leave the stocks whipsawed by investor sentiment toward the economy. The stocks till tend to be leaders on up days and laggards on down days. However, I have noticed a bit less traction on up days. I pointed this out last week and would have expected better bullish action following a lot of very positive presentations from advertising supported companies at last week's Bank of America Merrill Lynch Media Conference. Cable networks were notably bullish about 3Q and 4Q trends, noting no sign of slowing and strength across virtually all advertising categories.

There was one major bearish event coming out of the conference. Time Warner Cable indicated that 3Q was likely to see a drop in RGUs. This was unexpected in a seasonally strong quarter when college students return to campus and snowbirds begin to head south. TWC attributed the weakness to the economy, not too competition. However, DirecTV indicated that it was having a good quarter for subscriber additions driven by its free HD for life promotion. Other cable companies echoed TWC but did not indicate trends were quite as weak. TWC has had a habit in the past year of announcing poor subscriber numbers relative to its cable peers. I am not sure if this is a demographic, geographic, or management issue but it is odd in such a homogeneous industry.

TWC did tell conference attendees that major merger and acquisition activity was off the table. This refutes the rumors of a deal Cox Cable that were reported by Reuters last week.

Disclosure: No positions at Northlake Capital Management, LLC in stocks mentioned.

Macro Concerns Still Dominating Media Stocks

Trading volumes on Wall Street are seasonally low in late August until Labor Day passes. But that has not led to a lack of movement. Stock prices are under severe pressure having given up most of the gain off the July yearly lows. The major concern continues to be the economic outlook. Data remains weaker than expected and the risks of a double-dip recession have risen in reality and in the eyes of investors. The stock market discounts the future so sellers are ahead of the economy. What makes investing so hard, particularly for shorter time horizons is that we won't know the economic facts for a few months.

I've written regularly that the macro concerns are overwhelming individual company fundamentals. This is true whether the stock market is rallying or selling off. Another way to say this is that correlation among individual stocks, industries, and economic sectors is unusually high. In media, this means, sell all the stocks when economic concerns intensify and buy all the stocks when the economic outlook improves. It does not matter if third quarter guidance for advertising growth is better than expected when the sentiment toward the economy is negative. No one believes the advertising dollars will actually be sent. Instead, the assumption is that late 2010 and 2011 earnings estimates are too high.

For the time being, I expect this macro driven market to remain dominant. However, other than day traders, we can't ignore micro level fundamental developments, and despite the late August lull, there have been a few items worth noting.

The biggest news was Netflix buying the streaming rights to Paramount, Lionsgate, and MGM films from EPIX. Netflix is betting its future on streaming hoping to finance expensive content purchases by attracting new subscribers and buying and shipping fewer DVDs. I understand Netflix approach and I give them credit for going all in but I am uncertain how this will play out. The only obvious winner appears to be Liberty Starz (LSTZA), which controls the streaming rights for Disney and Sony films to be produced and released through 2015. Starz has sold this content to Netflix for several years at a huge discount to the price paid to EPIX. Furthermore, Disney and Sony are more valuable than Paramount et al especially when considering scarcity since most of the rest of studio output is controlled by HBO.

The studios (Time Warner, News Corporation, Viacom, and soon to be Comcast) might be winners as the streaming rights are suddenly worth big money. This is a nice development given the collapse in DVD sales. However, the risk of substitution to box office, rental, VOD, and more DVD sales is high. The fight over windows for availability of studio content is what is really at stake, however. Windows have driven profits, so elevated uncertainty about future windows leaves the Netflix-EPI deal as mixed for studios.

Cable, satellite, and telco TV distributors seem like losers as a robust Netflix option threatens video subscriptions and premium purchases such as movie channels, VOD and DVRs. The timing could not have been worse for cable as 2Q10 subscriber counts showed a decline in video subs for the first time ever. In last week's column for SNL Kagan, I mentioned that I was surprised the year-over-year drop in subs had not gotten more attention. That is no longer the case: the Wall Street Journal and Business Insider wrote about the drop in subs.

I still think that over-the-top-video is a much smaller threat than feared but in a market deep in negative sentiment, the combination of the Netflix-EPIX deal and declining subs came at a bad time. Despite the risks to cable and poor action in the stocks I remain long a lot of cable stocks at the Entermedia hedge fund as I feel the over top risk plays out very gradually over many years while declining capital intensity and rising free cash flow on still low to mid single digit revenue and operating cash flow growth is here today and for the foreseeable future. Domestic cable stocks are less attractive than the advertising driven stocks held in Northlake client accounts.

Disclosure: LSTZA is widely held by clients of Northlake Capital Management, LLC , including in Steve Birenberg's personal accounts. LSTZA is also a long position in the Entermedia Funds. Steve Birenberg is sole proprietor of Northlake, an SEC registered investment advisor. Steve Birenberg is co-manager of the Entermedia Funds, long/short hedge funds focused on media and communications stocks. Steve also owns a portion of the Entermedia Funds' investment management company and has personal monies invested in the Funds.

Good Earnings Reports for CBS, Virgin Media, Discovery Communications, and DirecTV

Over the past two weeks, three of Northlake's media long positions reported second quarter 2010 earnings. In addition, the recently sold DirecTV (DTV) reported results. The other three companies to report were CBS, Discovery Communications (DISCK), and Virgin Media (VMED). All four companies met or exceeded consensus estimates on most important financial and operating metrics. Guidance and/or commentary on the second half of 2010 and 2011 was positive and generally better than current consensus estimates. CBS, VMED, and DTV shares responded positively, while DISCK pulled back after reaching an all-time high on the eve of the report.

CBS comfortably beat estimates across the board driven by double digit advertising growth and excellent controls. Following a couple of quarters where programming investments offset the advertising recovery, 2Q10 revealed the operating leverage inherent in CBS' ad heavy business model. Management was firm in noting that cost controls would remain for the long-term. CBS has refinanced and improved its balance sheet which will lead to an announcement of higher dividends or a large share repurchase before year end. If the economy holds together, CBS shares can trade to the upper teens.

DISCK reported accelerating domestic advertising growth of 13% and continued 20% plus ad growth outside the US. Management made very constructive comments about long-term margin expansion and outlined plans for development of the new kids network, The Hub, and the Oprah Winfrey Network, OWN. The Hub launches in the fall and OWN in January 2011. With accelerating momentum in core channels like Discovery, TLC, and Animal Planet about to be accompanied by the elimination of startup losses and potential value creation at the new nets, DISCK shares can trade to the mid to the upper $40s. Helping matters is a long awaited announcement that the company will begin to buyback shares via a $1 billion authorization. This should be especially helpful to the DISCK shares which trade at over a $4 discount to the DISCA shares for no good reason. Management indicated they will buy back the shares "that make the most economic sense." It seems pretty obvious to me that would the DISCK shares.

VMED continues to benefit from its superior broadband network, improved competitive position in TV programming, and very effective management. Growth in financial and subscriber measures continues to pick up leading to very strong free cash flow that has dramatically improved the company's balance sheet and set up the potential for large share repurchases. Much of this positive outlook has been evident for over a year but the European sovereign debt crisis and the UK's weak economy and deep austerity policy kept the shares under pressure. An easing of the crisis, most evident in sharp rallies in the Euro and Pound, has allowed VMED's improving operating and financial performance to take center stage. The shares are nearing my initial target in the low $20s and may be due for some trimming but financial performance arguably justifies a higher target and suggests holding a core position makes sense.

DTV was sold from Northlake accounts ahead of its earnings report as I feared a slowdown in subscriber growth would lead to even more competitive conditions in the battle for subscribers in the mature pay TV industry in the US. My sell decision turned out incorrect as DTV reported better than expected US subscriber growth accompanied by higher ARPU (average revenue per unit or subscriber). Furhtermore, the rapidly growing Latin America operations accelerated again thanks to the World Cup. DTV raised its 2010 guidance at both business segments and authorized another large share repurchase. I still think competitive conditions in the US could upset the otherwise excellent DTV story and 2Q10 results did see a sharp increase in subscriber acquisition costs as the company is now giving HD away for free. However, extremely aggressive share repurchases, strong focus on segmented, higher end US subs, and rapidly growing LatAm operations should support the stock at current or higher prices.

Disclosure: CBS, VMED, and DISCK are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve Birenberg is sole proprietor of Northlake. CBS, VMED, DISCK, and DTV are net long positions in the Entermedia Funds. Steve Birenberg is co-portfolio manager, an owner of the Funds' investment management company, and has personal monies invested in the Funds.

Early 2Q Earnings: Stocks Being Sold But Hopeful Signs for Media

Earnings season is off to a rough start as far as stock prices go. Some stocks gap higher on good numbers but can’t hold the gains (Intel). Some stocks have mixed results and get smacked (GOOG and the big banks). Some stocks miss and get smoked (MAT) and others beat and get sold (HAS).

The broad message from the early reports is that business in 2Q was just fine relative to expectations and guidance so far indicates that fears of a slowing economy have yet to show up in demand beyond weak revenues for banks. Communications datapoints are quite limited and will kick into gear late this week when AT&T reports on Thursday and Verizon reports on Friday. The news so far in media looks good with advertising revenues in 2Q and guidance commentary constructive.

Despite a big sell-off in its stock, Google (GOOG) actually beat on revenues. The issues worrying the street are slowing growth and the heavy investment GOOG is making to sustain growth. Margins are under a little pressure but what really seems to worry investors is that Google's decision to invest suggests a much more competitive and mature search market. For media companies in general, the beat on Google's revenues is a positive. Advertisers are clearly spending on search (up over 20% globally and stronger in the US). Google does not provide guidance but the Q&A on the call did not reveal any worry about near-term demand trends.

Good news on advertising also came from NBC Universal, which reported as part of General Electric's report on Friday. Revenues rose 5%, operating profit gained 13%, and trend in advertising were at the high end of expectations. Cable nets were up high single digits and local TV stations reported ad gains in the mid to the upper 20% range. Given NBCU's broad reach, these ad growth rates speak well to what is to come from other cable and broadcast network companies.

Gannett also provided some good news even though the stock sold off 10% on the report. Gannett reported a 20% increase in 2Q TV station ad revenues and provided a forecast for even stronger growth in 3Q, up in the mid 20% range. Furthermore, according to the Wall Street Journal, Gannett indicated that ad rates are firming and "haven't seen" any pullback in advertising due to recent worries about the economy and financial market volatility.

This week won’t bring much more clarity or information on the advertising outlook. Yahoo reports Tuesday after the close and Street commentary and action in the stock price indicates the results could be decent. The only other media company of note to report is Netflix. The commentary could provide some read-through to DVD trends at the major movie and TV studios and maybe some insight into the re-basing of windows.

The big action for media earnings is the first week in August. I think there is reason to be optimistic about 2Q results and guidance commentary but until we get some better data on the US economy I think it will be hard to make money in the stocks. Expect the stocks to remain volatile, leading the market on up days and lagging on down days. Until we get firm data on the outlook in the second half of 2010 and 2011, the stocks remain hostage to investor sentiment toward the economy.

Disclosure: Google is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. Google and Hasbro are net long positions in the Entermedia Funds. Steve Birenberg is co-portfolio manager of the Entermedia Funds, partial owner of Entermedia's investment management company, and has personal monies invested in the Entermedia Funds.

Media Stocks Ignore Solid Quarterly Earnings

One of the oddities in specializing in media stocks is that most all of the companies report quarterly earnings within a tight two week window including the last week of the first month of the new quarter and the first week of the second month. This quarter media earnings season overlapped with two trips to NY related to my son's graduation from NYU. The busy schedule kept me from providing the usual in depth earnings analysis of Northlake's holdings in Virgin Media, DirecTV, Liberty Starz, Discovery Communications, and CBS. Fortunately, each company at least met expectations with several exceeding Wall Street estimates.

In lieu of detailed company-by-company analysis, here is a general review of the entire media earnings season followed by some comments on how stocks reacted.

Second Quarter 2010 Media Earnings Recap

The latest earnings season for media stocks is now about two weeks in the past. Even before the market turned lower a pattern had emerged. Media companies would report better than expected or in line results and the stocks would trade lower. Most companies showed upside at the revenue, EBITDA, and free cash flow lines built upon upside to key financial drivers including advertising growth, movie box office performance, or subscriber metrics like net additions or ARPU. In other words, from a purely fundamental standpoint, media companies reported excellent first quarter results.

It hardly mattered to the stocks, many of which have traded down close to 10%since reporting. Granted media stocks have been leaders with many up 100-200% since the March 2009 lows. Most stocks were trading at 52 week highs entering earnings season. With the benefit of hindsight, the expectations bar was clearly too high. This was even the case for companies who produced "beat and raise" quarters including Time Warner, Viacom, Discovery Communications, HSN Inc., and Scripps Interactive.

Periods like this are tough if you are long stocks. I take solace in knowing that value was built during the first quarter as evidenced by rising 2010 and 2011 estimates and numerous increased share buybacks or dividend increases. In the short run that has not done any good but I am confident that most media stocks will make new 52 week highs later this year if the U.S. economic recovery remains on track.

Northlake Media Stock 1Q10 Comments

Virgin Media saw its operational and financial turnaround accelerate. Unlike most media stocks, the shares responded well. VMED shares ultimately gave back the post-earnings gains due to weakness in the Euro and Pound and fears about European economic growth. I think the weakness will prove temporary as new management is finally exploiting the competitive advantage of Virgin's high speed broadband network. I think there is a lot more to come for the stock now that Virgin's balance sheet has been refinanced.

The highlight for Discovery was 9% growth in domestic advertising. Revenue and EBITDA slightly exceeded estimates. Trends in the U.S. and abroad were both good. The company raised 2010 guidance indicating that April was as good, or better, than the first quarter. Despite the good news, DISCK shares sold off in a perfect example of "sell the news" and "good news already priced in." DISCK remains the best growth story in traditional media and a large share buyback announcement lies ahead in the second half of 2010 providing a catalyst for shares and for DISCK to close the gap with DISCA.

CBS merely hit estimates, which was not good enough for the stock even ignoring the market decline. We like what we heard on the advertising outlook, however, which was better than CBS' closest peer, News Corporation. Some investors are worried about rising programming expenses that led the Entertainment segment, dominated by the CBS Network, to slightly lag on profitability. Nonetheless, 2010 estimates rose slightly coming out of the quarter giving more comfort to my bullish outlook for the shares.

DirecTV had another solid quarter. Subscriber growth in the U.S. missed expectations but ARPU was better than expected as was expense control. Latin America beat estimates across the board. The big news was the company affirmed a massive share buyback equating to one-third of the shares outstanding by the end of 2011 by establishing new balance sheet targets. Slowing sub growth in the U.S. and an intense competitive environment with Dish Network, cable, and telcos remain worrisome but DTV remains the poster for returning free cash flow to shareholders, the holy grail of media investors at the moment. DTV is the only media stock to trade up and hold its gains off the quarter indicating investor preference for cash return to shareholders.

Liberty Starz had good news with the report that it grew subscribers at Starz and Encore from the December quarter. Subscriber losses are one of the primary concerns of investors in the story. The balance sheet is underleveraged leaving lots of room for share buybacks. However, repurchases slowed during the quarter creating some concern about possible big increases in programming investment in original series. The shares are extraordinarily cheap and I trust Liberty Media management to realize the value as they have done with their other tracking stocks. Northlake's LSTZA positions are generally small as they were obtained in a transaction involving DirecTV. I would like to add to the holdings on a pullback to the upper $40s.

Disclosure: VMED, DISCK, CBS, DTV< and LSTZA are widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts. Steve Birenberg is sole proprietor of Northlake Capital Management, LLC. VMED, CBS, LSTZA, DTV, TWX, VIA.B, HSNI, and SNI are long positions in the Entermedia Funds. DISCK is a net long position at Entermedia vs. a short in DISCA. NWSA is a net long position at Entermedia vs. a short in NWS. Steve Birenberg is co-portfolio manager of the Entermedia Funds, owns a portion of the Funds' investment management company, and has personal monies invested in the Funds.

U.S. TV Viewers Remain Couch Potatoes

This column originally appeared on SNL Kagan on March 23rd.

With all the headlines about over-the-top video, retransmission fees, and the iPad, one would think the business of TV is about to massively change for the worse. Add in the continued growth of DVR households and it seems like TV as we know it is doomed. One thing overlooked in all these articles is that in the U.S. viewers continue to consume more TV than ever.

According to the latest Three Screen Report from Nielsen Company, in the fourth quarter of 2009, U.S. viewers watched an extra hour of TV per month compared to the same period in 2008. U.S. viewers spend over 153 hours a month watching TV! TV viewing is rising even as internet video watching grew over 16% to 3 hours and 22 minutes each month.

A portion of the increased TV viewing comes from continued penetration and use of DVRs. DVRs are now in about 36 million households, up more than 1 million on a sequential basis in the fourth quarter, representing about 33% of U.S. households. SNL Kagan estimates that penetration of the most valuable digital TV subscribers is even higher at 43%. Nielsen notes that DVR viewing, or time-shifted viewing continues to grow and has recently reached more than 8 hours per month. The growth in overall TV viewing includes time shifted-viewing, which does raise issues surrounding advertising skipping.

The most important takeaway from the latest Three Screen Report is once again that U.S. viewers continue to watch more and more TV. Despite the ongoing concern that viewers will cut the cord and watch only the shows they can find online, the reality remains that traditional viewing habits are largely unchanged.

One reason for this is that despite steady and rapid use of DVRs and internet video remains a modest portion of TV total TV viewing. DVR and internet viewing combined is still under 10% of total monthly viewing. Furthermore, TV networks and advertisers are operating under a Live + 3 system for advertising sales, limiting the impact of time-shifted viewing on the TV business model. Another factor is that digital penetration continues to deepen, offering viewers more channels and content from which to choose. Even the upgrade cycle to HDTV helps as viewers like to watch the great picture on their new investment on an increasing array of HD content.

If DVRs are excluded, the over-the top video threat seems minor with just 3 hours monthly, or 2% of traditional monthly TV viewing. In addition, Nielsen reports that for anywhere from 4 minutes to 35 minutes a month, depending on viewer age, there is simultaneous use of a TV and the internet. It is likely that at least a small portion of this is simultaneous use of internet video and TV.

I do not mean to minimize the challenges facing the TV business by parsing the viewing data in a favorable light. However, I continue to think the challenges to the TV model are playing out more slowly than perceived. TV networks and multichannel distributors are fighting back with Live + 3 ratings, TV Everywhere, continued penetration digital packages, and more HD content. But most importantly, U.S. viewers remain couch potatoes.

One of my adages as an investor is to stay focused on the big picture. For TV, the big picture is whether viewers are watching. For now, they are. And they are overwhelmingly watching as they always have.

Disclosure: Virgin Media is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Virgin Media common stock and convertible bonds are long positions in the Entermedia Funds. At the time this column was written, City Telecom is a short position in the Entermedia Funds. Steve Birenberg is co-manager of the Entermedia Funds, owns a portion of the Funds' investment management company, and has personal monies invested in the funds.

Quarterly Media Earnings Good But Stocks Trade Lower

The following commentary summarizes recent media company earnings reports including Discovery Communications (DISCA), which remains widely held by Northlake clients. Since I wrote these comments, it was announced that DISCA will be added to the S&P 500. This provided about a 10% pop in the stock price.

The past several weeks have witnessed a series of earnings reports from many major entertainment and media companies. Following the initial round of reports from communications companies I wrote the following:

"On a macro basis, the story so far this earnings season has been pretty solid earnings reports, but stocks have sold off as guidance commentary is being interpreted cautiously. Investors seem to be saying that the big run in stocks from March 2009 through early January already discounted the improved results being reported."

Unfortunately for long investors in media and communications those words exactly describe the reports and stock market reactions for entertainment and media stocks reporting in the past two weeks.

I had hoped that stock market correction that kicked off in mid-January, which deeply punished entertainment and media stocks, had lowered the bar enough for the stocks to react positively as long as companies did not miss on earnings or guidance. Sadly, that was not the case.

Obvious upside surprises, including the always rewarded "beat and raise," at best lifted a stock for a day or two before profit-taking began. News Corporation and Starwood Hotels belong in this category.

The plain, old inline report and guidance was generally met with selling. Comcast, Time Warner, Disney, Discovery Communications, and Viacom all reported in line to better than expected result for the fourth quarter of 2009 and provided guidance in line with current analyst estimates. The stocks all sold off.

Scripps Interactive reported a confusing quarter that missed some analyst estimates. Guidance for 2010 also fell short from some estimates. Confusion stemmed from the acquisition of the Travel Channel. The company also appeared to tone down extremely high expectations for affiliate fee growth, which I would argue management had previously supported. Scripps shares sold off sharply in a deserving reaction to missed results. The decline as compounded by the industry leading valuation multiple given the shares as of early January.

While I believe I have accurately characterized the response to quarterly earnings reports so far this quarter as "Sell the news," there have been a few exceptions. In an odd coincidence, all three companies with big positive reactions in their stocks reported on February 10th. Wyndham Worldwide was rewarded for its "beat and raise" quarter getting a further boost from a dividend increase. Millicom International bucked the trend of disappointing results from wireless companies with upside to its financial numbers and a blowout on subscriber additions. Millicom shares jumped 10% as investors found a growth vehicle again in wireless. Activision Blizzard reported in line results and guided slightly below street estimates. However, after every other video game company missed and guided lower, the expectations for Activision were quite low, so the results were good enough to separate the company from the pack. The stock jumped about 10%.

My comments so far have focused on investor reaction to the earnings. People who do not follow stocks for a living need to understand that short-term reactions are based on how results and guidance compare to expectations and what expectations are built into stock prices. However, most observers and many investors still focus on longer term trends.

On this front, for media stocks, the key takeaway from this quarter's reports and guidance is that advertising is improving sequentially but visibility for further gains remains low. First quarter 2010 ad trends look set to for further sequential acceleration. Other areas of focus for investors have been programming expenses (rising as expected) and affiliate fees (growing nicely despite the confusion at Scripps Interactive), and subscriber gains (slowing everywhere except for international cable TV networks). None of these secondary issues contained surprises.

Overall, investors remain concerned that the economy is not recovering strongly enough to meet current expectations for 2010. Management commentary was just cautious enough to leave an opening for the bears to argue that expectations are too high. In a market environment that has a newly bearish tone, the selling is not surprising.

Trading Activity Recap

Over the past two weeks, my trading activity for my long only and hedge clients has been on the quiet side. This is usually the case during quarterly earnings season as I tend to a patient investor and prefer to adjust positions after the dust settles. There have been a few trades of note, however, in my hedge fund.

I added to my long position in News Corporation and the News Corporation pair trade long NWSA/short NWS) after the company's outstanding earnings report. I also added to my long position in CBS which should have similarly good results to News Corporation. I took a bullish option position in Time Warner after the stock sold off following what I thought was a solid report and outlook. So far this trade is a loser but a small pop in the stock above $28 is in reach and would generate a nice profit. Finally, I took a new position in Adobe Systems as the stock has sold off due to controversy surrounding Flash and HTML5 ahead of a next upgrade of the company's flagship Creative Suite. The stock normally does well into new software releases and I believe there is pent up demand as the last upgrade hit when the economy was decelerating and company's were looking to cut costs and save cash.

Disclosures: News Corporation, CBS, Adobe Systems Time Warner, Comcast, Starwood Hotels, Discovery Communications, Wyndham Worldwide, Millicom, and Viacom are net long positions in the Entermedia Funds. Discovery Communications is a long position at Northlake Capital Management, LLC. Birenberg is co-owner and co-manager of Entermedia and has personal funds invested. Birenberg is sole proprietor of Northlake and has personal funds in Discovery Communications. Opinions expressed in this piece are solely those of the author and do not represent the views of SNL Kagan.

Steve Birenberg to Co-Manage Entermedia Growth Partners Hedge Fund

I am pleased to announce that beginning January 1, 2010, I will be co-managing Entermedia Growth Partners. Entermedia is a 16 year old hedge fund focused on media, communications, entertainment, and communications technology. Entermedia will be a separate business from Northlake but is highly complementary. The Entermedia investment portfolio contains long and short investments in many of the stocks that Northlake clients currently own or have owned in the past. The universe from which investments are drawn at Entermedia is virtually identical to the universe I research on behalf of Northlake clients.

Northlake clients will benefit in several ways from my involvement with Entermedia. First, Entermedia may be a good investment option for some Northlake clients. The fund is managed more aggressively than the typical Northlake portfolio but Entermedia also uses lots of hedging strategies. This has allowed the fund to perform well in both rising and falling markets. In fact, one of Entermedia’s best years was 2008 when the fund fell just 8% despite a 40% decline for many major market averages. Second, the larger combined asset base of Northlake and Entermedia will allow greater access to research services, company management teams, and Wall Street analysts. More resources will be available to Northlake as I strive to continue the fine record of investment performance created over the past five years.

Entermedia is currently managed by Ken Goldman, one of my best friends and my primary confidante on media and telecom stocks. Ken is several years older than me and is retiring so he and his wife can spend time in China where Ken’s wife was born and raised and her family still lives. Another of my best friends, Tom Curran, will be my partner at Entermedia. Tom and I have been friends since our kids were in the same classes in grade school. Amazingly both of us have a child about to graduate from college! Tom has prior experience managing his own hedge fund and will handle all operational aspects of Entermedia in addition to bringing his expertise at analyzing balance sheets and corporate credit quality. Northlake clients can also gain comfort in that Tom will be sharing my office space and available to cover for me when I am out of the office during market hours.

I am very excited to be expanding my own money management activities and thrilled that Entermedia is such a complementary business that will bring many advantages and opportunities to my Northlake clients. I look forward speaking with each Northlake client about Entermedia as we discuss year end planning. In the meantime, have a great Thanksgiving holiday!

Renewed Takeover Speculation Adds Another Leg to Media Stock Rally

Media stocks continue to be market leaders in the latest phase of the stock market rally. The market rally is based on improved sentiment and data toward a global economic recovery. Most revenue drivers for media companies are highly sensitive to economic growth so it is not surprising that media stocks are among the sectors leading the rally. However, I think another is at work. After a multi-year lull, mergers and acquisitions have returned to the forefront of media company strategic planning.

Until this decade, media companies were very acquisitive providing strong support for media stock prices. The AOL-Time Warner merger represented the peak and quickly went wrong putting an end to media M&A except for divestitures. The recession, the collapse of credit markets in 2008, and accelerating secular challenges completely took takeover activity off the table. Now it appears that activity is picking up. In the past, media properties always were sold at a premium to their public market values because they were trophies and often produced good cash flow. Renewed acquisition activity now supports higher valuations for media properties which still trade at a discount to private market value.

The big M&A news, of course, was Disney's recently announced acquisition of Marvel Entertainment. The deal garnered major headlines but to put it in perspective, Disney is paying $4 billion for Marvel against its own market cap of $48 billion. I think this is an important deal for Disney but we are not talking AOL-Time Warner.

Published reports rehashed the deal pretty well so I am not going to dwell on it. However, I think the major takeaway is that branded entertainment may have a leg up on advertiser supported entertainment. Marvel has great brands which Disney can exploit in movie production, theme parks, merchandising, and cable and broadcast TV. No media company has a better array of consumer touch points than Disney but the idea that revenue share for major entertainment conglomerates may shift in favor of branded product at the expense of advertising is legitimate.

Brands can be exploited through any distribution. Advertising is fragmenting and its effectiveness in the digital age is being questioned. All the entertainment companies are already exploiting brands. Time Warner has DC Comics and Harry Potter. Viacom is late to the game but has Transformers, Star Trek, and maybe a revived G.I. Joe. Discovery Communications is rebranding one channel with Hasbro and another with Oprah Winfrey. Whether the brands are being used to attract viewers and advertisers or sell product, the idea is the same: defend market share and attract revenue not just with distribution but with branded entertainment.

The M&A front has also heated up elsewhere. Press reports indicated that bids for Travel Channel were coming in at a better than expected than $800 million. Leading bidders are said to be Scripps Interactive, News Corporation, and private equity in partnership with Discovery Communications. Helping the deal may be a rumor that Cox Communications is willing to guarantee Travel's current debt.

According to SNL Kagan, Travel Channel will have operating cash flow of $69 million in 2009 and $76 million in 2010 with margin of 37-38%. On these estimates the pricing does not appear to be attractive, just 10-11 times EBITDA, or not far off current pubic valuations for Discovery Communications and Scripps Interactive. However, Street analysts have lower estimates with Jessica Reif of Merrill Lynch at around $50 million. A 16 multiple would not be far off pre-financial crisis levels and has positive implications for valuations of publicly held cable networks.

Even if the deal is completed at 16 times, it offers upside to the acquirer. At best it appears that Travel is operating at an upper 30% margin. Many other non-fiction based cable networks operate near a 50% margin. With economies of scale and broader reach enabled by a stable of networks, the new owner of Travel seems to have a good opportunity to quickly raise profitability and slightly accelerate revenue growth.

Somewhat surprisingly, Time Warner and NBC Universal have not been bidding. Travel fits well with either and both have shown a willingness to acquire new assets. The participation of private equity is also a surprise. Apparently, Discovery Communications would partner with private equity by providing management services including advertising sales.

At $800 million, an acquisition of Travel Channel by any of the companies I have mentioned would not be a make or break deal financially. News Corporation probably faces the most skeptical audience of investors given concerns about Rupert's strategic vision but a move to add to the one business segment that offers growth may be well received. Scripps Interactive is the most obvious buyer with the best fit. Normally a smaller company may face financing issues but Scripps is debt free and can easily handle the deal. In fact, easing of financing conditions is one of the reasons that M&A activity is picking up.

M&A speculation also got a boost when a Federal judge threw out the FCC's 30% ownership cap on cable TV system operators. This mainly impacts Comcast and has renewed speculation of a Comcast-Time Warner Cable deal or an acquisition of Cablevision by Comcast or Time Warner Cable post the spin-off of its Madison Square Garden properties. I am a little skeptical that any of these deals happen in the next two years but the renewed speculation adds to valuation support for media stocks and gives investors another reason to focus on the group.

Disclosure: Discovery Communications is widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts.

Stability Without Recovery Defines Second Quarter Media Earnings

Most media companies report quarterly earnings in a two week span beginning with the last week of the first month of each calendar quarter. Below is a two-part recap of second quarter earnings season that was originally published on the Dow of Steve Blog at SNL Kagan Interactive.

Week One Recap: July 27 – July 31

Entering second quarter earnings seasons media stocks faced a very high bar due to their leadership in the rally off the March lows. Most media stocks entered earnings season trading at post-crash highs with the pace of gains accelerating since first-quarter earnings reports suggested fundamental decline had ceased and management commentary offered hints of recovery.

In general, media earnings reported the last week of July met or exceeded expectations. Trends in advertising and consumer demand for media products and services were quite similar to the first quarter, supporting the idea that media stock fundamentals have reached a bottom. However, there were few signs, if any, that fundamentals have begun to improve. In fact, compared to first-quarter commentary, media management teams seemed less sanguine about a recovery in demand. Given the big run in the stocks, this setup led to selling even though the results themselves were OK and forward estimates are little changed.

Selling of media stocks might have been worse last week except for a strong underlying bid for stocks in general and growing investor acceptance that the economy was beginning to recover. Friday's gross domestic product report showing a decline of just 1% confirms that the economy will likely grow in the second half of 2009. This should provide solace to media investors hungry for improved fundamentals, as most drivers of media demand are sensitive to broad trends in GDP. As a result, barring a negative shift in investor sentiment toward the economy, I do not see significant downside in media stocks relative to the market.

There are still many important media companies that will report earnings this week, including Comcast Corp., DIRECTV Group Inc., Scripps Networks Interactive Inc., News Corp., CBS Corp. and the Liberty Media Corp. complex of tracking stocks. I suspect we will hear more of the same, with the best news coming from the cable networks companies and DIRECTV. I also expect the stocks to respond similarly to last week unless any company indicates that demand is actually improving.

Here is a brief recap of the key earnings reports from last week:

Viacom Inc. led things off on Tuesday and reported improved results in its cable network business offset by another rough quarter at Paramount and very weak sales of Rock Band video games. Domestic ad trends improved to -6%, 300 basis points ahead of the first quarter. Ratings are also on the upswing offering hope that trends will continue to improve. I was pleased that excluding Rock Band cable network operating margins appear to be improving. I thought Viacom's results would cheer investors. Initially, the stock popped more than 3%, but when it reversed those gains in a few hours, I realized that media stocks faced a tough go of it this earnings season. The expectations bar had been raised too high.

Time Warner Inc. followed on Wednesday morning with a better-than-expected report. Most of the gain was fueled by filmed entertainment, with "The Hangover" already benefitting results. Cable networks were a bit better than expected with domestic trends flat, as entertainment networks had positive advertising gains while news networks declined due to tough comps from last year's elections. Analysts and investors were quick to discount the positive surprise by noting that the third quarter was going to prove tougher. Furthermore, analysts pointed out that there were several small one-time benefits that made the numbers look better. I think the reaction to the results is indicative of investor unwillingness to bid media stocks ever higher without concrete signs of fundamental improvement. These same results reported a few weeks ago would have been met with a nice upward move in Time Warner shares.

Walt Disney Co. reported Thursday, and it had the worst numbers of the big three. Partially this is due to the greater economic sensitivity of its business operations. Weak trends at ABC, the local TV stations and theme parks are no surprise. However, a 10% decline in ad spending at ESPN is troublesome compared to other cable networks. Disney management is responding capably to the economic headwinds. Dramatically less margin pressure at theme parks amid still weak demand is impressive. Unlike Viacom and Time Warner, where I felt the drop in stocks was related mostly to expectations, at Disney I think there are reasons to be a seller. While the company has an impressive set of assets and management team, in a tougher economic environment, the premium accorded the shares is less warranted. Furthermore, the other conglomerates are reorienting their asset mixes and operating strategies and starting to look more like Disney. For the stocks, I think this resolves itself with a smaller gap in relative valuations. As the expensive stock in the group, I think, Disney struggles until a demand-driven economic upturn is at hand.

Regal Entertainment Group reported in-line results, reflecting the positive box-office trends in the second quarter. The shares sold off sharply, however, because profit margins are under pressure from the digital upgrade and higher interest expense. I think Regal is making the right decision to accelerate the digital upgrade rather than wait on the industry consortium to arrange financing. 3-D movies are proving their ability to bring premium ticket prices, but the premium may shrink over time as moviegoers become accustomed to 3-D. Digital upgrades are costly to earnings estimates and coming at a time when the box office has cooled considerably and year-over-year comparisons are deeply in negative territory. I'd be a buyer of Regal on further weakness toward the $10 level.

Cablevision Systems Corp.'s report was overshadowed by the formal announcement of the spinoff of its Madison Square Garden assets. Going ahead with the spin unlocks value and comes as a relief given past missteps by the company and the Dolan family regarding restructurings. The company's cable results were in line with estimates and show that it is coping well with competition from Verizon Communications Inc. Cablevision's business cycle is running a few years ahead of the other major cable companies, so the fact that free cash flow is expanding rapidly as growth slows is a sign of the future for cable. I think it is an attractive financial profile, but cable stocks remain in transition between growth and value investors. What would really help the group is better-than-expected results this week from Comcast. I am not expecting that to happen, but if it does, look for a strong positive reaction in the group similar to the bounce in AT&T Inc. (up 8%) since it reported solid second-quarter results.

Week Two Recap: August 3 – August 7

The second week of the latest quarterly earnings season for media stocks looked a like the first. Most earnings reports met or slightly exceeded expectations. Positive news came from cost cutting, operating margins, and improved balance sheet liquidity. The news on revenues was mixed at best. Many companies fell shortly of Wall Street estimates and there was no evidence that demand for advertising or consumer spending on media had improved.

Against this backdrop, media stocks performed well again as they did during the first week of earnings season. Over the past week, the SNL Kagan Media and Entertainment Index has risen 3.7%, against a gain of just 45 basis points for the S&P 500. TV and Radio station stocks led the way but all Kagan Primary Focus and Business indices beat the S&P 500 except for Publishing and Theaters. Publishing stocks took a breather after newspaper stocks exploded higher following Gannett's better than expected results. Theater stocks suffered following a mediocre report from Regal and negative year-over-year comps at the box office.

Radio and TV station stocks rebounded from severely depressed levels as there were continuing signs that local ad markets were improving. Most companies reported a several hundred basis point in the rate of decline of ad spending and indicated that third quarter trends continued the improvement. Keep in mind revenue declines still range form mid-teens to upper 20's depending on the media. However, as far as Wall Street is concerned what matters is trend, not level. For now, the street is willing to be on the improvement trend proving sustainable at least through year end.

Conference calls were uniformly cautious. As during week one of media earnings season, commentary was less sanguine than on first quarter calls. Management teams noted slight improvement in demand and revenue drivers but were less willing to call the possibility of a return to positive growth.

The one exception was CBS. Keeping in mind that CEO Les Mooves is always optimistic and spins hard to support the outlook for his company, his comments were notably optimistic. Only Les could show emotional excitement about the Collector's Edition DVD of the first six seasons of NCIS!

Moonves indicated that CBS was seeing a strong recovery in network and local TV. He said scatter is up 30% and at a premium to last year's upfront. He indicated that CBS would sell about 65% of this year's upfront inventory with flat revenue. He noted that Cash for Clunkers and political were unexpected and material boosts to advertising demand. CBS stock responded strongly, peaking at a gain of 34% above the closing price just prior to the earnings report.

Overall, here are my key takeaways from second quarter earnings season:

• Advertising trends have stabilized but only minimal improvement is evident. Easier comparisons not better demand from advertisers is the reason for trend improvement.

• There is no pattern to ad trends by TV networks. Networks with ratings gains like Fox News or CBS or Discovery are seeing no or minimal difference in ad demand than weak networks. For example, CBS and ABC both reported -6% ad demand despite ratings gains for CBS and double digit ratings loss for ABC.

• Expense control is in line to better than expected across the board. Cuts appear to be in fixed and variable expenses.

• Wall Street is excited about positive operating leverage due to expense control. This is the fuel behind the outperformance of media stocks.

• Cable industry subscriber trends remain under pressure but free cash flow is benefiting from less new subs. It is unclear how this plays out for the stocks as growing data, voice, and digital TV subscribers can last only so long if analog TV subs continue to fall.

• Initial signs of ARPU pressure at DirecTV emerged.

• Foreign exchange headwinds are moderating and could shift to modest tailwinds in the fourth quarter if recent U.S. dollar.

• Video games are no longer an unequivocal positive. A rising tide no longer is lifting all boats. Consumer demand has slowed and the individual title is now what matters.

• DVD demand remains weak although pricing is holding up on animated titles. Animated titles are down in units but holding up better than live action.

Exiting earnings season I am maintaining a less than usual exposure to media stocks. I am comfortable with current valuations but further upside in the stocks from here relative to the S&P 500 is going to require definitive signs of a turn in advertising.

I have made no changes to my media holdings as a result of earnings season. I still own the CBS/Discovery Communications barbell giving me a leveraged cyclical play and a defensive/growth play. I am considering trimming my position in CBS given that the stock is up 75% since I bought it in early July. I also continue to hold Liberty Media Entertainment. The outlook for the indirect play on DirecTV is a little worse but the stub is looking better after a big positive surprise at Starz in the second quarter.

Disclosure: CBS, Discovery Communications, and Liberty Media Entertainment are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Barron's Boosts Media Stocks Ahead of Earnings

Earnings season for media stocks begins in earnest next week but there is still news flow that is impacting the stocks.

Media stocks soared on Monday after leading last week's rally. Monday's move was the result of a bullish cover story (subscription required) on the sector in Barron's. The author, Michael Santoli, essentially reiterated my view that TV and movie related media stocks are too cheap given that changes in the TV business are happening more gradually than conventional wisdom. Investors are extrapolating cyclical issues to an accelerated secular decline in industry profitability. I do not deny that secular challenges exist but TV and movies are not the same as newspapers, radio and music it is the implosion of those businesses that have investors on edge toward all media. Major media companies will grow again with significant earnings and cash flow upside in the early part of the economic cycle thanks to material and permanent cost cuts in response to the current crisis. Stock prices assume no or negative growth creating an opportunity for investors in media stocks.

After it appeared that the upfront might break, it appears that negotiations have again stalled. The broadcast networks continue to hold for flat to low single digit pricing declines, while media buyers want upper single digit declines. The bid-ask spread has narrowed but no meaningful business is being written by broadcasters. There are some signs of thaw in the cable network upfront but not enough to gauge pricing and volume trends. The longer the upfront drags on, the more pressure on media stocks as estimate risk for 4Q09 and 1H10 rises. The stalled upfront becomes a problem for the stocks if investor sentiment toward the economy sours again.

I have been a little surprised that cable stocks have not performed better since Cablevision's early July win at the Supreme Court in the Network DVR case. This is a clear positive for the group as it should lead to lower capital expenditures, fewer truck rolls and operating expense savings, and higher free cash flow. Investors appear worried about weak 2Q subscriber trends as little help is expected from the digital transition. In addition, over the top video and cord cutting remain a big concern.

Finally, news broke last week that Disney had reached agreement on expansion of Hong Kong Disneyland. Three new gates accompanying 30 attractions are on the way and should help to better position the park which many have felt was too small. Disney will invest $465 million and convert its current debt in the park to equity. While this news could be a financial positive for Disney in several years if park attendance and spending climb, I think the better news is that it clears the way for a deal on a park in mainland China near Shanghai. A Shanghai park would probably not make the same mistakes as Hong Kong and could be a real boon to Disney directly and its attempts to more broadly build its brands and characters in China. I remain on the sidelines in Disney, especially not that I have added cyclical media exposure though CBS. I can see a bullish opportunity coming for Disney, however, as 2010 should see a return of the content generation engine led by the return of Toy Story. A cyclical improvement in advertising and theme parks would also help.

Upfront Trying to Break Which Would Help Media Stocks

The following commentary first appeared in the "Dow of Steve" blog on SNL Kagan's subscription website on July 1, 2009.

There were signs in last that the upfront market was finally beginning to move although few if any deals have been struck between broadcast networks and advertisers. Experienced observers can point to only one other instance of the market breaking so late and rumblings about a haphazard, last minute ad marketplace that serves advertisers and networks poorly are growing. [UPDATE: The upfront stalled again after the July 4th holiday though the bid-ask spread on advertising has narrowed]

The stand-off appears to relate primarily to advertiser demands for double digit cuts in ad pricing based on CPMs. The news last week was that broadcast networks were close to deals ranging from upper single digit CPM declines for NBC, the weakest network, to low single digit declines for industry leader CBS.

If this pricing holds the upfront could prove better than expected for broadcast and cable networks but pricing is only part of the equation. Broadcast networks will also take a hit from lower rating guarantees and are almost certain to sell less inventory than they did a year ago. With so many prognosticators believing the economy will begin to recover and grow again this summer and fall, networks seem willing to gamble that scatter pricing during the TV season will be far better than what can be negotiated now in the upfront.

Overall, if last week's reports are accurate broadcast networks may be able to exceed the -15% overall upfront decline that many Wall Street analysts have been expecting. This would be good news for the stocks of the network owners including CBS, Disney (ABC), News Corporation (FOX), and General Electric (NBC).

The cable network upfront usually breaks after the broadcast networks so if broadcast networks can limit the decline, it is likely that cable nets, which generally enjoy stronger ratings, will be able to limit year-over-year declines to low to mid-single digits. This would be a win for cable networks stocks including Discovery Communications and Scripps Interactive, whose networks should be among the best performers. The big conglomerates also will have pockets of strength including Fox News for News Corporation.

While the latest news makes sense, the late breaking upfront still leaves the risk that that a scramble to sell most of the ad inventory right before the new TV season starts is going to create inventory management problems for networks and advertisers.

It is funny but with all the talk of eliminating the upfront it just might be the current economic crisis that kills it or alters it significantly. After all, the upfront is based on analog TV economics that is still being used in a digital world. NBC already claims to have opted of the upfront with the changes it made last year. Could it be that a very late breaking market in 2009 effectively ends the upfront as we know it?

Should the theme that 2009 represents the end of the upfront as we know it, it would be a negative for TV network offsetting the possibility that the upfront itself is not as bad a as feared. I suspect that networks and advertisers can make the transition but Wall Street abhors uncertainty. For the networks the uncertainty is heightened because even though cancellation options exist, selling much of your inventory up to a year in advance provides a degree of predictability in financial results and business operations.

Disclosure: Discovery Communications is widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts. A handful of clients of Northlake Capital Management hold positions in General Electric.

Over The Top Video Threat Less Than The Hype

The following commentary first appeared in the "Dow of Steve" blog on SNL Kagan's subscription website on June 17, 2009.

The most significant secular debate in the TV industry surrounds over the top video (OTT). Whether or not consumers cut the cord has significant ramifications for cable and satellite companies, broadcast and cable TV network owners, and TV and movie producers.

Presently, Wall Street is worried about over the top video. The secular challenge to the long-standing TV business model is rising just as advertising is under massive cyclical pressure due to the global recession, which has been especially severe for the auto industry, historically TV's largest source of advertising revenue.

Media companies face other challenges as well but I believe currently depressed price-earnings ratios for stocks with TV exposure reflect a high degree of bearishness about OTT. I believe the worries are overdone as any material impact is many years away. As a result, I currently focus my limited media stock exposure on TV related stocks including Discovery Communications and Liberty Media Entertainment as a proxy for DirecTV. Other TV stocks are on my watch list including CBS and Cablevision.

This blog post was triggered by a recent column by Henry Blodget published on The Business Insider section of Silicon Alley Insider. The title of Blodget's column pretty much says it all, "Sorry, There's No Way To Save The TV Business." Blodget compares the current state of the TV business to the newspaper industry in 2002-2003. We all know how the newspaper industry has imploded just seven years later so the warning is quite dire for TV.

I strongly encourage you to read the whole article including the comment section, which is unusually insightful. Here is a recap of Blodget's argument:

Blodget argues that the very successful TV industry has been built on a foundation that is crumbling. He believes the foundation is built on the fact (1) that there is not much else to do at home that is as simple and fun as TV, (2) that there is no way to get video content besides the TV, (3) that TV advertisers have few other options to reach consumers, (4) that cable and satellite have an oligopoly over TV delivery, and (5) that "tight choke points" exist throughout the TV business model "through which all video content must flow."

Blodget believes that each of these foundations is slowly crumbling and has reached critical mass where the damage to the TV business model is going to accelerate much as it did for the newspaper industry over the past seven years.

Sticking with Blodget's foundations, it is easy to see why he believes there is no way to save the TV business. And OTT is the single factor that is weakening each foundation. Blodget extends the comparison to newspapers by stating that TV executives are responding poorly to the OTT challenge much as newspaper executives failed to counter and adapt the internet revolution.

As I noted, I generally disagree with Blodget. My primary area of disagreement is that I see the timing of material financial impact from OTT as being very extended. SNL Kagan supports this view while noting (subscription required) that OTT will gain share it will come mostly from new household formation that never purchases the cord. In other words, total households receiving TV under current distribution models are going to be stable. Furthermore, as I have noted before, despite the massive increase in internet usage, video games, and home theaters, total TV viewing is still growing.

On their own, these two factors strongly suggest that the outlook for the TV business is not nearly as dire as Blodgett or other OTT advocates suggest. However, there are many other faults in the OTT argument which were neatly summarized in the comments section of Blodget's article by my good friend KG, a hedge fund manager specializing in media stocks since the 1980s.

KG makes five excellent points. First, he notes the "behavioral inertia" related to TV viewing. Couch potatoes are far deeper engrained in U.S. culture than newspaper readers including a generational aspect. Second, as I already noted, usage patterns for TV suggest little impact despite years of secular challenges to TV (fragmentation yes, loss of viewing no). Third, the ability to deliver massive numbers of simultaneous streams of OTT may crash the current wired broadband networks. Current wireless broadband networks have no chance to handle millions of mobile TV watchers. This problem only gets worse as HD TV becomes more engrained with TV viewers. HD files are much bigger than the current experience of OTT. Finally, KG notes that live sports and special events are uniquely suited to the current TV business model which delivers this programming very efficiently to tens of millions of simultaneous viewers.

Building on KG's last point, I believe the delivery of multichannel TV is far more efficient for TV viewers than OTT advocates realize. Yes, today we all pay for a package of hundreds of channels and only watch a handful. However, if each network were forced to go a la carte, which is essentially what OTT promises, few networks could survive. Food Network gets affiliate fees from 90 million households. Its advertising revenue is composed at least partly by companies seeking casual, channel surfing viewers. If Food Network goes OTT or a la carte, it will be forced to finance its operation on just a few million subscribers. Subscriptions fees will have to be $1-2 a month to offset lost revenue from cable and satellite companies. CPMs on committed OTT subscribers will have to rise sharply to produce similar advertising revenue. Without replacing this revenue, Food Network won’t be able to invest in quality programming and viewership could suffer.

And Food Network is relatively cheap to operate. Use the same concept on networks that program dramas or movies or sports or live events and three things happen. First, consumers will find that their a la carte monthly bill for TV viewing quickly rises to $30-50. Second, the quality of TV programming suffers across the board. Third, many networks will not survive enraging their committed viewers.

In the end, multichannel TV is a good deal for consumers – they get the channels they want for a fair price and lots of other channels for "free" – and a good business model that is efficiently delivered for all aspects of the TV business.

I am not denying the secular challenges from OTT and other competitors for the TV viewer. Furthermore, the deep cyclical downturn in the TV business is exacerbating and accelerating the secular challenges. However, conventional wisdom is quickly forming that TV is in material secular decline.

I do not think that is the case, and when conventional wisdom overreacts, opportunity often knocks in stocks. Today, that may be the case for TV-related stocks. If advertising begins to grown again in 2010, the opportunity for investors will be at hand as OTT worries recede against a cyclical upturn.

Disclosure: Discovery Communications and Liberty Media Entertainment are widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts.

M&A Speculation Hits Hollywood

Over the past few trading days, shares of the two major independent Hollywood studios have moved up sharply. Dreamworks Animation (DWA) is up four straight days for a total of 13%. Lionsgate (LGF) is up 16% over two days. Both stocks were unusually strong on Tuesday on well above average volume.

Another studio in the news is MGM which is looking to refinance its balance sheet. MGM is privately owned by Comcast (CMCSA), Sony, Providence Equity, and TPG Group (formerly Texas Pacific Group).

I suspect what is going is speculation that these studios are going to be acquired. The Breaking News Blog at SNL Kagan reported that Liberty Media President and CEO Greg Maffei stated "We would look at a studio." Maffei also said that studios were an attractive and relatively stable business, while stating that "one or two" could be for sale in the near future. It does not hurt studio values that the movie business is booming so far in 2009, with the North American box office up 15%.

Besides Liberty there could be other buyers. Time Warner (TWX) is looking for acquisitions and has a very good balance sheet post its separation from Time Warner Cable (TWC). I find it interesting that TWX was down more than 3% as DWA jumped 3% on Tuesday. DWA's market cap of $2.3 billion is not massive and Warner Brothers could use the animated/family fare as it becomes more important to the new, smaller TWX. Also, TWX is looking to be more integrated, similar to Disney (DIS), and animated properties offer the best cross platform synergies in media.

CBS is a long shot buyer as it seeks to diversify from its reliance on advertising, particularly local advertising. CBS has a stretched balance sheet but recently refinanced its 2010 maturities relieving pressure. In addition, CEO Les Moonves is not shy and would gladly do a controversial deal if he thought it was in the interests of the company. In fact, he just did that when he bought CNET.

LGF has been in Carl Icahn's sites for several months. Sale to Liberty might be a good alternative. Liberty already owns a movie network in Starz and has started Starz Media for original productions similar to HBO or Showtime.

I think both DWA and LGF are overvalued presently and if no deals or stronger rumors emerge both are vulnerable to a pullback.

We're Still Watching TV The Old-Fashioned Way

I have pointed out repeatedly that media stocks are suffering a two pronged assault from cyclical and secular challenges. Making matters worse is that the cyclical downturn in the economy might be accelerating secular trends. Investors certainly believe this as evidenced by the combination of falling near-term and long-term estimates and a drop in relative valuation of media stocks compared to other industries.

One of the events that established the cyclical-secular link was the fourth quarter conference call by Time Warner Cable (TWC). TWC is the second largest cable company in the U.S., behind Comcast (CMCSA), and the third largest provider of multichannel TV. DirecTV (DTV) is #2.

During the call, TWC President and CEO spooked investors when he said ""The reality is we are starting to see the beginnings of cord-cutting, where people — particularly young people — are saying, 'All I need is broadband, I don't need video, and obviously they're already saying they don't need a wireline phone."

The implication is that entire business model of the TV industry, from content development to broadcast and cable networks to cable and satellite TV providers, is going to change for the worse. That is a huge deal as TV is the primary driver of the media industry.

But does the data support Britt's dire warning? I don't think so. I am not saying TV does not face secular challenges. I am saying that fears of an imminent acceleration of the challenges that reach a tipping point are overblown. The challenges are coming but they are going to take longer to play out that investors currently expect. This means that the potential for snapback rally in many TV related stocks is significant once some stability in the economic outlook arrives.

Beneficiaries of such a rally would include Viacom (VIA), CBS (CBS), Time Warner (TWX), Disney (DIS), News Corporation (NWSA), Scripps Interactive (SNI), Discovery Communications (DISCA), Comcast (CMCSA), Time Warner Cable (TWC), Cablevision (CVC), DirecTV (DTV), Liberty Entertainment (LMDIA), and Dish Network (DISH).

One area of the TV business that I do not feel would benefit much from a countertrend rally is local TV stations. Local stations face secular challenges that are changing the business model today with little chance for an easing of the trends. In particular, the shrinking of the automobile industry is a crushing blow to local TV stations which rely heavily on local auto dealers for advertising on the local news. Hearst Argyle (HTV) and Sinclair Broadcasting (SBGI) are TV station groups that still have a decent amount of market cap. CBS is most exposed among diversified media companies with DIS and NWSA also vulnerable as they own and operate local TV stations in most of the ten largest cities.

As mentioned, I accept the cyclical and secular challenges facing TV. However, I think the risk are currently a bit overplayed. Investors are lumping all TV related stocks together even though the risks vary.

The reason I am more sanguine about the TV business is that TV viewing remains healthy. A Nielsen study released in late February revealed that Americans are watching 151 hours of hours per month in 4Q08, up about 3% from 4Q07. This occurred even as online and mobile video consumption grew strongly on a sequential basis. In other words, traditional TV faces competitive challenges that may alter business models negatively but the core underlying fundamental, viewing, is not under intense pressure yet.

Another way to look at this is to review trends in multichannel subscribers. SNL Kagan notes that the news here is not as bad as feared. In a February 26th article, Kagan quotes Bernstein Research analyst Craig Moffett who notes that despite Britt's worries during 4Q08 total cable, satellite, and telco TV subscriptions rose by 441,000. The 4Q08 increase was larger in absolute amounts than 4Q07 providing a further indication of health. Once again, I am not ignoring the challenges raised by the competitive dynamic, in this case telco and satellite gains at the expense of cable. However, the basic underlying fundamentals indicate that multichannel TV is still healthy despite the secular threats of cord cutting.

Finally, often lost in the debate over viewers moving online is that the cable and telco companies which provide multichannel TV subscriptions also provide the broadband connections that cord cutters need to watch TV online. High speed internet subscriptions are also still growing despite cyclical headwinds exacerbated by the housing contraction. Wireless bypass via Wimax is a plausible technology but even here cable companies are partners with the leader in Wimax, Clearwire (CLWR)

Media stocks have been a terrible to place invest as cyclical downturns in advertising and consumer spending are steep at the same time that secular changes to the media business model are rising. I am generally skeptical of the pace at which secular changes occur. For TV, I am especially skeptical because usage habits are so deeply ingrained. Changes are coming but just as broadcast network TV has remained resilient on a financial basis despite decades of share loss to cable networks, many feared changes to the TV business model will occur more slowly than currently expected.

TWX and DISCA are held in Northlake client accounts including my personal accounts.

Media: 2008 Year In Review

It's been a rough year for investors. My own performance has been mediocre with most Northlake clients plus or minus a couple of percent relative to the S&P 500. I think I could have done better but I use a fully invested strategy so it was a very tough to make much progress.

Further complicating matters was that it was a terrible year for media stocks. SNL Kagan's Media and Entertainment Index is down almost 53% this year, far worse than the 41% decline for the S&P 500. Kagan has 13 sub indices for Media and Entertainment and ever single one was down more than the S&P 500. Keeping in mind there is some overlap in these indices since companies are included in more than one index (e.g. TWX is in Diversified entertainment and Cable Networks), here is the ugly numbers:

Download file

The damage was worst among small cap media companies. The SNL Kagan Small Cap Media index fell an amazing 86% while the Large Cap index dropped 48%. The complete collapse in radio stocks, most of which now trade for less than $1, led the decline in small caps.

Northlake's stock picking in media was mixed in 2008. I made one very good decision, a few very bad ones, and a bunch that were not terrible on a relative basis but that I wish I could have back....

....My best move was to sell client positions in Disney and News Corporation in late May. Both stocks collapsed since then, with NWS dropping 52% and DIS falling 36%. I made these sales following Viacom's May announcement that it had witnessed a rapid deterioration in advertising sales. This weakness occurred before the economy completely succumbed to the deep recession and was definitely prior to Wall Street's total acceptance of the weak economy thesis.

I eventually reinvested the proceeds of these sales in Discovery Communications, Dreamworks Animation, and Time Warner. These purchases were made in September, August, and November, respectively. The stocks held up fairly well relative to the market but with the market collapsing in October, declines were still steep, in the range of 25-35%. The consistent theme in these reinvestment choices was reduced exposure to advertising and where the exposure was going to exist to skew it heavily toward cable networks which were holding best and still may be down just low single digits in 2009 against a drop of 10% in overall advertising.

My poor investment decisions were in Apple and Central European Media Enterprises. I stubbornly held both and rode them down. In each case, my view of the fundamentals turned out to be rosier than reality. However, the big thing I missed was the collapse in valuation. Both stocks were big winners for many years and had high multiples relative to their peers. This left a lot of room for multiple compression, which was also accompanied by lower estimates. The results for the stocks were ugly with AAPL falling 56% and CETV dropping 82%.

There is a good lesson in the action of AAPL and CETV. While estimates for both stocks did come in as the year progressed, both companies will still have far superior organic growth compared to their peers. I assumed that superior relative growth would allow the premium valuations to be sustained. This was poor analysis. High growth, momentum stocks have little ability to withstand any slowing in fundamental operating momentum even if the fundamentals deteriorate less than other comparable companies.

One other decision I made hurt my relative performance materially. At the very end of 2007, I threw in the towel on Northlake's position in Comcast. The stock had performed poorly in 2007, falling about 30% from my purchase in late 2006. As it turned out Comcast was a good stock to own in 2008, falling just 15%. The stock benefited due to its recession resistant business and excellent operating and financial management which focused on free cash flow and balance sheet strength. I have since moved back into an investment with a similar profile by opening a position in AT&T in early December.

Looking ahead to 2009, I expect media stocks to remain a difficult area for investment. Advertising remains under severe pressure and consumer spend is falling on media such as DVDs and advanced services from cable and satellite companies.

Northlake's investment strategy is to always own some media stocks so I am sticking with my approach of limiting exposure to advertising, especially in the US, and owning stocks exposed to the highest possible revenue growth opportunities, cable networks and emerging markets.

CETV is pure emerging markets advertising in Central and Eastern Europe. Currency will likely dictate near-term performance but I remain confident that in local currency advertising will be in positive territory for each of the companies major markets.

DISCA gets over one-third of its revenue outside the US just half of its revenue form advertising. Almost 100% of revenue is from cable networks.

DWA is pure content with zero advertising exposure. 2009 estimates have upside and 2010 is a big year with three films in theaters including Shrek 4.

TWX will get 40% of its revenue from cable networks after the spin-off of Time Warner Cable is completed. TWX also will benefit from additional internal restructuring including the possibility that AOL will be jettisoned. The company will also be in a position to reward shareholders after it receives $9 billion form the TWX spin-off.

UBS Media Conference Part Two

As noted in Part One, the main message coming out of the conference that was that advertising continues to deteriorate and visibility into 2009 is minimal. This means that for most media companies the risk remains to the downside for earning estimates.

Part One contained a reasonable positive review of Time Warner and Discovery Communications, both of which I am long. Neither presentation was earth shattering and both companies indicated business has slowed further recently but the bigger picture driving the shares to the top of my media buy list was on display. I also reviewed Gannett which remains a very troubled situation due to the collapse of newspaper industry on a secular basis while cyclical headwinds are blowing at full force.

Today I'll recap presentations by Liberty Global and Scripps Interactive along with the analyst meeting for Dreamworks Animation which took place Thursday in NY, conveniently for everyone in town for the UBS Conference....

....Liberty Global is on the largest cable companies in the world. Operations are focused primarily on Europe with a large presence also in Japan, Chile, and Australia. The stock has gotten killed as the company has fairly high leverage, lots of exposure to the hated Europe, and is feeling competitive pressures on the subscriber front. I think it is a bit overdone partially because investors don’t see Liberty Global as a European Comcast with similar defensive characteristics. There is also a lack of appreciation for the company's exposure to the even more hated Central and Eastern Europe where a real growth opportunity exists. My biggest takeaway from the presentation was how management refused to comply with conventional wisdom. Instead they talked about not hoarding cash, continuing to buy back stock, and making tuck in and distressed acquisitions. This is par for the course for an always aggressive management team. It's a gamble if the economy stays down forever but if a recovery gets underway within a year or two the stock will be super leveraged for upside.

Scripps Interactive owns HGTV and Food Network, several other emerging cable networks, and a couple of decent online businesses in the comparison shopping area. I've always liked the company because of their great success at developing HGTV and Food but none of follow on businesses have been able to develop into major winners. That said, SNI is a solid growth stout with 40% of revenue coming from consistent growth areas like affiliate fees and referrals. The major networks have been rating challenged and thought it doesn't get enough discussion the exposure to home related advertising has got to be a problem given the collapse in residential real estate. This narrowly focused advertising base is why I prefer Discovery Communications to SNI. A couple of upcoming developments to keep your eye include the possibility of buying the minority interest in Food form Tribune out of bankruptcy at a good price, emerging materiality from a financial perspective for secondary networks DIY and Fine Living, most importantly trend is in ratings and advertising. SNI says 4Q ad trends are in line with guidance but that 1Q09 will be weaker.

Dreamworks Animation did not present at the UBS Conference but held their first ever analyst meeting the day after it ended. I bought DWA for the second time this year in early November anticipating positive catalysts from the debut of Madagascar 2, the DVD release of Kung Fu Panda, and the analyst meeting. So far it hasn’t worked out too well (-10%) but I think the analyst meeting is going to help in the near-term. The bad news is that DVD sales for Kung Fu Panda are good but not great and Madagascar 2 is going to come in slightly less than I expected at the US Box Office after quicker that expected start. The good news is that Madagascar 2 is kicking butt overseas, 2009 estimates have upside if the next film, Monsters vs. Aliens performs decently at the box office, and the company is developing a series of business line extensions to build earnings power and consistency.

These new businesses were the focus of the analyst meeting and include TV series, TV specials, Broadway, 3-D, online virtual worlds, theme parks, and live entertainment. There are also initiatives to raise profitability and quality by outsourcing to India and working with Intel. Broadway and TV have th most near-term potential. Shrek the Musical formerly opened yesterday. If it could become a hit similar to The Lion King or Wicked with a successful Broadway run and 2 to 3 national touring shows, management estimates upside of $30-50 million in operating income annually. We'll know soon enough if critics and audiences like the show but given the mammoth popularity of Shrek it may be somewhat critic proof. TV is less risky as DWA already has a commitment for series to be aired on Nickelodeon and holiday specials to air on the major broadcast networks. The specials will be based off Madagascar and Monsters vs. Aliens with the hope they will prove as successful as last year's premiere of Shrek the Halls on ABS.

DWA is trying to morph into a more Disney-like company with creative animation driving multiple revenue streams. Recently, the company has been on a creative role which sets up 2009 for upside surprise and 2010 for similar when three films will be released including Shrek 4. In an environment where media stocks are hated due to advertising exposure, DWA stands out as a pure content play. As a result, I think it is worth owning in a media stock portfolio. The nice pop in the stock (+4%) on Friday after positive reviews on the analyst meeting might be a sign that I will be gaining company in this view.

UBS Media Conference Part One

I spent Wednesday in NY while sitting at my desk in Chicago. In a sing of the times, I skipped the UBS Media Conference in a cost saving measure. I've gone many years in a row to this well run event. Fortunately, modern technology means I can still "Attend" although the upside in these soirees comes from one-one meeting with companies, chatting in the hallways with companies and other money managers, and building the connections that can only be done face-to-face.

I listened to presentations by Time Warner, Discovery Communications, Gannett, Liberty Global, and Scripps Interactive. Before providing a brief recap of each presentation, I want to add some color to the advertising forecasts that came out of the meeting.

Advertising represents 20% to 70% of revenue for most major media companies. Even for those less exposed, the strength and tone of advertising market materially impacts stock prices by controlling sentiment toward the group.

At the conference, major advertising forecasters including Zenith Optimedia, Magna, and CBS all dramatically lowered their 2009 forecasts. However, the forecasts were not any worse than the already bleak outlooks form Wall Street analysts. Consensus has formed around a 5-8% drop in US advertising in 2009. This slightly overstates the weakness as 2009 will not have the Olympics of a Presidential election.

Local media is expected to continue to underperform with newspapers, radio, and local TV stations each dropping 10% plus. National advertising will hold a up better but still be down mid-single digits. The worst national category is going to magazines with broadcast TV finally succumbing. Broadcast TV which had held up well until recently now is encountering weak pricing and slack demand. It could be down 8% in 2009. Cable TV networks and the internet will be areas of relative strength. Cable TV should be flattish as it continues to benefit form ratings gains and relatively cheap pricing. Internet faces problems in display ads but search remains a growth area and overall spending remains in positive territory.

US ads spending is going to be worse than Western Europe and Asia but emerging markets should see growth. As a result global growth will likely be down 4-5%.

This background colors the commentary from management at the conference as well as my opinion of what stocks are best to own. My media portfolio presently consists of Central European Media Enterprises, Discovery Communications, Dreamworks Animation, and Time Warner....

....Key takeaways from TWX focused on advertising trends, AOL, and coming split with Time Warner Cable. On advertising, CEO Jeff Bewkes admitted business is slowing and visibility is poor but says TWX's cable networks continue to outperform the industry. On AOL, Bewkes discussed at length AOL's positioning and indicated they have reached the conclusion that it is better off paired with alarger entity or maybe even operating independently. On the cable split he idnciated it is on schedule for 1Q09 and that the cash ($9.3 billion) and improved balance sheet (Debt 1.6 times EBITDA) would be prioritized to shareholders in a "steady" manner. I hear that as a meaningful annual dividend which would be a positive. Overall, not much new but I think Bewkes is gaining investor confidence in improved performance for TWX on an operating and strategic level.

CEO David Zaslav offered very little new info in his overview of Discovery Communications. He did outline the unique growth profile for DISCA driven by international subscriber growth, international advertising growth, US digital subscriber growth, and redevelopment of US channels. The advertising recession is going to pressure DISCA, especially in the US but relative operating performance vs. peers should remain quite positive. Improved ratings recently at Discovery and TLC should help near-term results. Animal Planet needs better monetization and this is a focus of management. The investment case for DISCA is non-fiction programming plus international plus dual revenue stream plus HD.

Gannett spent a lot of time reviewing digital initiatives which now represent about 15% of revenues. Career Builder is by far the biggest piece of online revenues. There is no change to the bleak outlook for the printed newspaper. GCI warned that the toughest comps in 2009 will be in 1Q. Furthermore, visibility remains extremely low which I interpret to mean that current trends continue to get worse. Newsprint pricing is set to drop which combined with sharp volume reduction is a positive for 2009. The company is actively managing its balance sheet and faces a $750 million maturity in 2009. Balance sheet stress is not yet severe but with revenue and EBITDA dropping at double digit rates the risk grows every day. The destruction of GCI for reasons beyond management's control is sad. It was a great and important American company. Management does the best it can against hurricane force winds. The stock may bounce significantly when economic conditions ease but it is not something I am willing to try to time.

No Recession for Super Bowl Ads

Some fun news from news the world of media:

According to the most recent issue of Sports Illustrated, demand for Super Bowl advertising is not showing any weakness. NBC has sold 59 of the 67 30 second spots for an average of $3 million each about the same pace as FOX for last season's game. Most of the spots were sold before September but cancellations have been non-existent. Several advertisers are quoted about the unique value of advertising on the Super Bowl. SI offers the following math:

Last year's game had 97.4 million viewers. At $2.7 million per spot, last year's price, the cost to reach one thousand viewers is $27.70. Assuming unchanged ratngs, at this year's $3 million per spot, the CPM is $30.80. SI says that on a typical Sunday Night Game, NBC gets 11.7 million viewers and charges $435,000 for a 30 second ad, a CPM of $37.16.

So buying the Super is more effective reach even before you consider the fact that people actually watch Super commercials.

Now, if only my Bills could ever win a Super Bowl. Heck, I'll just take another visit to the playoffs!

Leno to Primetime: Desperate NBC or Desperation for Network TV?

Big news in the world of media comes from NBC where Jay Leno will be on NBC 46 to 48 weeks per year every weeknight at 10 PM ET. Jay is giving up The Tonight Show to Conan O'Brien in June. The re are a lot of moving parts but this move is being driven at least in part by NBC's very poor ratings performance and inability to develop any new hit programs for several years. In other words, NBC can take the risk.

Also, contributing to the decision is the likelihood that Leno would have gone to NBC or FOX and severely undercut profits on The Tonight Show. In addition, NBC spends $15-25 million per week during the TV season to produce scripted dramas. The cost for the new Leno sow will certainly be less than $5 million per week. Some of the savings will be given back when Jay is live and NBC would have been in reruns. Leno also is likely to earn a lower CPM due to lower ratings than might have been achieved with scripted dramas. Zome savings amy also be reinvested to try to revive the sorry state of NBC's ratings in 8 to 10PM period.

Ratings is probably the biggest risk for NBC. According to the Wall Street Journal, Leno averages 4.8 million viewers on The Tonight Show. While the #11 show on TV this season has averaged 15 million viewers at 10 PM. Clearly, more viewers exist at 10 PM than 11:30 PM but will viewers want to watch the same show every night? If Leno's ratings tank, the loss will be more than just revenue at 10PM. 10 PM shows provide important lead-ins to local news which is where TV stations make most of their profits. NBC owns TV stations in all the largest markets so it is putting itself at risk. It is also risking ratings and revenue for its affiliates who are even more reliant on local news for profits and are already unhappy with NBC due its multiyear run of poor rating performance.

Investors have little to worry about here as NBC is owned by GE. This shift, which is monumental in the world of network TV, is immaterial to GE.

Important Fall TV Season For Networks Set To Launch

With the conventions and the Olympics over, the next big event in the TV world is the launch of the fall TV season. Things have been kind of quiet on this front which I had thought was due to the poor advertising environment. However, a recent preview by Goldman Sachs may have a better explanation: only 12 new shows will debut on the big four broadcast networks this season(Disney/ABC, CBS, General Electric/NBC, and News Corp/FOX), down by almost half from last year.

I suspect that the writer's strike is why fewer new shows are on the docket this season. During the program development season last winter and spring, the writer's were not doing any work. Fewer new shows this fall and a higher number of mid-season offerings this coming January is the result.

This season is particularly important for the networks. For the first time in several years, the year-over-year ratings comparisons will be on an apple-to-apples basis. Last year saw a huge decline in viewers, down double digits, well above the low single digit drip that had been going on for years. Changes in the ratings measure and the strike might have been at fault for the excessive decline. I suspect that is not fully the case and that the secular challenges from cable networks, online video, DVRs, and alternative entertainment will lead to another above trend viewing decline. The strike's legacy is likely to be that it permanently drove viewers away.

....Here is a preview of the new TV season from the perspective of the network owners....

Disney/ABC had a very successful turnaround over the last few years starting with Desperate Housewives and Lost. Last season the turnaround stalled and ratings fell sharply. New shows did not work particularly well and recent ratings stalwarts lost viewers at double digit rates. With the economy possibly biting Disney's theme parks and a cooling of the hot streak in new content from the movie studio and cable networks, another weak year by ABC would hurt Disney more than usual. It is worth noting that ABC is a relatively small part of Disney, producing just 10% of trailing four quarters operating income.

CBS is primarily a TV company, getting over half its revenue from its broadcast network and local stations. The network has been the leader in prime time for several years, likely making several hundred million dollars. The last few years have seen dents in its #1 position which can now only be claimed if you really slice and dice the data. CBS had the largest loss of viewers last year with some of its leading shows particularly hard hit. The swing from the top network to the bottom network can be $300-500 million, something CBS can not afford given the poor state of its radio business and dramatically slowing growth in the previously strong outdoor business.

Results at NBC prime time have little impact on GE. The best that can be said for NBC is that last year saw stabilization as the last place network. Ratings were down in line with overall network TV. A few bright spots have appeared on the network in recent years but NBC has not been able to build a schedule that works across many nights of the week. Heavy promotion of new and returning shows during the Olympics should give NBC a boost but right after the Olympics studies of awareness of the network's new shows were disappointing.

News Corp/FOX became the number one network last year which appears to have helped during the upfront ad sales season when the company sold more ads at higher prices than in the prior year. There was one potential problem last season: American Idol ratings fell sharply for the first time ever. Idol was still easily the #1 series, however. This year FOX will benefit from the return of 24 in January and some inroads it made on Thursday, previously a major weakness and the most heavily watched and expensively advertised night on TV. Like Disney, News Corp can ill afford a shortfall at FOX as it also faces dramatic slowing in other growth engines.

One other thing to watch (besides the new TV season!) is cancellations of upfront commitments. There has been some noise about elevated cancellations according to reports from Wall Street.

Presently Northlake does not have any long positions in the broadcast networks except a few low cost core positions in GE. I do not expect to get long any of these stocks in the near future. I prefer fundamentals in cable networks where Time Warner is a more direct play among diversified entertainment and Scripps Interactive and Discovery Communications are pure plays. Cable network stocks provide resiliency if advertising continues to sputter and will offer aggressive growth if advertising picks up.

Googles Expands TV Biz with NBC

Given all the market volatility and really important macro issues, sometimes I feel bit odd writing about mundane fundamental factors for media stocks but maybe focusing on the micro is a useful distraction.

A couple of days ago news broke that Google has reached with NBC to access TV ad inventory across a wide array of NBC's broadcast and cable TV networks. This is a significant expansion of Google's entry into traditional media ad sales. Thus far, Google has worked with radio companies and some smaller, but not insignificant TV broadcasters. The idea is that Google will create a system similar to its search business to allow advertisers to access efficiently priced TV inventory.

For NBC, the upside is that Google may bring lots of advertisers who use search but have thus far never used TV. While it seems as those many of the search players would be too small to afford TV, if a system were in place where excess inventory was attractively priced, maybe these new advertisers would be truly incremental. NBC also benefits form getting into bed with Google as a partner and thus possibly controlling them as a competitor.

For media stocks in general, I see Google's entry as a broker of ad time as something to watch but not to worry about. Eventually it may be a worry as the possibility of an auction system for selling traditional media ad time could put sharp pressure on ad pricing. However, I think that changes like this tend to be overhyped. The change does happen but it is incremental. Eventually, a tipping point is reached. I see Google's entry into TV advertising as so far form the tipping point as to not be an investment worry. For now. But monitor.

Cable Nets Best Positioned Media

The world of TV transitioned from the Olympics to the political conventions over the past week. The ratings of each event provide some insight to investors.

Broadcast networks (ABC/Disney, CBS, FOX/News Corp, and General Electric/GE) are still the only place where really large audiences can be reached. This is true for event programming or nightly prime time. Fundamentals for broadcast networks face sever secular and cyclical pressure but the ability to draw tens of millions of viewers means the fundamentals will deteriorate gradually and that there will be winners and losers.

Cable networks continue to gain viewers. The trend is firmly in place and will not change anytime soon. Advertisers will follow viewers. This provides a revenue growth opportunity that can drive operating fundamentals even as similar but different secular and cyclical challenges abound for cable networks. Cable networks are the only place in domestic media that still have decent fundamentals with upper single digit advertising growth. The most direct pure plays are Discovery Communications (DISCA) and Scripps Interactive (SNI). Among the diversified major entertainment conglomerates, Viacom and the new Time Warner have the most exposure. News Corp and Disney also have meaningful cable networks segments. If you are going to maintain exposure to domestic media companies you should restrict your holdings to that list. I recently bought Time Warner for Northlake clients. DISCA and SNI are my next choices though Northlake is not yet long either....

....
As widely reported, the Olympic ratings were enormous. NBC pulled in 20 million viewers on many nights. Over the course of entire Olympics, over 200 million Americas watched at least a few minutes of the coverage. Nothing shown on cable networks can rival these numbers. ESPN can get high single digit millions for NFL football but most nights, most cable networks will only bring a few hundred thousand to a few million viewers. Top rated primate time programs pull 10-15 million viewers. Poorly rated programs on the big four broadcast nets get at least a couple of million viewers, almost always larger than anything on cable.

The ability for the broadcast networks to get mass audiences will keep advertisers aboard even as ratings steadily dwindle. If you want to promote your new movie, you have to do it on networks that reach tens of millions of ticket buyers. Same thing if you want to launch a new car or roll out anew brand of soap. This reality means that broadcast networks will continue to offset ratings declines with price increases. The result is a surprisingly stable or even very slowly growing advertising revenue pie to be split among the big four networks. Winning networks who are on top in the ratings or rising can gain advertising share and produce decent revenue growth. Broadcast networks are a high operating leverage business so a revenue surge can lead to a larger profit surge. Right now, FOX and ABC are the winners, CBS has stalled and is in risk of decline, and NBC is struggling mightily to get out of the cellar.

The Democratic convention is a reminder of why the future of TV remains cable networks. Ratings from the first three nights were quite good, up sharply over 2004 on a combined broadcast and cable basis. However, all of the growth came from cable networks. On Monday, Fox News was up 84%, CNN was up 85%, MSNBC was up 88%. On Tuesday and Wednesday the trend was the same with the cable news nets up 40% plus across the board. Through the first three nights, broadcast networks as a group were flat with 2004. NBC was up, ABC was flat, and CBS was down.

Besides the massive market share gain for the cable news networks, their showing in the all-important demographic race also improved. CNN and MSNBC enjoyed a more than doubling of their ratings in the coveted 25-54 year old demographic, while Fox News was up over 40%.

While the political conventions happen once every four years, the market share/ratings gains for the cable news networks are a microcosm of the trends in TV. Cable wins, broadcast loses. Every year a couple percent of viewers move form broadcast to cable. This is why cable network advertising growth is still in the mid to upper single digits even as ad budgets are being cut due to the economy and the internet steadily gains shares. This is why cable networks can charge cable and satellite operators a slightly higher subscription fee for every subscriber every year.

Challenges remain. The ad cycle is working against all media stocks. Cable networks face increasing programming costs as they attempt to close ratings and ad pricing gap. However, in a media world starved of growth, cable networks are the only play in town.

NBC's Olympic Sized Ratings

By now everyone knows that NBC's Olympic coverage produced great ratings, the best since TV truly became multichannel as opposed to just a three or four channel nightly option for viewers. Press reports also indicate that ad demand picked up as the games were going enabling NBC produce a profit of as much as $100 million on the telecast.

One would think that profits are the primary motive for purchasing TV rights and televising the Olympics. While this is important, another huge motive is the ability to promote your own network's shows and brand to an enormous audience. The Super Bowl and the Oscars are similarly sized events where the networks also try to launch new shows or relaunch returning shows.

The Olympics are undoubtedly a success for NBC and its family of networks. NBC's parent, General Electric (GE), probably will get enough of an incremental profit boost to be meaningful – that is saying a lot for a company of GE's size! The news on the promotional front might not be as positive, however. And given the possibility for a several hundred million dollar profit swing in prime time for a network going from last place, where NBC currently resides, to first or second place, this will be the real story to watch for the next few months as far as the Olympic TV ratings go....

....Variety is reporting that "awareness" figures for NBC's new shows that were consistently promoted during Olympic coverage are up but not by as much as might be expected. NBC executives acknowledge this fact but respond by noting that much of the promotional time was spent to further build returning emerging hit shows like Heroes, Life, Chuck and Lipstick Jungle.

We won’t really know the answer until later in September when the new TV season starts. The record of using the Olympic to launch new shows is mixed. However, the stakes are greater this time around given the many secular challenges facing network TV. If the huge Olympic ratings can't be translated into effective promotion of new and returning shows, it adds another nail in the very slowly closing coffin of network TV.

It also could have implications for TV rights for future Olympics as a negative offset to the assumption of rising fees due to the success of Beijing. The 2014 Winter Games and the 2016 Summer Games are the next ones that will be bid. NBC owns the rights to Vancouver in 2010 and London in 2012. ESPN has already indicated it will be bidding and CBS and FOX have bid in the past.

One huge impact on the TV rights bidding would be if Chicago gets the 2016 Summer Games. The ability to broadcast everything live and the added interest of having the games on home soil would likely drive the bidding well above the $2 billion that NBC paid for Vancouver and London.

The stakes are high for CBS, Disney/ABC/ESPN, and News Corp/FOX if any bid aggressively vs. GE/NBC. It is nothing for investors to worry about for now but on a light research day in late August it is worth filing away.

Media On A Holiday Weekend

The media biz never rests. Even on a holiday weekend.

NBC Universal is buying The Weather Channel for $3.5 billion from privately held Landmark Communications. With NBCU buried in General Electric, the stock impact stretches to other media companies. First, Time Warner at one time was in the running. TWX has tons of cash coming its way due to its split with Time Warner Cable. Investors do not want that spent on acquisition so getting this potential deal officially off the table is good news. Second, the price was substantially less than initially rumored indicating that the deal market may be soft even for prized media assets. Much of the value in this deal comes form weather.com, however, which limited bidders as other cable network owners like Viacom, Scripps Interactive, and Discovery Communications did not have natural synergies....

....The box office fell 6% from the same weekend a year ago but comps are tricky because the 4th of July fell on a Friday, likely hurting weekend business. None of the major films are disappointing. Disney is feeling good about Wall-E which is tracking to be #3 or maybe even #2 for all Pixar films. Dreamworks Animation is relieved to see Kung Fu Panda fall just 36%, the best hold of the weekend, indicating that the brunt of the damage from Wall-E has been incurred. Panda is heading nicely over $200 million, still better than most analyst estimates but not quite as high as I originally hoped. Theatres are facing their toughest comps now as last July saw two $300 million movies, two others at around $200 million, and additional four between $118 and $140 million. Still too early to buy the very depressed theatre stocks but keep them on your radar screens.

AdAge reported last week that Anheuser-Busch was cutting way back on its radio advertising. BUD spent $38 million last year and is known as innovative and supportive ad buyer to the radio industry. BUD execs say it is not related to savings to fend off InBev. If that is true it is especially bad news for the radio industry as it means one of the top advertisers is almost deserting the medium. According to AdAge, Clear Channel and Emmis Broadcasting have already been informed of big cuts.

Media Stocks Still Struggling

Media stocks continue to act poorly. When I sold Northlake's positions in Disney and News Corporation on the last trading day in May I was beginning to see more evidence that the deep recession in local advertising media like newspapers and radio was beginning to spread to national advertising such as TV. I had also started to notice the term "media recession" in a lot more news articles and research reports. Admittedly, this is one of those squishy sentiment indicators but I figured if the concept of a media recession that was still debatable was on its way to becoming conventional wisdom it would not be good news for any stocks in the group.

On Monday, in the daily Media and Communications Report from SNL Kagan (a must for any serious media investor), lo and behold, there was a story titled "Media Recession To Hit Some Industries Harder Than Others." The article recapped a recent piece authored by IDC which stated that advertising expenditures across all media companies will fall by 7% in 2008 even including a material boost from the Olympics and the Presidential election. A 7% decline would represent acceleration from the first quarter which witnessed a low single digit decline across all media driven primarily by an upper single digit drop in newspapers and a mid single digit fall in radio. Network TV remained barely in positive territory but there are more and more indications that the scatter market softened sharply and suddenly during the later half of 2Q.

Given a weakening fundamental and sentiment backdrop, I still see little reason to maintain meaningful exposure to standard media stocks. Northlake continues to own just two pure media stocks, Central European Media Enterprises and Dreamworks Animation....

....CETV continues to experience very strong growth in Central and Eastern European countries that thus far are not witnessing a slowdown in economic growth. CETV also has upcoming positive news from the closing of its acquisition of the controlling interest in its operations in Ukraine and what I expect will be another very good quarterly earnings report. DWA is a play on the fact that analysts are underestimating the near-term and long-term earnings benefit of the better than expected North American and International box office performance of Kung Fu Panda.

I'd also like to reference my Real Money buddy, Doug Kass', comments yesterday that he was thinking of using Morgan Stanley's belated downgrade of its view of the theatre companies to cover his very successful shorts. I think Doug is making the right call due to: (1) yield support offered by Regal Entertainment, (2) the fact that starting in September box office comparisons should be very favorable, particularly in the important holiday season, (3) the additional declines the stocks took on the downgrade, and (4) estimate reductions by other analysts. In my Monday post I mentioned that the stocks needed estimate cuts before they could put in a bottom and look ahead to 4Q strength.

In the bigger picture, negative headlines about the summer box office present another headwind for the media companies which own the major Hollywood studios. That is not to say that individual studios might not perform well (Viacom's Paramount is off to a great start and Fox has a couple of profitable films already under its belt) but a couple of months of down 5-10% weekly box office comps will reignite the "box is dying myth" and add yet another dose of negative sentiment to the media landscape.

Sluggish Blu-Ray Sales Another Headwind

So far my sales of Disney has held up pretty well, down just a bit, while News Corp has fallen about 5%. Disney might be getting a boost from some initial reports that ABC is writing upfront business at decent CPM increases, maybe even large enough to offset potentially double digit down ratings guarantees and thus produce a small increase in upfront sales. It is also possible that investors are beginning to anticipate the next Pixar film, Wall-E, due at the end of June and are putting the disappointing North American box office for Prince Caspian in the rear view mirror. Caspian continues to outperform the first Narnia film in overseas markets where it has opened cushioning the downside. More confidence in the economy also helps given Disney's exposure to advertising AND theme parks. Regardless, I see upside in the shares as limited and downside of 15-20% in the event that the "media recession" spreads to national TV advertising. I don’t like the risk-reward tradeoff so I am on the sidelines.

One thing that I have been hoping would provide a boost to Disney, News Corp, and the other studio owners is the settling of the next generation DVD war in favor of Blu-ray. Given library rebuilds and higher DVD prices, Blu-ray will eventually push DVD growth back into positive territory. However, a recent report by SNL Kagan suggests that thus far Blu-ray players remain slow sellers....

....According to SNL Kagan, Blu-ray player sales remain sluggish even though the format war has been settled for more than four months. The problem is most likely that the players are still too expensive. Kagan notes that Blu-ray players on Amazon.com were selling for $300 to $1,000 on June 3. Clearly that is too high a price to trigger mass adoption when current DVD players work just fine and are fully penetrated in American households. A weak consumer economy does not help matters nor does the huge selling push on smartphones priced at $100 to $500.

The worry for the studios is that player prices do not come down to $200 or less for this coming Christmas. That currently looks like it may be the case which means that mass adoption is put off until Christmas 2009 and significant Blu-ray DVD sales wait until 2010.

Kagan data shows that U.S. home entertainment sales fell 3.2% in 2007. At the wholesale level, DVD revenue inched up 0.6% implying that pricing is under pressure as consumer interest in DVD purchases wanes. Christmas sales of new titles were mediocre despite the all time box office record in 2007 driven by a slew of blockbuster films last summer including five films grossing $291 million or more. The most popular titles in 2007 sold between 10 and 14 million DVD units (Transformers was #1). In 2006, the most popular titles sold between 15 and 20 million units (Disney had the top three titles with Pirates 2, Cars, and Narnia 1). In 2005, the top selling title was The Incredibles, also from Disney, sold 19 million units.

Back in February, shortly after Blu-ray won the format war, I wrote a column for RealMoney.com outlining the potential upside for the studios of mass adoption of Blu-ray players. I outlined the potential upside as follows:

"Content creators can benefit in two ways from Blu-ray. First, Blu-ray DVDs are priced at a premium. If Time Warner merely exhibits substitution of one Blu-ray DVD sold for one regular DVD sold, the company could pick up tens of millions in extremely high-margin revenue. There is not a lot of argument about this concept, although it is possible that Blu-ray pricing collapses more quickly than is generally assumed. But this would probably take place only if Blu-ray DVD player sales massively accelerate such that the uptick in units sold offsets the reduced pricing.

A second way for the content creators to benefit is if current home libraries of DVDs are upgraded to Blu-ray. One great benefit of creating content is that technological change in the delivery system allows you to resell your library again and again."

In my earlier column I suggested that in a few years, 20 million households might have Blu-ray players and repurchase five already owned standard DVDs. At Time Warner's recent wholesale price of $10, that is $1 billion in incremental revenue to the studios, a meaningful amount against Kagan's estimate of $10 billion in wholesale revenues in 2006 and 2007.

The bottom line is that weaker Blu-ray sales in 2008 create another headwind for the big entertainment conglomerates. With cracks showing in national TV advertising, tough comparisons at the box office, double digit declines in TV ratings at the big four broadcast TV networks, and a weak consumer, loss of an incremental driver is an unwelcome development and provides another reason to be cautious committing investing dollars to the big media stocks.

TV Upfront Season Poses Long-Term Risks

The broadcast TV networks made their upfront presentations this week. As I've written before, this year's upfront is going to be problematical for the broadcast networks (ABC/Disney, CBS, FOX/News Corp, and NBC/General Electric). During the upfront, the networks sell advertising time for the upcoming TV season, in this case the 2008-09 season that begins in September.

I don’t think the upfront is tradable on a short-term basis but trends established as ad sales are completed over the next month definitely have ramifications for the stocks of broadcast and cable networks owners over the next six months and into 2009.

The combination of very poor ratings, the writer's strike, and the weak economy makes this a bad time for the broadcast networks to be selling advertising. Most observers expect the upfront to be down this year which means revenue is less predictable for the owners of the networks. Raising the risk further is the possibility that in order to generate greater upfront sales the networks may liberalize cancellation terms.

The pain to the broadcast network owners will be somewhat mitigated by what is expected to be a good upfront for cable networks. Cable networks have gained in ratings and their narrow genres translate better online. Broadcast and cable networks are both packaging online ads with TV ads. One caveat is that if the most cautious views of the broadcast upfront come true (down mid-teens), even the cable networks will suffer from spillover.

Among the broadcast network owners....

....Disney gets relief thanks to strength at its cable networks. ESPN continues to produce strong ratings especially and more sponsorship/promotion spending at the Disney Channel also will provide a boost.

News Corp also probably doesn't have much to worry about thanks to the leading ratings performance from FOX. Idol may no longer be a growth engine but FOX broadened success across its nightly schedule and gets hit show 24 back next season.

CBS has problems. Ratings stink. Long-time favorites like CSI, Cold Case, and Survivor are down more than 20% this year. CBS acknowledged that crime may no longer pay when it unveiled six new shows and a comedy heavy lineup at is upfront presentation.

Pure play cable network companies are better positioned. Winners include Viacom, Time Warner, Discovery Communications, and EW Scripps.

Implications of A New HBO-Like Pay TV Network

Viacom, Lionsgate, and MGM announced that they will no longer sell their movies to Showtime (owned by CBS) and instead will launch a new, fourth pay TV channel. The announcement leaves Showtime, the current owner of rights to films from VIA, LGF, and MGM without the rights to output from any of the major movie studios.

This announcement impacts many companies in the entertainment industry including the owner's of the current pay TV services, Time Warner (HBO and The Movie Channel) and Liberty Entertainment, (Starz and Encore). Time Warner also will be affected at the studio level via its ownership of Warner Brothers. Other movie studios impacted include Universal (GE), Sony Pictures (SNE), 20th Century Fox (NWS), and Disney. Cable, satellite, and telcos distribute the pay TV channels and will also feel effects from the new venture.

Pay TV is a big business but at the margin the financial impact on any of the company’s involved in the pay TV industry is not likely to significantly impact stock prices as pay TV is a modest revenue stream for both studios and pay TV network owners. Nevertheless, there are positive and negative implications for the companies involved....

....Showtime, owned by CBS is going to feel the largest impact. According to Jessica Reif Cohen of Merrill Lynch, Showtime represented 8% of revenue and 12% of EBITDA for CBS in 2007. As a result of this new venture, Showtime will not have a supply deal with any major film studio. Given that pay TV does not get new movies until well after the films have been available for sale or rent (usually six months), I have long wondered about how valuable the films are in terms of gaining and retaining subscribers. I suspect that films play an important psychological role in that subscribers like the idea that they will be able to browse their pay TV channels and find something to watch. On this basis, the loss of new movies will hurt Showtime's subscriber retention efforts. Fortunately, Showtime has been on a role in terms of original series production, generating buzz not far from what HBO used to get. In the near-term, Showtime's margins will probably rise as movie rights are very expensive. That would be a good thing for CBS if subscriber numbers can be maintained. Another possible risk to CBS is that the recent decision to start its own movie studio will now lead to a much greater commitment to movie production, a difficult and volatile business. Overall, this news is negative for CBS because Showtime has been one of the few growing businesses the company operates.

For Viacom and Lionsgate, the deal also offers mixed news. Even at a lower rights fee, the companies will be foregoing a very profitable revenue stream in exchange for the commitment of potentially significant capital to launch a new channel. Equity ownership has a chance to offset capital commitments and likely operating losses, especially if the model can be tweaked by shortening the window to pay TV and developing digital opportunities via video on demand, streaming, and other digital distribution channels. Expect to hear a lot from VIA, LGF, and MGM about "reinventing the pay TV model in a digital world." I remain skeptical that the there is sufficient consumer demand to support a fourth pay TV network.

For the other pay TV networks, a new entrant in the pay TV business would be a negative as the potential subscriber base would fragment. On the other hand, a potential positive is that as other studio output deals expire, there will now be only two bidders for their content since it seems unlikely other studios' parent companies would support the new competitor. This might lower pricing on future rights deals, which were expected to trend significantly lower anyhow.

The other major studios, Sony, Universal, Fox, and Disney will be in a worse position to negotiate new output deals as there will now be more supply of films than demand with just two pay TV networks bidding for product. Many rights deals are expiring in the near future and substantial cost savings were already expected by the networks. I am not sure how much analysts have adjusted their operating profit estimates to account for lower fees in the new rights deals but I suspect they need to come down further now.

The final impact from this deal is on cable, satellite, and telco companies which carry and sell the pay TV networks. Cable has modest capacity constraints and probably isn’t too happy about having to carry another network. In fact, according to Tuesday's Wall Street Journal, cable is leading a push back against creation f the new network with threats to not carry it. However, cable's big competitive advantage over satellite is VOD which is likely to be a major emphasis of the new channel. Furthermore, satellite companies (DirecTV and Dish Network) and Telco TV (AT&T and Verizon) are not capacity constrained and might use the new network as a weapon in the battle for subscribers. Thus, I expect the channel to gain carriage despite the rhetoric. Cable, satellite, and telco companies are the least impacted by the new channel but to the extent they are I would put cable at a slight disadvantage.

Thinking About Mobile TV

At the recent National Association of Broadcasters conference, one of the more popular topics was mobile TV. Mobile TV is the ability for consumers to watch live TV on their cellphones. Standards are still being set but according to SNL Kagan, MobiTV has 4 million subscribers of various global wireless companies using its platform.

For content owners, broadcasters, wireless operators, and smartphone manufacturers, mobile TV could represent a new multibillion revenue stream. How quickly it ramps up and how revenues are divided remain open questions but for the industries in the question the incremental growth opportunity is significant as secular headwinds present growth challenges to their core businesses.

I believe the most likely winners are wireless operators, specifically AT&T and Verizon. Next in line would be handset manufacturers. Nokia as the dominant global player and Research In Motion and Apple as the highest profile smartphone manufacturers would surely benefit from pull through demand if mobile TV became a "must have" service. Content owners like Disney, Viacom, and Time Warner will gain incrementally as new subscription and advertising revenue will come at extremely high margins. Local TV broadcasters seem least likely to benefit. They are still facing technological bottlenecks to merely get on mobile TV platforms. Furthermore, the same secular trends that are hurting local TV, radio, and newspaper advertising seem likely to carryover to mobile TV.

Mobile TV is not a sure thing....

....In Europe, early enthusiasm has given way to muted expectations as after a quick start, over the past year consumer usage and interest appears to be waning. Nevertheless, there are reasons to expect that US interest in mobile TV may be high. First, there is a clear trend in favor of smartphones with big, high resolution screens. Goldman Sachs just put out a report stating that smartphones will move from 11% market share today to 40% by 2012. The same report sees mobile video revenue growing form a few hundred million in 2008 to $3 billion in 2012. Second, the US has a TV centric culture that may overcome the cumbersome experience of watching TV while on the move.

Verizon and AT&T are becoming increasingly dominant wireless service providers in the US. However, with wireless penetration nearing 100% growth in subscribers is likely to continue a slowdown that may have began in 2007. Loss of subscriber growth as a revenue driver does not mean that growth will end, however. Rising minutes of use for voice, increased number of data subscribers, and increased usage of data services should allow monthly cellphone bills to continue to rise. Mobile TV is a driver of the data driven growth. Fears of a price war due to slowing voice subscriber have moderated in the past few months so the idea of rising average revenue per user and slower but still growing subscriber growth driving double digit top line growth for the next three to five years remains realistic. In a growth starved world, investors seem likely to pay up for consistent and financially strong companies like Verizon and AT&T.

If mobile TV takes off, there is risk to cable TV companies like Comcast, Cablevision, and Time Warner Cable. One of the reasons investors have abused these stocks is because of fears that they will be required to dramatically increase their capital spending to enter the wireless business. Initial worries were focused on adding voice the triple play bundle of TV, broadband, and VOIP telephony. I am more worried about the loss of broadband subscribers to high speed wireless networks. Broadband is the highest margin part of the cable bundle and represents the industry's competitive advantage due to its speed and geographic reach. The advent of mobile TV over higher speed wireless networks also represents a threat to the core cable TV product, a product already under attack from TelcoTV and still aggressive satellite companies. Thus, while I still feel current cable valuations are cheap compared to my expectations for growth in operating and free cash flow, success in mobile TV would by wireless operators would be yet another reason to keep investors from paying up for cable stocks.

Big Media Fundamentals Holding Up For Now

Catching up some email, I found a couple of interesting pieces on the major media companies from Merrill Lynch analyst and my friend, Jessica Reif Cohen. Back in early March, Jessica noted that as a group the media companies she follows reported 4Q07 earnings ahead of her estimates. Her universe had revenue growth of 15% and EBITDA growth of 12%, ahead of her estimate for 10% and 6%. Jessica's estimates weren't far off consensus. Among major companies, Disney and News Corporation easily beat estimates as did Dreamworks Animation. Viacom reported at the high end and Time Warner reported inline. CBS results showed no growth but were close to consensus as well.

In this initial report, Jessica noted that she thought 1Q08 results would be similarly strong but she was worried that this was a "head fake" as media company results tend to lag the economy by a few quarters, especially when the economy has slowed significantly.

I own DIS and NWS on behalf of Northlake clients and even as the I reported favorably on the 4Q results and higher guidance from both companies I was worried that results could slow quickly if not unexpectedly. The fact that DIS and NWS have reported a string of positive surprises but seen their absolute and relative valuations sink to historic lows strongly suggests the market has a similar worry.

With this in mind, I have been on the lookout for any evidence that fundamentals were slowing for the major media companies. Mostly, that means that TV advertising slows. DIS has the added issue of slower sending on vacation travel....

....Jessica's report of March 14th had the first commentary that suggested TV advertising might be slowing. She mentioned that News Corp said that Fox TV stations are running about 5% under budget and that CBS mentioned slower advertising growth in some smaller markets. Both companies mentioned strength elsewhere that would at least offset the weaker TV ad trends but this is definitely something to watch.

The bottom line is that if TV ad trends (and travel trends for DIS) do not slow markedly over the next quarter or two the shares of the major entertainment companies are deeply undervalued. Another question is whether current prices reflect enough of a slowdown to insulate stock prices against lower estimates. I am not sure how this plays out but I think in the case of NWS and DIS downside is about 10% while upside is 20%. That is a risk-reward tradeoff that encourages me to maintain my positions in both stocks.

Watching Movie Windows

For 2008, I have treated myself to a subscription to SNL Kagan. Kagan is a long-time research firm focusing on media with a great reputation. They don’t care if I mention their research, in fact they encourage it.

This week in their Media Money newsletter, Kagan looks at the windows between movies in theatres and their release to home video and pay-per-view or video on demand. In general, the time between each of these events has been shrinking for the past ten years with acceleration in the past few years. The timing of windows impacts financial results for the studios that make the movies, the theatres that show them, and the cable and satellite companies that show them via PPV or VOD. Now these windows also impact the digital download business which is at its inception but expected to be a game-changer.

According to Kagan, the window between a movie being in theatres and appearing on DVD was 132 days last year. This figure has trended down steadily since 2001 when it was 176 days. The shorter window is due to the explosive growth experienced in the DVD business. Studios wanted to get DVDs on store shelves when their marketing of the film was still fresh in consumers' minds.

The shrinking window to DVD has also been accompanied by a shrinking window from DVD to PPV/VOD. Last year the DVD to PPV/VOD window was 34 days, down from 58 days in 2000. With cable companies especially wanting to press their VOD advantage vs. satellite, studios are happy to shorten the window to VOD as long as it doesn't cannibalize the DVD sale and rental business. Lots of commentary and study has been made of this issue and over the past year, and conventional wisdom has settled on the fact that DVDs are not hurt by shorter VOD windows. And even if they are, the impact is small relative to the risk of missing a consumer transition toward VOD and digital downloads. The trend is clearly toward day and date release where a movie goes to DVD, VOD, PPV, and digital download on the same date.....

....For studios, the transition to shorter windows is mostly defensive. The goal is to preserve the revenue from the home video window. If VOD and digital downloads eventually become the dominate technology then studios won’t be behind the curve like the music companies were.

For theatres, there is small risk to a shorter theatrical to DVD window. Some people may skip the theatre knowing they won’t have to wait long to buy or rent the film and watch it on their HDTV in their home. However, studios know where their bread is buttered and the marketing push behind a film in its theatrical release is what sets up the revue streams form the later windows – not just DVD, VOD, PPV, and digital download but also pay and broadcast TV domestically and aboard and merchandising. The theatres are the beneficiary of the studio model, a model unlikely to change materially in the near future.

Cable companies win from a shorter window because their networks can deliver VOD while satellite can not.

Keep in mind the benefits and risks I discuss are marginal in terms of financial impact for the next few years. On the other hand, the long-term risk of cheap digital HD downloads could be devastating for the entire chain. Experiments now and gradual shortening of windows as technology develops is probably about the best anyone long studios and theatres could hope for.

Newspapers and Radio Ad Markets Remain Troubled

Within traditional media, the newspaper and radio industries have been in their own recession for some time. TV is better off for now. Both newspapers and radio are in secular decline due to two major trends. First, the internet is stealing market share from traditional advertising. Newspapers are especially hurt by this trend as classified advertising is arguably more effective for the advertiser when presented online than in print. Radio faces a similar problem but less so. Second, there is a shift toward national advertising and away form local advertising. This trend is less obvious and seems to have limits but the consolidation in many industries and changing views toward brand development suggest that national will remained favored for the time being.

Recent datapoints from the newspaper and radio industries offer little hope. Newspapers have reported their January monthly revenues and according to Goldman Sachs, ad revenues feel over 11% in from a year ago. Classifieds are getting the worst of it, down more than 19% in January. Classifieds include auto, help wanted, and real estate. Each faces severe cyclical and secular issues. Two other major categories, retail and national, have also moved firmly into negative year-over-year growth. The issues in these categories are probably more cyclical than secular but to the extent that ad budgets are shifting online, the secular impact should not be underestimated.

Radio ad growth is also in negative territory but not quite as bad off as newspapers. The Radio Advertising Bureau recently announced that 4Q07 radio revenues fell by about 2%. The downtrend has accelerated in 2008 with most companies forecasting mid-single digit declines for 1Q. Unlike newspapers, radio is facing steadily rising costs as investment is being made in on-air content to try to stem the loss of listeners. As a result, operating expenses are rising in the mid single digits for most radio companies, creatng negative leverage and upper single digit or double digit operating income and EPS declines. Newspapers, to their credit, are keeping operating expenses flat or even down a bit and limiting the damage to just the revenue decline.

Leading newspaper and radio stocks have been destroyed. Take a look at a chart of Gannett, New York Times or McClatchy. Radio has held up better as long as the company isn’t massively leveraged. Cox Radio is probably comparable to the newspaper companies. The chart is ugly but not quite so bad. Leveraged radio operators like Citadel, Radio One, or Spanish Broadcasting are trading under $2.

No reason to own any of this from the long side at the moment. Shorts are still fine as long as the market remains in a down trend.

TV Ad Market Holding Up(front)

The Wall Street Journal reported that TV networks, advertisers, and ad buyers are all saying the upfront ad market will be strong this year. The writer's strike lead to lots of speculation that the upfront would be scrapped or altered but it appears to be going on as usual. Not only is it going on as usual but it looks good.

In English, a strong upfront that means that advertisers will spend more than last year and will be paying a higher price per ad. Strength in this year's market is not really surprising. Broadcast and cable TV networks have been selling ads for many months at a large premium to the prices paid in last year's upfront. This is known as the scatter market. Higher prices this year in the upfront just reflect the pricing currently in the scatter marketplace. Also contributing to the anticipated strength is the fact the this was the second year in a row where scatter pricing was at a big premium to upfront. As a result, advertisers are anxious to lock in a greater amount of inventory than the past two years.

Of course, selling more inventory at higher prices for the upcoming fall TV season does not guarantee that the total TV advertising will grow vs. last season. Advertisers have the option to cancel upfront purchases and next season's scatter market may be weaker than the upfront. Weak scatter in the 2008-09 season is more likely if the economy remains weak or weakens further. Several analysts have noted that advertising lags the economy going into a recession based on recent recessions. This means that current economic weakness won’t hurt TV ad markets until the summer or fall.

TV ad markets have been surprisingly strong over the last few months even as the economy has weakened. This has been evident in results reported from Disney, News, Corp, Viacom, and others. A strong upfront is certainly a positive as station and network owners hope to continue to buck the economic headwinds. I wouldn’t look for upside at individual companies due to the upfront but it does suggest that network owners have lower risk in their 2H08 financial performance. And that is a good thing if you are long DIS, NWS, CBS, VIA, SSP, TWX, or DISCA.

Sundance Wrap Before Reality Returns

If you love movies and have never been to Sundance I highly recommend it. This was my first visit and I found an incredibly well organized and orchestrated festival. Pulling it off is no easy task. There are seven venues with nine screens in Park City alone plus additional showings in Salt Lake City and Ogden. In Park City, eight films are simultaneously running from 9 AM through the midnight showings. We attended 9 films total including 4 each on Friday and Saturday. Every showing was easily sold out including last minute "wait list" tickets which are available in limited quantities in the two hours prior to the start of a show. The venues are scattered over several miles of Park City so a free transportation system of buses is available. We never had to wait more than 10 minutes for a shuttle and only got caught in a really packed bus a couple of times.

The only downside is the expense but the incredibly well staffed and friendly volunteers (many standing outside directing pedestrian traffic for hours at a time) make you accept the stiff price for meals. Film tickets were $15 and available at the main box office early morning for each day's showings.

Of the nine films I saw with my 17 year old indie movie addicted daughter, we liked Anywhere USA the best. It probably doesn't have much of a commercial future but it is really well done and makes its editorial viewpoint known without being preachy. We also enjoyed Hamlet 2, the big story out of Sundance because it sold for $10 million, the second largest sale ever after Little Miss Sunshine. It is a straight out comedy and was the far and away the crowd favorite. On Friday night we had dinner with several critics, including David Poland of Movie City News, who explained that Focus Features bought the film figuring if they could get the theatrical run to $20 million the film would be nicely profitable including DVD sales. Hamlet 2 is no academy award nominee but it should be a box office success.

Sorry to have used up space to chat about movies but I hope you enjoyed the diversion from the always intense and recently often sour market commentary. It's time to get back to reality, the market, and stocks.

Slow Sales At Sundance

I got to Sundance yesterday and caught my first movie. I am visiting a good friend in Salt Lake City so I won't be spending full time at the festival until today. I hope to catch 3-4 films on Saturday and Sunday before heading back to Chicago. Even though I've missed some good stock market rallying, it is very good to be away. My investments have done poorly so far this year. Space and distance helps to clear my head and will allow me to confront the difficult decisions better next week.

This is my first visit to the Sundance Film Festival. From Wall Street's perspective the festival only matters as it relates to the purchase of films by the major studios. Sundance historically ahs been a festival more about independent film that the sales of those same films. Over the past few years, it has become more of marketplace, and this year it the marketplace that is generating the most news. Or maybe I should lack of news.

Because of the writer's strike, which has postponed production on many films due in theaters in late 2008 and 2009, I believe expectations were raised that sales of films at Sundance would be robust in terms of both volume and price. Most of the stories about film sales at the festival have noted they have been slow and at prices below expectations. I suspect this is a case of the bar being set too high, much like with earnings on Wall Street. The agreement between the Director's Guild and the Studios may also be impacting sales because it has raised hopes for a quick end to the writer's strike.

I realize none of this has much to offer for market forecasts or stock ideas but it's been a crazy two weeks so I hope you appreciate the diversion. I'll be seeing the top selling movie on Saturday, Hamlet 2, which went for $10 million. I'll tell you what I think about it and the other films I see next week.

DVD Sales Moderately Weak But No Disaster

I still got my eye on holiday DVD sales. Data is now available at the-numbers.com through December 16th. This includes the launch of the latest Harry Potter film and the second week of sales for Pirates of the Caribbean: At World's End. Please note that this data is for the US only. This could be especially important for popular international titles like Harry Potter, Pirates, or especially Ratatouille which performed exceptionally well in the overseas box office.

My impression of these sales figures is that they are moderately light pretty much across the board relative to analyst estimates. Holiday DVD sales are very important to December quarter earnings for the major entertainment conglomerates which own movie studios including Disney, General Electric, Viacom, News Corporation, Time Warner, and Sony.

It is hard to call winners and losers among this group but I do have some observations....

....First, Disney, the company most reliant on DVD sales, seems OK based on depth of titles. Pirates, Ratatouille, High School Musical 1 and 2, Meet The Robinsons, The Santa Calsue 3, and the Lost TV series are all presently in release and appear to be selling at least OK. Pirates had the biggest week one sales figure of the year and looks like it will be the top selling of the year. Some analysts have expressed concern about sales for Shrek The Third which might translate to Ratatouille since they have sold about the same number of units. However, Ratatouille did an unusually high 66% of its box office abroad vs. a more normal 60% for Shrek.

Second, the NBC Universal division of GE looks like it has a big hit, likely better than expected, in The Bourne Ultimatum, which sold over 5 million units in its first week. It is too bad that any upside gets lost at GE but NBCU has had a good year at the box office and in the event that a merger or acquisition is completed in 2008 it will be good to remember that the content pipeline has been recently strengthened.

Finally, executives at Viacom must be smiling with Transformers occupying the top spot on the sales chart so far in 2007 with a finish no worse than second in the cards. The DVD was releases was in October so look for most or all of that $126 million in very high margin revenue will be flowing through Viacom's Paramount studio this quarter.

TV Ad Market Strong. For Now.

On Monday, the New York Post reported that scatter market TV advertising on the big four broadcast networks is running up 18%. Scatter market represents TV ad inventory available for sale on the spot market. This price increase is occurring despite another year of accelerated declines in ratings for prime time network TV shows. What is happening is that advertisers have not achieved the reach they desired with their upfront ad purchases so they are aggressively bidding for limited inventory and driving up pricing. This situation bodes well for 4Q EPS of the owners of the broadcast networks – Disney (ABC), News Corporation (FOX), CBS, and General Electric (NBC).

A gentler version of this rising ad prices/falling ratings dynamic has been going on for more than a decade enabling the broadcast network TV market to grow modestly despite the steady market share gains for cable TV and other forms of media. The concept sold by the broadcast networks has been that “we are the only place where you can still reach a mass audience even if it is ways less massive than it used to be.” The winners at any point in time are the networks that are on top of the ratings or sustaining ratings momentum (currently ABC and FOX)....

....This situation could change for the worse over the next months, however, if the writer’s strike continues. TV ratings are likely to dive as most of viewers favorite shows leave the air and are replaced by reality programs, repeats, or a limited number of new original series. Advertisers seem likely to take a tough line and being to fight back against rising prices amid deteriorating ratings. This is the real risk to the broadcast networks from the writer’s strike. As a result, the scatter market bears very close watching over the next month as the final episodes of most viewer favorites are aired.

FOX is best positioned to weather the storm in the short-term because it has a fresh season of American Idol ready to start. CBS might also hang well in the near-term because its schedule is loaded with shows like CSI that repeat well. On the other hand, CBS is most exposed long-term as it gets over two-third’s of its revenue from advertising.

DVD Sales Mixed So Far

Just before Thanksgiving I highlighted my concerns that holiday spending on DVDs could be weaker than expected. At the time, I identified two potential problems. First, the studios have to deal with a generally weak holiday spending environment. Second, the amazing success of the box office this summer put a glut of high profile DVDs on retailer shelves. So assuming consumers were inclined to spend on DVDs, any single title could get squeezed or all the titles might lag sales goals. Now, another problem has emerged which is great success for video game titles. Halo, Guitar Hero 3, and others appear to be selling very well this holiday season.

Early returns on DVD sales were mixed. Transformers was first out of the box and did very well selling 8 million units at its launch. Spiderman 3 was next and underwhelmed with 3 million units. Ratatouille got off to a good start with 3.8 million units but Shrek The Third, which had domestic box office more than 50% above Ratatouille, sold just 3.3 million units in its first week. Things looked a little better when Live Free or Die Hard sold a better than expected 2.1 million units.

While the jury remains out, the latest sales data is much more promising. Last week saw the release of Pirates of the Caribbean: At World's End and The Bourne Ultimatum and both performed very strongly. Pirates sold 8 million units and Bourne sold 3 million.

I suspect the final outcome will be a moderately weaker than expected DVD sales season with more titles than usual underperforming.....

....But the breadth of titles across the industry and within individual studios should mean that weakness in individual titles won’t have a meaningful impact on 4Q results for the studio owners. The one exception could be Dreamworks Animation, which is relying completely on Shrek The Third. However, DWA shares already have been killed mitigating risk relative to expectations. Disney is most highly reliant on DVD sales among the majors but as long as shortfalls for Ratatouille or Pirates are not severe, the breadth of the company's offerings, including Meet The Robinsons, High School Musical 2, and Hannah Montana, should prevent DVDs from causing an earnings shortfall.

A moderately weak DVD season does have longer term implications as it will reinforce the thesis that this critical driver of movie and TV studio economics is in a gradual state of decline. Resolution of the format war between next generation DVD players would be the best tonic for the DVD flu but that is not happening this holiday season which means the industry likely has to wait another year.

The Writer's Strike Is About To Bite

I am surprised that the talks broke off between writers and producers. When the strike was launched there was a lot of discussion on both sides about how close they were to a deal. I figured that when they decided to start up negotiations again under a strict blackout a deal was at hand. My view was reinforced by two factors. First, the writers union is led by a folks who were willing to wage a strike so they had already proven to the producers that they were serious. Second, the fact that the writers seemed be winning the public relations war in a landslide. It seemed like a perfect setup for a deal.

Now things are looking ugly and the strike is dragging on long enough that it could impact media stocks. As a reminder, it is TV that could get hurt. That means that network owners and TV producers have the most to lose. Disney (ABC), NBC Universal (GE), News Corp (Fox), and CBS are the network owners. NBCU, Fox, Viacom, and Time Warner are the big TV producers.

The problem is most acute at the networks. Network TV is in a long-term state of decline as viewers diversify their media consumption. Cable networks have steadily gained share and now new digital distribution is starting to build viewership. With most popular original series about to run out of episodes, ratings will take a nosedive starting in January and February. The timing couldn't be worse as this is the first year advertisers are using the new currency of live commercial ratings plus three days of DVR playback. Ratings were unusually poor last TV season and although there is no an apples to apples comparison, they appear to be down sharply. Finally, the lousy ratings have actually tightened the ad market because the networks have had to offer "make goods" of ad time to compensate for low audience delivery. That means that if ratings nose dive under a prolonged strike scenario there is no obvious way for the networks to make good other than cut prices dramatically.

The financial impact of a prolonged strike on the networks is unlikely to hurt earnings at the networks owners because the cost of the replacement programming is going to be very cheap. However, the big picture risks of an accelerated decline in audience ratings and the shifting ad currency have serious long-term implications that could impact valuation of network assets. That said, CNBC is way overdoing the coverage of the strike relative to the stock price risks for the companies.

CBS is by far most exposed as the network is the primary driver of its profits. Disney and News Corporation have less to worry about given their broad base of entertainment assets. I remain bearish on CBS which also has serious ratings issues that put hundreds of million of operating income at stake. I still like News Corp and Disney which have plenty of growth levers away from network TV to drive operating income.

UBS Media Conference Recap

I'm back in Chicago and have had some time to digest the UBS Media and Communications Conference. Below are brief comments from every presentation I attended. As you read, keep in mind that I found the general background of the conference to be cautious. This impression is based mostly on the uncertain advertising environment and the decelerating growth in the cable sector. Don’t confuse my comments with a bearish view, however. Media companies are in pretty good shape to weather the storm due to strength in margins and cash flow, and new growth initiatives. The group as a whole may not work well for a few more quarters but there is enough good for individual ideas to be money makers.

The following comments are meant to provide my immediate impression of the presentations with an emphasis on stock price performance in 2008 weighted to the first half of the year. I am trying to find the best media stocks to own not necessarily big absolute price gainers. The comments are listed in the order of the presentations I attended....

....Rogers Communications (RCI): This presentation was the company's first chance to respond to newly announced spectrum auction rules in Canada. Management was calm and confident. The stock should continue to bounce back toward the mid $40s but a move back to recent highs will be difficult given the shift in investor sentiment toward skepticism about the sustainability of growth.

Time Warner Cable (TWC): CEO Glenn Britt was reassuring about seeing real progress in the troubled Dallas and LA systems in 2008. However, this presentation was before Comcast lowered guidance and it is unlikely that TWC shares can perform well until sentiment improves for the entire cable sector. Don’t hold your breath but late spring might work for bulls.

Disney (DIS): This presentation was solely about ESPN. My main takeaway is how similarly ESPN and Disney use their brands. ESPN seems largely autonomous but definitely fits comfortably within the Disney corporate culture. ESPN will be a consistent driver of growth for Disney for at least several more years.

NBC Universal: NBCU is a division of General Electric so no investment insight here. I was a little surprised to learn that cable networks produce 50% of operating profits. Granted that figure is inflated because of the profit collapse at NBC Prime Time but the breadth of cable network exposure (USA, Sci-Fi Bravo, Oxygen, CNBC, MSNBC, and 57% of Sundance) is impressive. Now if Jeff Immelt would just spin NBU out or merge it into another media company.

Viacom (VIA): A turnaround appears in place due to improved ratings at MTV and a much tighter focus on operations including cost cutting. Margin expansion will be crucial to the stock price and may lag investor expectations as higher ratings come at the cost of increased programming investment.

Liberty Media: Presently two tracking stocks, Capital (LCAPA) and Interactive (LINTA), but shortly Capital will be split in two when the acquisition of News Corp's interest in DirecTV is completed. I still think it is all too complicated and Liberty lacks top tier assets with superior growth potential.

Fox Interactive Media: This presentation focused on how MySpace was being monetized away from the Google deal. The focus on targeted marketing to groups of MySpace users seemed very plausible to me. I like News Corp (NWS) and feel better about MySpace after seeing this presentation. With the help of MySpace, NWS should offer the best operating income growth in big media for the next few years.

Charter Communications (CHTR) debt to EBITDA ratio is over 9 times. With Comcast trading at 6 times EBITDA this means there is no value beyond an option in Charter shares. Investors will pay for the option, however, when cable stocks are performing well so if Comcast recovers and you want a leveraged play, Charter is your stock. The company is being much better managed since the new team came in a year or two ago. Still no way they can ever produce enough free cash flow to grow their way out of the debt. The bonds have gotten killed due to the credit crunch and may be a better play.

JC Decaux is the largest outdoor advertising company in the world. The stock is not listed in the US. I liked the story very much a year ago at this conference and nothing has changed. If I bought stocks listed outside the US for Northlake clients, I would be long. Growth should hold at double digit levels as JCD continues it s expansion in emerging markets.

Time Warner Telecom (TWTC)was a brand new idea for me. I have never heard them speak and barely knew what they did. It seems like a good growth story as they expand their network of buildings wired for enterprise voice and data services. Plenty of room left to penetrate in their markets and companies are always looking to move away from the administrative and customer nightmare that AT&T or Verizon often offer.

Discovery Communications (DISCA) has made quite a turnaround under David Zaslav who joined the company from NBCU just one year ago. Money losing units have been sold and widely distributed but undermanaged channels are being rebranded. I think some upside remains and if the company eliminates its tracking stock status in 2008 the shares would surge on takeover speculation.

Les Moonves was his usual optimistic self as he told attendees how everything is great with all of CBS's businesses. His schtick is getting old though as CBS (CBS) continues to offer no revenue growth in the near-term or long-term. And one more year of lousy ratings at the CBS Network and EBITDA will start to suffer as a few hundred million of downside exists if the network drops to third to fourth place. It's not a short anymore following the fall from $33 to $28 but no reason to be long.

I enjoyed myself at Lionsgate (LGF)by hassling Michael Burns about the company's growth rate. The stock has asset value near the current stock price based on recurring free cash flow of $100 million. However, the company is unable to explain when or how free cash flow will step up. Until it can, the stock won't get of its trading range so buy near $9 and sell near $11.

America Movil (AMX) is the largest wireless company throughout Central and South America. Growth will slow a little as new markets are not being opened but the benefit will be a boom in free cash flow. Competition is rising in Mexico which has pushed the stock down. Of all the presentations I saw AMX is closest to a new buy idea.

Grupo Televisa (TV) is a buy if growth picks up in 2008 and the company gains traction in its gaming business. Both things should happen but I am less confident now than I was in the summer.

Not much left for me to say about Comcast (CMCSA) so just read here and here for my comments following the company's reduced guidance and UBS presentation. I plan to take my loss before year end but expect to do so slightly above current prices.

nTelos (NTLS) is a regional telco serving parts of Virginia and West Virginia. I think the shares have upside in late 2008 and 2009 as the EVDO buildout of its wireless network begins to generate added data revenue due to the higher download speeds customers will receive. In the meantime you have a good current yield and asset value. Put it on your monitor.

Liberty Global (LBTYA) is a great story with lots of emerging markets exposure and triple play potential for its cable operations in Western and Central Europe and Chile. However, the shares won’t go up until US cable stocks begin to recover so no reason to get long now. I love the aggressive buyback and high leverage strategy. Comcast CEO Brian Roberts should pay attention.

Verizon (VZ) was boring like a telco usually is but offered a compelling case for a continuing acceleration in its growth rate. It frustrates me that investors prefer the much slower growing but accelerating VZ to the much faster growing but decelerating Comcast especially when Comcast is gaining 5-10 telephone customers for every cable subscriber it loses. Nevertheless, no reason to hold that against VZ shares which I think will remain a good investment.

Holiday DVD Sales Could Disappoint Investors

A significant risk for fourth-quarter earnings for the major entertainment conglomerates is an extremely crowded DVD release schedule. The risk is heightened by generally weak DVD sales for the past 18 months.

Early indications from the launch of several blockbuster movie titles are not promising, so investors should keep an eye on Disney (DIS) , DreamWorks Animation (DWA) , News Corp. (NWS) , Time Warner (TWX) and Viacom (VIA) for possible trouble.

DVD sales are critically important to the major movie studios. I have seen several analyst models in which the operating margin on DVD revenue is projected at more than 40%. Even for companies the size of Disney or Time Warner, the numbers are meaningful.

For example, a title such as Ratatouille might sell 25 million DVDs worldwide in its first release. At a wholesale price of $15, total revenue could be $375 million, and operating income could be north of $150 million. During the December quarter alone, Disney might sell 18 million units, generating operating income of over $100 million, which represents over 5% of projected operating income for the quarter.

During this holiday season, there are 16 movie titles set for DVD release that grossed over $100 million at the domestic box office. Several mega hits are for sale, including Ratatouille, Pirates 3, Shrek 3, Transformers, Spiderman 3 and Harry Potter 5. Crowding out is a definite risk, but it would not be so worrisome if DVD sales as a category were not already weak. According to Jessica Reif of Merrill Lynch, year-to-date DVD sales are down midsingle digits, the second consecutive year of flat to negative growth.

DVD sales peaked in 2005-2006 as penetration of DVD players into U.S. households reached saturation. For many years, DVD sales boomed, riding the wave of more players in more homes and the building of personal DVD libraries. A huge number of releases, including TV shows and movie catalogues, also boosted consumer interest and demand.

Growth ground to a halt as penetration of DVD players rose and early adopters finished building their initial libraries. Late adopters of DVD players naturally bought fewer DVDs. Adding to current sluggish sales trends is confusion over next-generation DVD technology (HD or Blu-ray) and initial developments in digital downloads.

Several Web sites track DVD sales and releases, including the-numbers.com and BoxOfficeMojo.com. According to sales data from early holiday season releases, the outlook for the rest of the quarter looks mixed.

Transformers (Viacom) got things off to a good start, selling over 8 million units so far, including a debut week of more than 5 million. Sales were not nearly so strong for Spider-Man 3 (Sony) or Shrek 3 (DreamWorks Animation). Spider-Man sold 2.4 million in its opening week and is at 3.4 million after two weeks in release. Ratatouille was the next major release, and it sold over 3.8 million units in its first week, a level variously described in trade publications as "very strong" and "as expected."

Shrek 3 was just released last week, so early sales have not been formally reported, but according to an article on VideoBusiness.com, sales are close to the Spider-Man level. This would translate to a disappointing quarter unless sales pick up considerably, given analyst estimates for 15 million to 20 million units.

Here is a brief look at the outlook for major studios this holiday season. Keep in mind that the holiday season is just starting, so it might be early to draw conclusions. Nonetheless, there is reason to be nervous based on early trends....

....Disney has three key films: Ratatouille, Pirates 3 and High School Musical 2. As mentioned, Ratatouille appears to be off to a good start in the U.S., but keep in mind that an unusually high two-thirds of the worldwide box office will have been generated overseas. High School Musical 2 is unlikely to have problems, so keep an eye on Pirates 3, especially in light of sluggish sales so far for the other $300 million grossing "threequels" released in May.

DreamWorks Animation has everything riding on Shrek 3. Initial indications of first-week sales are disappointing. With Bee Movie tracking well below most box-office estimates, it is not surprising that DWA shares have fallen 15% this month and are trading close to their August low.

News Corp. released Live Free or Die Hard this week, but the big action will come the week before Christmas when The Simpsons Movie goes on sale. The Dec. 18 release date positions the film as the perfect last-minute shopping gift. It is sure to get prime shelf space and plenty of advertising support, because the other blockbusters will have been in stores for one to six weeks.

Time Warner has already had a good year in home video thanks to 300, which sold over 8 million, and Happy Feet, with over 9 million units. The big holiday release is Harry Potter 5 on Dec. 11. For an upside, keep an eye on Hairspray, due in stores on Dec. 11. The film is getting a big push for a Best Picture nomination, it performed well in theaters, and its status as a remake of a popular musical gives it a built-in audience.

Viacom is already in good shape for the December quarter thanks to Transformers, which kicked off the DVD selling season in late October and has sold over 8 million units so far.

Advertising Growth Remains Below Par

According to AdAge.com, advertising spending in the first quarter fell by 0.3% excluding paid search. The data is from a study by TNS Media Intelligence. With GDP growth in the low to mid single digits, historical correlations would suggest that advertising growth should have been closer to 3-5%. Part of the problem was a tough comparison to 1Q06 when Winter Olympics spending added to the total. TNS thinks that adjusting for the Olympics ad spending grew just over 2%, still a weak performance that indicates traditional advertising is losing market share to online advertising. TNS believes that major advertisers have also been spending cautiously given slower economic growth and concerns about the health of consumer spending. An interesting aspect of the study is that for the first time in several years growth in advertising outside of the top 100 advertisers was flat. These smaller advertisers had been picking up the slack and driving overall growth above the rate of major advertisers.

TNS also tracks spending by media and by advertiser industry. There are 19 categories of measured media advertising and in 1Q only 6 were up year over year. Outdoor and Spanish TV were up 2-4%, cable TV and consumer magazines rose 6-7%, Spanish magazines were up 14%, and internet ex-paid search was up 17%. Among industries, domestic auto continues to be a major laggard, falling almost 11%. This is especially negative for newspaper which are losing the most market share in auto advertising to the internet. Other industries with notable declines include telecom, foreign auto, and travel and tourism. The only industry mentioned in the Ad Age article that showed an increase was direct response companies.....

The implications of slower than expected growth in advertising are obviously significant for major media companies reliant on advertising for a significant part of their revenue. Economists may also point out that slowing advertising indicates low confidence by corporations in the pace of economic growth and the health of their customers. Bears on the stock market will find comfort in the lack of advertising growth.

If advertising growth fails to pick up, all the major media companies could see pressure on revenue growth and operating margins later this year. Among the media giants, Viacom (VIA) and CBS (CBS) are most exposed to advertising with News Corp (NWS), Disney (DIS), and Time Warner (TWX) having significant but lesser exposure.

Wrapping Up A Busy Week

I covered eight media earnings calls this week in addition to closing the books on the month of April and getting fresh updates on Northlake's Market Cap and Style models. Total words written, including this post, are 10,006. I really don’t have much more to say so here are a few tidbits from one very tired money manager:

• Time Warner Cable (TWC) would clearly pay more for Cablevision (CVC) than the Dolan's latest offer that has been accepted by the Board. Unfortunately for CVC's minority shareholders the Dolan's aren’t willing to sell to TWC or anyone else. Knowing that a higher but unattainable is out there will a majority of the minority shareholders voted down the deal? The Clear Channel (CCU) saga suggests using the shareholder vote to extract added value can work. Then again, the Dolan's already control CVC whereas private equity doesn’t own CCU. I'd be surprised if this deal isn’t approved but with downside limited I'd stay long CVC for a few more weeks to see how it plays out.

• Speaking of CCU, do you think private equity firms need to draw a line in the sand regarding shareholder vote blackmail? If CCU shareholders vote no and then private equity goes even higher, isn’t that setting a bad precedent? The outcome of the CVC is sort of similar.

• Finally, I'd like to point you to my CVC earnings call coverage. I went light on the earnings analysis since it has no relevance to CVC's stock price. However, I laid out some insights on how CVC's results impact the debate over cable stocks. It is worth a read if you care about cable.

Media Madness

Time for some mid-week media madness:

• Everyone is talking Dow Jones (DJ) so I don't believe there is a lot left to say. I think a deal will occur and that News Corp. will be the buyer but I don’t see upside of more than upper single digits in percentage terms (the stock is trading close to $58 as I type this) which is only enough for nimble traders.

• Comcast announced that it has a deal in place with Yahoo (YHOO) to provide display advertising at Comcast.net, a top ten website. The deal is expected to enhanced in a few weeks when YHOO takes over search on Comcast.net from Google (GOOG). I think the combined search and display EBITDA upside for Comcast from these deals is likely in the $50-100 million range annually. Comcast is looking at $12 billion in EBITDA this year so further monetizing Comcast.net is nice but not enough to boost the stock. I'm not complaining....

• Comcast also held an analyst meeting yesterday at which it provided three year guidance for revenue, EBITDA and subscriber growth. The 2008 and 2009 growth guidance is clearly above analyst estimates so this should be good news. I do think that analysts had built some conservatism into their 2008 and 2009 estimates. Comcast bulls, like myself, assumed that 2007 growth rates would be sustained for at least 2008.

• While DJ is the news, the newspaper industry as a whole received more bad news from the latest industry circulation report. Overall circulation in the latest six month period fell 2.1% with Sunday circulation falling by 3.1%. These trends aren’t any worse that prior reports but with the industry focused on cleaning up its circulation numbers over the past year I might have expected some moderation in the decline. This report just reinforces that the DJ news does not easily flow to the rest of the newspaper industry. I'd be a seller of newspapers stock that rose sharply yesterday.

• Does anyone else think it is odd watching CNBC report on DJ and the Fox Business Channel while it seems logical to assume that at least some of the on-air personalities are talking the Fox Business Channel about new jobs? I am not saying anything unethical is going on. Just an observation.

Monday Morning Media Madness

Here is your Monday Morning Media Madness:

• On a year over year comparison basis, it was the worst weekend of 2007 for the box office. When all the data is tallied the decline should be a little over 20%. Fortunately, it is usually a small weekend as studios clear their inventory ahead of the launch of the summer on the first weekend in May. Quarter to date, the box office is still running 2.9% behind year ago levels but there is no to worry as May brings the third films in the Spiderman, Shrek, and Pirates of the Caribbean franchises. Speaking of Shrek, the distribution on that film is being handled by the Paramount division of Viacom (VIA). Paramount has now had the #1 film for four consecutive weekends (Disturbia and Blades of Glory) was the #1 film for the second consecutive weekend, continuing much improved performance for the studio. Paramount is only a small part of VIA, less than 10%, but every little but helps.

• Clear Channel (CCU) announced the sale of its TV stations for an attractive pre-tax multiple of 14-15X EBITDA. Additional radio station sales were alos announced at a price of around 11 times EBITDA. This news supports the recently upwardly revised offer of $39 from private equity and would have caused a major storm had it been announced prior the offer going up. I don’t think the TV sales will impact the outcome of the shareholder vote in either direction although it probably gives more talking points to those opposed to the deal. I'd still vote yes and be happy to escape with $39 if I were a CCU shareholder, which I am not....

• Friday's Wall Street Journal had an interesting article on how Hollywood studios are looking to Direct-to-DVD releases of film content as a way to boost revenues. Direct-to-DVD has always been part of the Hollywood's distribution but the focus now is on better quality films with dedicated and unique marketing campaigns. There is not a lot of money here as the largest grossing direct-to-DVD film only brought in $150 million range. Only three films have exceeded $100 million in sales and all were animated fare from Disney. Nevertheless, look for live action films in the year ahead which should have decent production quality despite budgets under $10 million.

• Comcast (CMCSA/CMCSK) reports Friday. I think investors should be long ahead of the call. I expect above consensus results on most metrics and believe there is a strong possibility that the company will raise guidance. I also think that any increased guidance on subscriber growth will no be accompanied by a meaningful increase in capital spending. In-the-money options such as the May $25s or the May $27.50s would be a good play if Comcast produces the good quarter I expect.

Mid-Week Media Madness

Time for a little mid-week Media Madness:

• It appears that David Poland and I aren't the only voices proclaiming that "movie theatres are dying" is a flawed thesis. According to this article, long-time media analyst William Kidd of Wedbush Morgan agrees with us. Bill's report agrees with my thesis that most of the problem in 2005 was bad movies. Bill makes the additional point that trends in 2005's lousy box office were consistent in the US and abroad even though international markets are much less impacted by home theatres and other alternative entertainment options. I have not read Bill's report but one thing not mention in the article is the fact that 2005 faced the unique, likely unrepeatable $370 million box office of Passion of the Christ. Passion account for almost 4% of the total domestic box office in 2004. I have no way of proving it but I think it is fair to say that a significant portion of the Passion ticket sales would not have been made on any other movies released that year. This analyst recommends Regal Entertainment (RGC), a long position in Northlake accounts for over a year, as the best play on the renewed box office strength....

• Clear Channel has received a sweetened bid from its private equity suitors in an attempt to bribe enough shareholders to vote in favor the merger. The new bid is $39, up $.140 over the original bid. I don’t know if it will be enough but I stand by my opinion that shareholders will be very unhappy if the deal fails and the private equity firms walk away. $39 will seem awfully good when CCU is trading at $32 later this year.

• The Wall Street Journal speculated yesterday that Time Warner (TWX) was going to aggressively divest itself of its 84% ownership of Time Warner Cable (TWC). The spin in the article and on CNBC was that TWX management is souring on the cable business do to fears that internet browser based TV is a looming threat to the business model. I call bullshit. The rumored split, if accurate, is because the content and cable businesses within TWX have different financial characteristics. One is a high growth, high capital intensity business, while the other is a moderate growth, low capital intensity business. Keeping them under one roof complicates capital allocation decisions potentially to the detriment of both entities. I think that one of the reasons for buying Adelphia in concert with Comcast (CMCSA/CMCSK) was recognition that the entire cable could be restructured in preparation for a more complete separation. The Adelphia deal was a good way to create the TWC currency and ease the way toward breaking apart two businesses that are incompatible from a corporate financing viewpoint. But let the spinmeisters keep dissing cable. When CMCSA and TWC are making new highs later this year, the cable bulls will get the last laugh.

Monday Morning Media Madness

Here is your Monday Morning Media Madness for April 16, 2007:

• A tough comparison against a $40 million opening for Scary Movie 4 pulled the box office down 5% this past weekend. The weak comparison does little to year-to-date comparisons which remain up 6%. With the a very strong release schedule for the summer season set to kick off in early May, comparisons are likely to improve. In fact, this could end of being one of the best years ever. With the big movies this year yet to come, the box office is already running at an all-time best pace and is up vs. any year in the past five. This should be good news for Regal Entertainment (RGC) which has produced a total return of 19% in the past year. RGC shares have already recouped about $1.30 of the $2 special dividend they went ex-dividend in late March and the shares till have a 5.7% current yield. A target of $23-24 over the next couple of months is realistic.
• Comcast (CMCSA/CMCSK) is buying movie ticket selling site Fandango. Fandango will continue to exist as is and will also be the core of a new entertainment site called Fancast. Fandanago and Fancast should both benefit from more than 11 million broadband subscribers that buy broadband internet access from Comcast, 70% of whom use Comcast.net as their home page. Comcast is developing a sizable internet advertising business that has thus far gone largely unnoticed on Wall Street. According to a recent article in the Wall Street Journal, solely from its relationship with Google (GOOG), which provides search for Comcast.net, Comcast is receiving about $70 million in revenue. This deal is due to be renegotiated this year and Comcast could see a significant boost in its revenue. The Fandango deal may get investors to notice the rapidly growing internet advertising business buried within Comcast. This is just another positive in a bullish story for Comcast over the next couple of years....

• Speaking of box office, it was another strong weekend with a gain of 25% vs. a year ago. RGC's quarter ends this Thursday and the box office is tracking to be up 7%. I think this is far ahead of current analyst estimates which are stale due to restrictions related to the NCMI IPO. Comparisons toughen for a few weeks before focus shifts to the enormous potential in May when Shrek 3, Spiderman 3, and Pirates 3 all hit theatres.
• Keep on eye on the Vonage (VZ) blow-up from the perspective of the cable industry. My first reaction was to wonder whether the Verizon (VZ) patents may be applicable to the cable industry. I've asked the question and so far I hear mixed results. In general, the expectation is that the cable companies don’t have to worry about violating VZ's patents. However, one contact indicates that VZ thinks that based on how the judge ruled the cable companies may be in violation. Another thing to keep an eye on is what happens to VON's current customers, who will get the customers that Vonage would have won in next year, and will pricing firm up now that the low price competitor is leaving the market. In general, the answers to these questions are positive for cable as long as they don’t get caught up in VZ's patents.

Media Madness

A few small items in the media world that are cluttering up my desk:

• Last week FCC Chairman Kevin Martin appeared before Congress for the first time since the Democrats took control. The questioning made it very clear that the FCC will face much different Congressional oversight until at least January 2009. Fortunately, the agenda for media companies is not that heavy but pending and rumored mergers are likely to find a much tougher road to approval.
• Martin's testimony revealed that the FCC will consider reestablishing the 30% ownership cap for any multichannel service provider, cable or satellite. This should not create much of an obstacle to further industry consolidation. Presently, a DirecTV-Echostar merger would just barely slide in under the proposed cap. Additionally, either Time Warner Cable (TWC) or Comcast (CMCSA/K) could acquire Cablevision (CVC).
• According to a Reuters article, 40% of all sub prime loans were made to Hispanics. There are already some signs that Hispanic advertising growth is slowing from its historical rate. I wonder how much Hispanic radio and TV advertising was from sub prime lenders. I also wonder if the sub prime meltdown could cause damage specifically to the Hispanic economy that could impact general advertising trends to the important population. Negative implications might exist for Spanish Broadcasting (SBSA) and Entravision (EVC).....

• As theatres upgrade to digital projection, expect a big expansion in 3-D enabled screens. I read an article that said currently there are 700 3-D enable theatres and that number is expected to grow to 6,000 to 8,000 by 2009. The upcoming Disney (DIS) release Meet The Robinsons will get a lot of 3-D distribution which is being supported by Disney's marketing campaign. More 3-D films is a benefit for theatre operators like Regal Entertainment (RGC) as 3-D is not presently replicable in a home theater.
• The box office was up 3.3% this past weekend according to BoxOfficeMojo.com. Year to date the box office is up 4.2%. RGC's 1Q07 includes the final weekend of 2006 and wraps a week from Thursday. On this basis, the box office is up over 5% so far this quarter. Comparisons toughen considerably in April but investors will look ahead to the guaranteed record breaking May when the third films in the Shrek, Spiderman and Pirates of the Caribbean franchises hit theatres.
• Speaking of Pirates, the theatrical trailer for the Pirates of the Caribbean: At World's End had its world premiere Monday night on Disney.com. Here is a link.

How Bad Are DVD Sales?

I don’t want to pick a fight with Jim Cramer and Doug Kass, my fellow contributors at theStreet.com's family of websites, but they are exaggerating the issues in DVD sales. The Pali report is correct in noting that consumer interest in DVDs is waning as evidenced by flat sales despite a huge increase in DVD households. But I have a few issues with the conclusions Jim and Doug are drawing from this report.

First, Circuit City and Best Buy are talking about low to mid-single digit comp store declines in this category. Just last quarter, both retailers reported positive comps for DVDs. I wouldn’t say that a low to mid-single decline "takes my breath away." Second, the development of alternative digital distribution channels for recent theatrical releases is in its very early stages and not likely the cause of the well-documented slowdown in DVD sales. Recent theatrical releases that drive DVD sales at major retailers are not available on VOD through your set top box as studios have not yet collapsed that window and show no signs of doing so. Furthermore, recent theatrical releases are only available on a very limited basis through internet downloads such as iTunes and data available on downloads indicates hundreds of thousands of units, not enough to move the needle when a single title like Cars or Pirates of the Caribbean: Dead Man's Chest is selling 15-20 million units just this quarter. And even if you think that digital downloads are about to explode, I wouldn’t bet on it. Current download speeds and the lack of an easy way to get the movies from your PC or Mac to your TV will prevent this channel from growing large any time soon. Apple's iTV product, expected in 1Q07, will be a good start but its impact will be limited for the next couple of years....

And is it really negative for the studios if iTunes or another download channel develops? I'd say not necessarily. The argument goes that that iTunes movie pricing undercuts Wal-Mart, Target, Circuit City, Best Buy and other retailers and this will hurt the studios. But downloaded movies should be cheaper. All the consumer gets from iTunes is the movie. No Director's Cuts. No Special Features. No booklet of information. Maybe most importantly, no HD download, just a low density picture much worse than current DVDs, let alone next generation DVDs like Blu-ray (that means even if you got your digital download over to your HD TV the picture would be really bad).

Consumers aren’t stupid. They will expect and deserve a lower price on digital downloads. Consequently, I see a two tier market developing for recent theatrical releases. You want it all and you want to watch on your new HDTV, head on over to Wal-Mart. On the go or addicted to your PC or Mac, go ahead and download.

Lower pricing on digital downloads is a negative: for the retailers. They lose share of a large product category and a key store traffic generator. But for the studios, this might not be a negative. Wholesale pricing might come down slightly in online channels. But lower pricing comes with lower costs for the studios which incur no manufacturing or packaging expenses. In other words, it is plausible that operating profit per unit on a digital download is no different than on a DVD bought in a store.

There is no doubt that DVD sales are no longer a driver of studio profits. But that isn’t new news. And it is far different than a collapse in operating profits from the DVD business. The end of DVD's as a growth business story broke in the summer of 2005 and is already deeply embedded in analyst estimates for the conglomerates that own the major studios. The story may be getting new legs thanks to the Pali Research report but it is neither new, nor as one-sided as Cramer and Kass suggest.

In fact, maybe if those digital distribution channels develop as fast as people think, it will set off renewed interest among consumers in building their movie libraries. Or maybe consumers will replace their favorite movie titles with HD DVDs once the format war is settled. Transitions in content delivery in the past have usually been positive for demand. Maybe it is different this time, but for now the "DVD is dying story" is more bark than bite for the major entertainment stocks.

UBS Media Conference 2006

Every year I attend the UBS Media Conference in NY to get a face-to-face update with many companies in the media industry. My goals are to find new ideas for client accounts, gain a better understanding of major industry trends, and connect with other money managers focused on the media sector. Below is a lengthy providing one paragraph summaries of all the presentations I saw during my four days in NY.

Overview and 2007 Advertising Forecasts

Sir Martin Sorrell, CEO of WPP Group noted is his keynote presentation at the 34th Annual UBS Global Media & Communications Conference that "if you compete on price, you create commodities, not brands." Usually we think of price competition on products and services purchased by end users. However, Sorrell made his comment in the context of a discussion of what is going on in the global economy for all things advertising related.

I think what Sorrell was getting at is that changes in media consumption due to digital technologies will be tricky to navigate. On the one hand, the digital technologies are opening new avenues for consumption of content supported by advertising. On the other hand, these same digital technologies could serve to depress profitability across all advertising-related industries because there is a major risk that the transition to digital/broadband delivery of content could depress pricing on the content, and in turn, the advertising.

The first day of the UBS conference was largely devoted to advertising forecasts and big picture, meta thinking about the future of the global media industries. I'd classify the news as mixed. 2007 advertising forecasts revealed by Universal McCann and Zenith Optimedia called for U.S. growth of 4.8% and 4.1%, respectively, and international growth of around 6%. International growth is boosted by continued double digit growth in many emerging markets with Central and Eastern Europe and Asia being the strongest geographies.

These growth rates overstate the outlook for traditional media as they include another year of 20% plus growth in internet advertising. Internet is contributing about 2% of the growth rate, leaving traditional media advertising growth at just 3-4%, or about inline with real GDP growth rates. Historically, advertising has been a considered a cyclical growth industry because it tracked nominal GDP growth. The loss of pricing power that Sir Martin noted in his comments reflects the new reality.

It is not pricing alone that is causing problems for traditional ad supported media. Newspapers, magazines, radio, and TV are all losing time spent using to alternative forms of entertainment including the internet. In fact, a study noted by Zenith Optimedia CEO Steve King concluded that the internet now represented 22% of our media consumption but just 7% of the total advertising pie. The cost to reach consumers on the internet is far lower than in traditional media so even if media companies can keep the lion's share of their users as the online transition continues, prices and profitability could compress.

Fortunately, this viewpoint is readily accepted by investors, analysts, and the companies themselves. Consequently, the upside is that most companies and industries are fighting back and are willing to risk new trying new distribution methods to reach consumers. Furthermore, when perception becomes reality and conventional wisdom, stock prices ought to reflect the news. In other words, whether it is the depressed stock prices of local media such as newspapers and radio or the outperforming prices of the big entertainment conglomerates and multichannel TV distributors, it is probably fair to say that the stocks reflect the tricky fundamental environment. This leaves it to investors to find opportunities where companies are meeting the challenges and thriving.

With that in mind, here are a few observations on other presentations I attended during the conference which ran from December 4th through December 7th.....

Monday, December 4th

Modern Times Group (MTG) is a Swedish company with leading free and pay TV positions in Scandinavia, Central and Eastern Europe (CEE), and Russia. There is no US listing for the shares. However, the company's commentary was very constructive for other companies operating in these regions including Central European Media Enterprises (CETV) and CTC Media (CTCM). News Corp (NWS) also has a growing presence in CEE markets.

My interest in CETV, long my favorite stock, always has me listening for commentary on CEE media markets. I believe I can state objectively that this conference represents the mainstreaming of the CEE opportunity. King of Zenith Optimedia, Sorrell of WPP, and Peter Chernin of News Corp all highlighted the CEE opportunity, often multiple times. King was unusually enthusiastic, noting that 15% 2007 advertising growth in this region was the highlight of Zenith's 2007 forecast. If my assessment is correct, it bodes very well for shares of CETV.

Additionally, MTG responded to several questions about their #2 station in the Czech Republic by noting that the would follow CETV's lead and attempt to raise TV advertising prices by 10-15% in 2007. CETV remains my #1 pick in all of media with 20% revenue growth and margin expansion driving margin expansion and a $90-100 target on the shares.

I would also recommend investors add to positions in NWS. Chernin and UBS Media analyst held a "fireside chat" that supported the bullish estimates and sentiment surrounding NWS. I've done very well with Disney (DIS) by riding the synchronized growth of the media networks, theme parks, and filmed entertainment that had led to a multiyear run of double digit EBOTDA growth. NWS is about to embark on its own multiyear run of double digit growth starting with guidance for 14-16% growth in 2007. NWS is benefiting from synchronized growth in its US and international cable networks, Sky Italia, digital and broadband efforts led by MySpace, and emerging markets exposure in CEE, India, and Asia. A massive share buyback triggered by the swap of NWS's Direct TV stake with Liberty Capital (LCAPA) would be icing on the cake.

One other company that impressed me was NII Holdings (NIHD). NIHD is not a media company. It is a leading provider of mobile phone services in Brazil, Argentina, Peru, and Mexico. This was my first exposure to the company and I was very impressed by the corporate strategy, execution, and CEO Steve Shindler. The stock looks expensive at 12-13 times EBITDA but the company has a 3 year growth record of 34% in subscribers, 34% in revenue, and 40% in EBITDA. And Shindler noted numerous times that growth is poised to accelerate in Brazil and Mexico. Additionally, free cash flow should surge as the company completes the expansion of footprint across all of Mexico in mid-2007. I have more work to do but this might be a case of you get what you pay for. Being new to this stock, I'd welcome any input form contributors or subscribers.

Tuesday, December 5th

New Media Economics Panel: This panel discussion attempted to explain the economics of ad supported content distribution on the internet focusing on video content that would be supplied by traditional suppliers like Disney, News Corp, Time Warner, and others. There were two conclusions. First, subscription based models would not likely produce enough revenue create profitable models especially considering the potential that online video might replace traditional viewing on TV. The reason for this conclusion is that a historical look at quadruple play household spending in the US shows stability indicating the consumer is not willing to allocate a larger portion of the monthly budget for subscription based video. Second, advertising supported models will work but current projections calling for a multi billion revenue stream from ads preceding "free" online TV shows would take longer to develop than currently forecast. The panel laid out a series of required advertising infrastructure such a critical mass of unique users and uniform technological standards and concluded that the infrastructure wasn't anywhere near ready. If the panel is correct the recent more positive sentiment toward the big entertainment conglomerates may be overly optimistic.

Evolution of Monetization Panel: This panel consisted of a half dozen start-ups that are trying to improve ad buying efficiency using internet tools. The presenters focused on everything form ad creation through ad placement. Much of the commentary went over my head but there was one interesting moment. UBS Internet Ben Schachter analyst asked the panelists to raise their hands if they were worried about Microsoft as a competitor. Two hands went up. Schachter then asked about Yahoo. Three hands went up. Finally, Schachter asked about Google. All six hands went up. My takeaway was that Google's strategic plan appears to be reaching the entire advertising economy from end-to-end.

Sundance Channel: Larry Aidem, President and CEO of the Sundance Channel, provided an overview of the company's strategy. Sundance is primarily a movie channel featuring independently produced and financed films. Sundance is privately held with ownership spilt among NBC, CBS, and Robert Redford. The channel appears in premium tiers of Dish and DirecTV and on digital tiers of cable operators. The present subscriber base is 25 million. Another 9 million subscribers have access to Sundance via a VOD channel. Like many cable channels, Sundance is trying to increase its originally produced content. Sundance is also looking to increase its sponsorship revenue. Presently, the channel sells no traditional commercial time. The promotion model is similar to what you see on local publlc TV channels. Sundance appears to be a valuable niche asset for NBC and CBS and either would likely want to add the channel to its stable of cable of networks. However, Redford doesn't sound like a seller. Sundance's value comes from the fact that it has 70% brand awareness (likely due to the success of the Sundance Film Fesitival) in the U.S. and its viewership is affluent. Given its status as a private company, there is no direct investment takeaway from the Sundance presentation. However, the presentation does reinforce the desire of many newer channels to be very niche oriented. Additionally, Sundance is another reminder that cable networks face increasing program costs as the growth in affiliate fees is moderating.

JC Decaux: This French company is one of the world's leading outdoor advertising companies with unusually large exposure to street furniture and transportation (buses, airports). I attended to learn more about the outdoor advertising market, which is one part of traditional advertising I know least. The presentation noted that worldwide outdoor advertising growth is around 7% and stable, far better than most other traditional media. Outdoor's competitive advantage is that people are more mobile allowing outdoor ads to reach consumers who are fragmenting time spent with other traditional media. There seems to be plenty of room to grow as outdoor represents just 5% of total worldwide advertising market and the three major players, Clear Channel, JC Decaux, and CBS, have market shares of just 12%, 10%, and 9%, respectively. JC Decaux indicated very firmly that it would bid for Clear Channel Outdoor (CCO), if the new private equity firms are sellers. This presentation was bullish for CBS and Lamar Advertising (LAMR).

Cable Networks: David Zaslav, currently in charge of NBC Universal's cable networks but on his way to become CEO of Discovery Communications discussed broad trends in the cable network industry. This was the first presentation I have seen which acknowledged this formerly double digit growth engine for entertainment companies was maturing. Industry revenues have been driven by subscriber growth, affiliate fee inflation, ratings growth, and CPM growth. Zaslav indicated that each of these revenue streams was slowing to low mid single digits. Offsetting positives are greater inventory sellout ratios and development of ancillary revenue streams such as VOD and online. International efforts are also beginning to mature. However, digital initiatives come with added costs and protecting current networks requires a greater investment in programming. Realization that cable networks are now an upper single digit growth business is a negative for Disney, Time Warner, News Corp, Viacom, and EW Scripps. However, I'd still much rather be a cable networks company than a newspaper, radio, or broadcast TV company.

Rogers Communications (RG): RG is the largest wireless company in Canada with a 37% market share. RG is also the largest cable company with a 29% share. For comparison, Verizon and Cingular each have about 25% of the US wireless market and Comcast has about 44% of US cable subscribers, but less than 30% of total multichannel TV subscribers. RG has been growing rapidly. Wireless in Canada is closely tracking the US adoption curve but got started several years later. Penetration is just 54% and is likely to growth by 5% per year for several more years. RG is unusually well positioned as it operates the only GSM network in Canada. RG's cable business is closely paralleling the strong growth in US cable with a mix heavier in high speed data but much lower in VOIP telephony. I was very impressed by this presentation, as I expected to be. I plan to buy RG on a modest pullback and may decide not to wait.

Grupo Televisa (TV): I have written favorably about TV before and deeply regret not having bought the shares despite my bullish outlook. TV dominates Mexican TV with its four channels garnering a steady low 70% share for many years. The company also supplies its TV content all over the world including as the dominant supplier to Univision. Over half of TV's revenue and EBITDA comes from TV Broadcasting, while an additional 20% comes from Sky Mexico, a satellite platform comparable to DirecTV. These core businesses should continue to drive solid double digit growth and margin expansion after a lull in 2007 when growth will be held back by the 2006 boomlet driven by the World Cup and Mexico's Presidential election. Promising new growth initiatives include 40% ownership of a new free-to-air TV channel in Spain and launch of a gambling business in Mexico encompassing bingo parlors, sports betting a second national lottery. The next time emerging markets sell-off and drag TV shares down, I plan to take a long-term position in this very high quality company. I hope that the shares won’t have moved up too much more before that happens. Take a look at a chart of the stock form last May and June to give yourself an idea of what might happen.

Disney (DIS): DIS shares hit a new 52 week high yesterday following comments by CFO Tom Staggs at the UBS and Credit Suisse conferences. While still cautioning investors that there are many headwinds for FY07 ending September, Staggs offered plenty of positive comments that increased investor confidence in the outlook for another year of double digit growth. Notable positive comments included (1) DVD sales of Cars are tracking equal to The Incredibles, (2) the ad market for ABC and ESPN is solid but not spectacular, and (3) the current quarter attendance and hotel occupancy at the domestic theme parks is holding up well against the toughest comparison of the year. Tough comps, loss of tax benefits, Pixar dilution, and other factors still present a growth challenge in 2007 for DIS, especially on the EPS line. However, on the operating income line, the outlook appears to be firming assuming the economy holds together. DIS also gets a boost from the weak dollar which helps foreign travel to the US parks. I remain long DIS and added positions in new accounts in the last two weeks.

Wednesday, December 6th

Verizon Communications: I sat it in on the VZ presentation to get an update on its FiOS deployment, the rebuild of its twisted pair copper network with fiber to the home. Despite the heavy dilution from FiOS, I think it is the correct strategy if VZ if going to hope to remain competitive with the cable industry in providing broadband and telephony to the home. While cable companies dispute VZ's statements, VZ claims it has achieved 14% penetration where it has rolled out FiOS. With a 2010 target of 6-7 million customer households, FiOS will begin to bite the cable industry in a few years. However, I think cable remains in a very strong position for 2007. Regarding VZ shares, broadband, business, and wireless are nice growth engines but investors have low confidence in VZ's forecast that FiOS dilution will peak in 1Q07. Were that to change or if additional dilution were the results of substantially greater than expected subscriber growth, VZ shares would likely be good performers again.

AT&T: T has shown great earnings growth as a result of synergies achieved in a series of mergers including Cingular/AT&T Wireless and SBC/T. The next big deal is the BellSouth merger which is stuck at the FCC. Assuming the deal closes, merger savings and additional cost cutting will drive earnings and likely lead T shares higher. However, I think T is making a big mistake by using a fiber to the node instead of fiber to the home strategy. T will have an inferior product and will not garner the massive cost savings from an all-fiber network. I think the decision to go fiber to the home will ultimately lead to the acquisition of Dish Network. Synergies won't be as high in that merger. T shares offer nice upside if the BLS deal is approved but I won’t be along for the ride because of my view that in the long-term the company will be in a weak competitive position.

Economics of Film: I sat in on a fascinating panel discussing the recent trend for movies to be financed by hedge funds. A representative from Creative Arts Agency and another firm that helps to validate the deals explained the history of film financing, how the current deals are structured, and why the financing of films is changing. Basically, the idea is to use capital markets theory so that film financing drives a more efficient production and marketing process for movies. Presumably, returns will be more stable, benefiting all parties. I suspect this won’t work in the long run because too much money will flood into film financing and investors will gradually reduce the hurdle rates for deals. Ultimately, it will produce a bubble in production much like Wall Street IPOs produce bubbles in other industries. That said, for movie studios, the new financing strategy might make their results more predictable as they trade upside for predictability and effectively become marketers and distributors while leaving equity mostly in the hands of the financiers. The exception to this would be when a studio owns its own intellectual property (Pirates of the Caribbean for Disney is a great example) or proactively decides it wants to develop the intellectual property. No immediate investment ramifications from this panel but if the new financing strategies actually improve the predictability and stability of the studio's filmed entertainment businesses, a higher multiple could be awarded to this operating income.

Time Warner (TWX): Jeffery Bewkes held a bullish fireside chat with UBS Media analyst Aryeh Bourkoff in front of a full ballroom. Bewkes is normally a good speaker but I thought he showed an unusually high level of self-confidence. I mentioned this fact to several big-time buysiders in the media world who all agreed with my assessment. I think this is actionable as it indicates TWX is going to report a strong fourth quarter and provide solid 2007 guidance. Notable among Bewkes comments were: (1) AOL's advertisng business is performing very strongly in 4Q, likely showing another quarter of 40% plus growth, (2) the recent trend of slower than expected VOIP telephony adds at Time Warner Cable is likely to reverse, and (3) there is no margin pressure in 2007 in almost all of TWX's businesses. If my feeling on 4Q06 and 2007 guidance proves accurate, I think TWX shares could trade up to $22-24 over the next few months. This is a more bullish outlook than I had previously expected and is largely the result of an unexpected highly positive vibe emanating from AOL. I totally whiffed on AOL so far, expecting the new strategy to fail.

NTL Incorporated (NTLI): NTLI announced before its presentation that it would be dropping its pursuit of ITV. Surprisingly, this did not result in a pop for the stock. I think the reason why is that in its attempts to explain to investors why the ITV was a good idea, the company endorsed the bear case that the competitive environment in the UK creates a headwind that even the Virgin rebranding and execution of merger synergies and NTL operational upgrades will not be able to overcome. Furthermore, in response to a question, management said that it "had better opportunities" than to buyback stock. Given that the company was willing to massively increase leverage to buy ITV but is not willing to increase leverage to buyback stock, a poor signal was sent. All that said, If NTLI shares traded lower ahead of the expected improvement in operational and financial metrics in 2007, valuation could get attractive enough to entice me back into the shares.

Liberty Global (LBTYA/LBTYK): Liberty is a large international cable operator with 13 million customers in 17 countries. Run rate revenues and EBITDA are $6.3 billion and $2.3 billion, respectively. The company is most focused on Europe but has significant exposure in Latin America and Japan. Recently, the company has been selling and buying cable assets which has mostly shifted its asset base in favor of higher growth markets, particularly in Central and Eastern Europe. An astute investor asked why the company wasn't growing faster (11% revenue, 15% EBITDA last quarter) given its heavy capital spending (almost twice as high as a percent of sales than US cable companies). The gist of the question was that Liberty wasn't earning a good return on its spending, while foregoing free cash flow that could be returned to shareholders. Management effectively responded by noting that today's heavy spending was extending the double digit growth profile many years into the future. Management also noted that despite the heavy spending and lack of free cash flow it was in the process of completing its third dutch auction share repurchase this year without pushing debt levels anywhere near the danger zone. I think management won the argument and have no intention of selling the shares I have owned in my personal account for many years. I guess that is a recommendation to buy the shares at current prices.

Charter Communications (CHTR): Aryeh Bourkoff introduced CHTR by noting that based on the massive dollars in private equity, CHTR's lousy balance sheet with a 9:1 ratio of debt to EBITDA was obviously the envy of companies everywhere. Given that cable stocks trade at less than 9 times EBITDA, I still see CHTR equity as effectively worthless. However, the CHTR shares have tripled and yesterday Aryeh raised his target to $4.50 while another analyst launched coverage with a $4.50 target. I see four reasons why CHTR shares have been rising and each could justify the new targets. First, restructuring of debt has pushed maturities out several years dramatically increasing the time value of CHTR's optionality. Second, a strong high yield market might be opening opportunities for further debt restructuring. Third, the sharp rise in value of Comcast shares has increased subscriber values to the point that CHTR's equity might have actual, not theoretical value, at current valuations. If that is the case each move up in Comcast increases the value of CHTR's tiny equity value geometrically. Fourth, the pending creation of a publicly traded Time Warner Cable that is likely to acquisitive, along with Comcast's willingness to expand its footprint, suggests that CHTR has greater options to fix its balance sheet through assets sales should it so desire. I like cable and I don’t mind leverage but I'll settle for Liberty Global and Comcast where upside exists but the risk profile is much lower. CHTR is just a bit too aggressive for me.

Thursday, December 7th

Mark Cuban, HD Net: Mark believes that TV will continue to dominate video delivery. His rationale is as follow. First, he sees HDTV's on the same price performance curve as PCs' meaning that the more and more households will have HD capabilities over the next few years. Second, all the studies show that once consumers have HD, their viewing habits change in that they immediately seek out HD channels at the expense of analog channels. Third, there are bottlenecks in the broadband networks that will prevent massive downloading of HD video programming. The files are just too big. Fourth, put the first three factors together and viewers will not be satisfied with the experience of watching TV on their PCs or in analog form if an iTV device does allow transfer of files on the PC to the TV. Cuban's view is bullish for multichannel TV providers such as Comcast and DirecTV. As usual Cuban addressed lots of other topics including his view that Google should not have bought YouTube, his bullish trading call on Yahoo for 2007, and the massive contracts filling up the roster of the NY Knicks.

Insight Communications: Insight is a private cable company, 50% owned by Carlyle and 50% owned by Comcast. Insight is the 8th largest cable operator in the U.S. with 1.4 million customer relationships in Indiana, Illinois, and Ohio. I sat in on this presentation to get a sense for what Comcast's intentions are toward Insight. Insight CEO Michael Willner pretty much admitted that the company would not exist in its current form within two to three years. Both sides are currently allowed to trigger an event that would rationalize the ownership structure. Despite lots of prodding from UBS Media analyst Aryeh Bourkoff, Willner refused to say whether a transaction was imminent. One other takeaway form this presentation is that the triple play bundle of TV, broadband, and phone works just fine in small and mid-size markets where population densities are lower and satellite TV penetration is higher. I'd expect Comcast to own 100% of Insight soon but don’t see it as something that will move Comcast shares.

Mediacom Communications (MCCC): MCCC is a smaller cable operator passing 2.8 million homes, mostly in markets sized from 50-100. MCCC is heavily leveraged. The company is producing double digit revenue and EBITDA growth but its growth rates significantly lag the industry. This is likely due to stiff competition from satellite companies in the smaller markets the company serves. I see little upside in MCCC shares because of relatively weak operating momentum and lack of free cash flow to pay down debt. Additionally, the resolution of MCCC's dispute with Sinclair Broadcasting (SBGI) over retransmissions fees will pressure margins next year as programming expenses, already at a premium to other larger cable operators, rise further. If I were interested in a highly leveraged play on cable, I'd go with Charter Communications.

Craigslist: Jim Buckmaster, CEO of Craigslist, gave a very interesting presentation in Q&A format with UBS Internet analyst Ben Schachter. Buckmaster stated that Craigslist puts the needs and wants of its users ahead of corporate goals. Craigslist is more interested in doing what it views is good for society than in maximizing profits. While this viewpoint was met with snickers and laughter by the audience, it was also clear that the company is growing rapidly and producing plenty of profits. Overall, I found the discussion refreshing as it led me to question conventional wisdom. As an investor, I found the discussion troubling for newspaper companies, whose classified ads are under direct attack by Craigslist. Growth at Craigslist could also limit the opportunity for Yahoo, Google, and other internet companies to capitalize on the local classified business.

Comcast (CMCSK/CMCSA): Comcast made a bullish presentation emphasizing its "accelerating revenue and operating cash flow growth." The gist of the presentation was that for the next few years, the trends driving this year's mid-teens growth are likely to remain in place. Furthermore, no significant rebuild of the networks is required to drive growth residential growth at least through 2007 and probably 2008. Capital spending will rise as more and more customers take the triple play but the returns on this variable, success based spending are very high, Comcast says north of 30%. There will also be a boost in capital spending of up to $250 million in 2007 as Comcast prepares to more aggressively enter the small and mid size business market. Expect to hear more about this opportunity in the next few months when it is positioned as almost as large as the current residential business with the ability to drive growth in 2008 and beyond. Comcast was trading at $26 at the 2005 conference when I was a lonely bull. I am a lot less comfortable with the shares at $42 and the bull side of the trade very crowded with portfolio managers and analysts. Howeve,r I think Comcast's operating results will surprise to the upside in 4Q06 and estiatmes for 2007 will head higher. This should be enough to drive the shares toward new analyst targets in the upper $40s. That is enough to keep me bullish on the shares.

I hope you enjoyed my coverage of the conference. I want to thank UBS and their analyst team, including Aryeh Bourkoff (media), Ben Schachter (internet), John Holdulik (telecom), Brian Shipman (publishing), and Matthieu Coppet (media strategy) for putting on another fine conference and welcoming Northlake Capital Management.

Bud Latest Company To Shift Advertising Mix

Advertising Age is reporting that Anhueser-Busch (BUD) "2007 media plans call for significant increases in marketing spending." However, not surprisingly, the company plans to shift its mix in favor of digital advertising. This is good news for internet advertising driven stocks, most likely those with strong positions in branded advertising such as Yahoo (YHOO). On the flip side, the losers appear to the broadcast television networks.

BUD's Chief Financial Officer, Randy Baker, told an investor meeting that the total advertising spend was going to rise significantly but the mix of media purchased would change "to reflect the viewing habits of our consumers." Baker noted two key mix shifts. First, more money will be spent on cable TV networks and less on broadcast TV networks. Since Baker noted that BUD's massive spending on sports would unaffected, this implies that prime time network TV would bear the brunt of the mix shift. ABC is owned by Disney (DIS), CBS is owned by CBS Corporation (CBS), FOX is owned by News Corp (NWSA), and NBC is owned by General Electric (GE). Fortunately, DIS, FOX, and GE also own a broad array of cable networks so the loss at the broadcast networks will be softened. CBS has extremely limited exposure to cable networks. The numbers here aren’t huge, BUD spent under $300 million on network TV in 2005, but given the high operating leverage in the network TV business, this is still a meaningful shift.....

The second shift is from traditional media to internet. This is old news. BUD made its intentions clear several months ago, while other large TV advertisers like Procter and Gamble (PG) have announced similar moves. In this case, only NWS through MySpace has any real hope of recapturing lost network TV dollars.

Yesterday, I discussed how advancing technology benefits content producers like DIS, NWS, CBS, GE, and Viacom (VIA). The news out of BUD reminds us that closely related technology changes are also working against these same companies.

I continue to believe that due to the momentum of its major operating businesses DIS is the best positioned entertainment conglomerates. NWS should enjoy a similar syncing of its major operating units beginning in 2007, while also benefiting from MySpace. Consequently, these are top two choices for current investment.

And I you are wondering why BUD feels the need to significantly up its marketing spend, look no further than shipment growth of just 2% for the first three quarters of 2006. #2 and #3 brewers, Coors and Miller are faring no better, with Coors up less than 2% and Miller seeing a 2% decline in shipments. Traditional media may face secular challenges, but apparently they aren’t alone.

Technology Advances Assist Media Growth

Rob Martorana, my editor at StreetInsight.com, and I had an email exchange the other day surrounding the advances in digital technology for media playback. Rob was discussing his new 30GB iPod with accessories, his new high def cable set top box, and his first experience watching a DVD in the new blu-ray format. The gist of our conversation was that new technology can drive the business for content producers, especially the ability to exploit a quality library of media.

Yesterday,I received another reminder of this when Bernstein Research put out a research report on Corning (GLW) discussing the high likelihood that 70 inch flat screen TVs will be on sale in the next few years. According to Bernstein, an 80 inch flat panel LCD TV would weight the same as a 36 inch CRT TV. Bernstein's pricing model indicates that by 2010 a 70-80 inch flat panel LCD TV might retail for $3,000, which would be "roughly the same percentage of US average disposable income as a PC in 1996." Furthermore in 1996, PCs had a "40% household penetration."

Now I suppose not everyone has wall space for a 70-80 inch TV, but the mere possibility supports the idea that producers of high quality video content stand to benefit as technology advances lead consumers to upgrade their equipment and refresh their libraries.

The winners would be video content creators like Viacom, Time Warner, Disney, News Corp, CBS, and Lionsgate. Multichannel TV distributors like Comcast, Echostar, DirecTV, and Time Warner Cable would also be indirect beneficiaries as consumers opt for broader packages of services that are delivered through advanced set top boxes. Distributors of User Generated content like Google's You Tube also would benefit.

I'll be attending the UBS Media Conference in NY next week where I hope to here more about the impact of new technologies on the media business.

Should We Believe The Hype on Borat?

Whenever something new and unusual comes along in business, it is easy to claim that it is an industry changing event. The of Borat is already spawning such talk. One thread of the discussion centers on whether Hollywood will now turn to "mocumentaries" or TV to movie crossovers. A second thread is whether the success of the movie is due to new internet driven marketing using websites like MySpace and YouTube, and text and instant messaging. The concept is that narrowly focused marketing campaigns seeking to reach only the target audience are going to supplant mass marketing.

For Borat, the conventional wisdom is that the unexpected success is the result of well conceived, narrowly targeted marketing campaign. I am not sure that is really fair as I saw lots of commercials on TV networks that would claim to have very broad demographic reach. But if we accept the premise that the film's success is being driven by internet-based marketing and further accept that this is the game changing event, the implications for movie marketing and broader advertising are significant.....

Movie marketing and advertising is already subject to the big trends wrought by the internet. As far back as The Blair Witch Project, released in 1999, industry pundits were claiming that movie marketing campaigns had changed forever. That hardly seems the case given the massive traditional TV ad campaigns mounted by the studios and available for viewing every Thursday evening on network TV's most watched night. However, given the large and continuing declines in print advertising of movies in the face of rapid increases in advertising per film, it is fair to say that movie marketing has changed and directly the impacted the future of one major industry.

The larger question though is whether the internet and other new technologies like satellite radio, digital TV, and video downloads are forever shifting the advertising dynamic from mass marketing to focused marketing.

Bob Lefsetz, a music industry pundit, wrote in a recent column about Borat, "If you want success today, create something good. Seed the early adopters. And then cease, or at least slow down, your marketing. Because the more you beat people over the head, the less attention they're going to pay. THEY want to feel in control, THEY don't want to feel tools of the system. THEY want to embrace the project…."

Look at Fox's strategy for marketing Borat. The film was pushed hard on MySpace to the exact audience that already knew about Sacha Baron Cohen and his Ali G and Borat characters. Fox put the first four minutes of the film on the internet and as of today on YouTube there have been over 67,000 views. Multiply that by all the other sites where it is available and you likely have hundreds of thousands of views. And I'll bet not too many StreetInsight subscribers were among them. And Fox could care less.

Fox went further and limited the opening to just over 800 theatres (a film like Pirates of the Caribbean opens in close to 4,000). The idea was just what Bob said, "seed the early adopters." In this case you had a quality product (the reviews are fantastic – 96% on Rotten Tomatoes), and now you have buzz driven off a marketing campaign that was narrowly focused and worked. The film will expand to triple the number of locations this weekend and is likely to match or exceed its opening weekend, something highly unusual in Hollywood for the prior weekend's #1 film.

If Borat is the moment that that Madison Avenue opts for a primary emphasis on narrow marketing, the implications on Wall Street are significant. The multiple contraction and sluggish financial performance we have seen across media over the past five years is already discounting the shifting advertising landscape which supplies 25% to 75% of revenue for most media companies. And those companies are primarily focused on delivering a mass market to advertisers. This spells trouble.

If you don’t buy the hype that Borat is a game changer (probably a good idea), keep this big picture trend in mind when looking at valuations for advertiser supported media stocks. Given the dull reception to the Tribune and Knight-Ridder auctions and subdued reaction to the announcement that Clear Channel is willing to sell itself, private equity investors, a group most concerned about terminal values, is already telling us things have changed on a long-term basis.

Media stocks are rallying. Don’t forget to take some profits.

NBC's Strategic Changes: The Future of Network TV?

I think the money quote from last Thursday's widely discussed article on steep cost cutting at NBC Universal came from Bob Wright: “As we reprioritize ourselves toward digital, we’ve got to be as efficient in our current business as possible.” The reality is that analog is under pressure due to continuing moderate viewership declines, alternative distribution channels like the internet and iPods, and ad-skipping friendly digital video recorders. The big TV networks have long been able to offset sliding ratings with prices increases but recent trends suggest that the additional challenges of digital technologies has finally restored balance to the pricing battle and CPM growth has stalled....

NBC’s response is a massive cost cutting program design t save $750 million against projected 2006 revenue and operating profits of $16.5 billion and $3 billion, respectively. The cost cutting is supposed to be across the board but it appears that primetime programming expenses, particularly in the first hour, and news will bear the brunt.

As far as saving money on programming, NBC wants to have more reality type programming in the opening hour of prime time. The Peacock network trails its rivals at CBS, ABC, and Fox in this regard, so I’d view this partially as a catch-up move and not a groundbreaking announcement. That said, entertainment executives do seem to recognize that the economics of content production breakdown as talent and other production costs soar while pricing power dissipates.

On news, there have been cutbacks for years and rumors of massive changes such as a joint venture between CNN and the news divisions of ABC, CBS, or NBC. The reality is that the internet handles news better than TV except for breaking news on big stories. Maintaining a huge news gathering and content distribution system just doesn’t make sense as consumers increasingly turn to the internet for timely and accurate reporting.

This story is likely to reignite the debate about how TV is headed the way of music, newspapers, and radio. The acquisition of YouTube by Google (GOOG) merely reinforces this view. However, I maintain that TV viewing habits are much more deeply ingrained and that the alternatives are much worse substitutes that is the case for these other traditional media. Consequently, I expect the erosion of TV economics be much more gradual than has been the case for newspapers and radio, especially the recent acceleration in challenges faced by those industries.

Additionally, the TV networks are owned by the same companies that are the content suppliers so unlike radio or newspapers, the transition to new distribution channels opens up a revenue opportunity. I don’t think selling ads on ABC.com of selling shows on iTunes for $1.99 can make up for the loss of pricing power on network TV, but it does provide a growing revenue stream against the slow erosion in network TV economics. You can’t say the same thing for newspapers or radio.

When the YouTube generation ages by 10 or 15 years, the economics of TV might breakdown more rapidly. For now, it will be periodic shifts in sentiment that hurt the stocks. But sentiment swings widely on Wall Street so don’t get overly concerned if the death of TV becomes a big story again for a few months.

Updated Advertising Forecast For 2007

Yesterday, Merrill Lynch analyst Lauren Fine lowered her 2006 and 2007 forecasts for U.S. advertising. Lauren has been ahead of the curve this year with below consensus forecasts for advertising growth so this is a call worth paying attention to, particularly for 2007.

Based upon Merrill’s forecast for nominal GDP growth of 4.5% and real GDP growth of 1.8%, Lauren is now calling for 2007 U.S. advertising of $298 billion, a gain of 2.8% vs. her prior forecast for a gain of 3.5%. Lauren lowered her forecasted growth for all the major traditional media categories but slightly raised her estimate for internet advertising growth.

In fact, excluding the $3 billion, or 22% gain for internet advertising, Lauren’s estimate for 2007 U.S advertising growth would be just 1.8%. Internet advertising represents $3 billion of the projected $8 billion gain for total advertising, or 41% of the incremental growth....

Looking at the traditional advertising media, Lauren lowered her forecast for newspapers to -1.5% from a prior forecast of 1.1%. I think this is the low estimate on the street. It also includes online classifieds so the negative growth in print advertising is even larger.

For broadcast TV, Lauren’s estimate is for growth of -1.2% pulled down by fact that 2007 is not a political year. Cable TV ad growth will be the healthiest among traditional media sectors at a gain of 5.8%. Nevertheless, this forecast is lowered from a previous estimate of 7.2%.

Radio and Magazines are each projected to grow by 1% in 2007, down from previous estimates of 2.2% and 2%, respectively.

Historically, advertising has been a cyclical growth industry, tracking nominal GDP when economic growth is rising. The current ad cycle has seen traditional media advertising track well below nominal GDP largely as a result of share loss to the internet. In turn, traditional advertising has suffered a loss of pricing power.

Right now, with the stock market apparently buying into a soft landing scenario, lowered advertising forecasts have little impact on media stocks. However, if Lauren’s below consensus view proves accurate and investors begin to fear a hard landing, the ramifications for media stock performance could become significant.

At a minimum, what appears to be a structural slowdown in advertising growth for traditional media should keep the pressure on public and private multiples of media stocks, rendering historical valuation levels irrelevant and sustaining the secular headwinds faced by the sector.

What's Going On With Yahoo!?

Yahoo! (YHOO) guides down and its shares trade off 12%. On the same day, Viacom (VIA, VIA.b), Time Warner (TWX), Disney (DIS) and CBS (CBS) all trade higher. Yahoo! says that advertising in economically sensitive industries including automotive and finance showed a sudden weakening. These two advertising categories are important for traditional media companies. At the same conference where Yahoo! guided lower, most traditional media companies said that there have been no recent changes in the ad environment. If anything, scatter markets for cable and broadcast TV have strengthened a little. What is going on here?....

Is Internet Vulnerable to Same Cyclical Forces as Traditional Media?

The valuation discrepancy between Internet ad plays like Yahoo! and traditional media stocks is enormous. With the Internet viewed as the share gainer, part of the premium is related to the belief that Internet advertising was not vulnerable to the general slowdown witnessed in traditional ad growth through most of 2006. Is it possible that weakness in auto and finance advertising, ongoing for years in traditional media, is finally spreading to Internet advertising? If so, has Internet advertising grown large enough, matured enough, to be vulnerable to the same cyclical forces that impact traditional media?

Is Yahoo! Losing More Market Share to Google?

Analysts will no doubt point to Yahoo! losing Internet advertising market share to Google (GOOG) (and others?). Yahoo! is undergoing a widely discussed and delayed transition in its monetization strategy for Internet search. This will also be pointed to as an explanation for Yahoo's guidance.

Is Ad Spending Falling All Around?

Or maybe the problem for Yahoo! is that advertising expenditures are taking another leg down. Recent data from newspaper and radio companies and local TV stations show weakness in July and August extending into September. This latest weakness follows lower estimates of ad growth that occurred earlier in 2006.

My Answer Is

I suspect that all three explanations have some validity. But until we see some revenue results from other Internet companies, I think investors should assume that Internet advertising is not as independent of larger advertising trends as previously assumed. The Internet is clearly a long-term market share gainer. The business model of Yahoo! or Google is superior in terms of margins and return on capital than traditional media. The Internet stocks still deserve big premiums compared to traditional media. But maybe the premium should be a little lower -- at least 12% lower it seems.

Why Traditional Media Is Losing On The Internet

I subscribe to a blog written by Bob Lefsetz. Bob writes about the music business and has done so for more than 20 years. His posts often touch on the business of music and many spread to other media content industries.

Last week, Bob wrote about Snakes On A Plane as it relates to the larger business of traditional media and the internet. I thought it was one of his best pieces and got his permission to post some excerpts. Bob uses Snakes on a Plane to explain how traditional media is losing market share to the internet because the internet allows the user to control his content, and especially to control where he gets recommendations for content.

Is it Internet buzz if you read about it in the straight media, hear about it on television? Isn’t that why it’s important to BEGIN WITH, that it’s happening OUTSIDE the system, and if you co-opt it and try to amplify it do you add to the buzz or are you just reporting a narrow phenomenon? In other words, can the straight media INCREASE Internet buzz and does it create worthwhile buzz unto itself?

I think this gets to the point of why emerging content distribution over the internet, such as YouTube, is such a challenge to traditional media content pitched to us by established TV networks, radio stations, music companies, and newspaper and magazine publishers. It is happening outside of the usual distribution channels. Traditional media can’t control it. Sometimes, maybe most times, they don’t even know about it until their ability to control it or benefit from it has passed.

Online you hear about sites from your friends, via e-mail, via IM. Or you’re referred by sites you trust. INHERENTLY, old media is out of the loop, so it has VERY LITTLE EFFECT ON WHAT GOES ON ON THE WEB!

Bob has got it exactly right here. I’d much rather watch or listen to content that comes from a trusted source. And who trusts traditional media these days.

Here is how Bob explains what’s happening in music content. Substitute movies, TV shows, books, or magazines in these paragraphs and he still makes sense.

The age of manipulation is dying. Oh, it will never disappear, but when you read the stories about deals with MySpace and other Websites know that it’s old farts feeling powerless in the new age and looking for SOME way to break bands.

But in a world where you can hear EVERYTHING, and you can on the Web, why settle for the CRAP?
Labels can hype their priorities all day long, but no kid’s gonna forward a link if he doesn’t like the music. It’s not like the days of yore, with the narrow gatekeepers of MTV and radio resulting in a closed world from within which the public had to choose.

Finally, there is this gem that really explains the secular challenges facing traditional media content creation companies.

Now you know why major media is scared. The RULES are different. It’s less about the sell and more about the product. And the sell can be perfected, but the product can’t. And this is very worrisome for those who employ the old rule book.

Cruise-Paramount Split, Part 2

Here are some further thoughts on the Cruise-Paramount split (Part 1). This post takes to look at Tom Cruise as a business by comparing the profitability of his two most recent films.

Cruise's last film prior to Mission: Impossible 3, (MI3) was War of the Worlds (WOTW) which grossed $594 million worldwide. MI3 grossed $393 million. According to BoxOfficeMojo.com, WOTW had a production cost of $132 million and MI3 had a production cost of $150 million. It is probably safe to assume that marketing expenditures on both films were similar and recent press reports use a figure of $100 million for MI3. Press reports also indicate that Cruise's production company had a deal with Paramount giving it 10%-20% of the worldwide box office gross before theatre splits. A good rule of thumb for DVD revenue is 1 times the domestic box office. For WOTW, domestic box office was $234 million, while MI3 pulled in $132 million. Another good rule of thumb is that TV rights are sold for 35% of domestic box office.

Let's look at the theoretical profits on each film assuming Cruise gets a 15% cut of the gross:

On WOTW, Cruise's production company would have pulled in $90 million. Paramount's take of the box office would be 55% of $594 million, or $327 million. Steven Spielberg directed WOTW and it is probalby fair to assume that he had a similar gross participation deal to Crusie. Subtract Cruise adn Spielberg's takes, and Paramount is left with $146 million, leading to a loss of $85 million on the theatrical run against production and marketing costs of $232 million. DVD revenue of $234 million could have had an operating margin to Paramount as high as 60% (Paramount's DVD costs likely included a participation for Cruise adn Spielberg). That is $140 million in operating profits to Paramount from home video. TV rights including domestic network, domestic cable, domestic pay TV and all international is another $80 million to Paramount at a margin that could be as high 80%. Add another $65 million in operating profits to Paramount. So before merchandise sales, on WOTW, Paramount might have had an operating profit of $120 million against production and marketing investment of $232 million. Not too bad.

On MI3, the numbers aren't quite so good for Paramount but are still pretty darn good for Cruise. 15% of worldwide box office brings Cruise and his production company $59 million. Paramount's take of the $393 million box office is $216 million. Deduct Cruise's cut and Paramount is left with a loss of $93 million on the theatrical run after production and marketing costs of $250 million (I've read on a usually reliable blog it could be as high as $280 million). Since the DVD market has weakened considerably over the past year and MI3 wasn't a smash hit, let's say DVD revenue is 80% of domestic box office at a 50% margin reflecting higher marketing and distribution costs. That still leaves around $50 million in profits from the home video window for Paramount. Again, let's adjust TV rights downward to account for the lower popularity of MI3, say 25% of domestic box office still at an 80% margin. That is another $25 million in profits to Paramount. So all in, MI3 will probably lose $10 million or $20 million, maybe as much as $50 million if the production budget really was as high as $180 million.

Now let's turn to negotiations over Cruise's new deal....

Paramount figures Cruise is broken goods, suffering a permanent lowering of his appeal. They baseline the MI3 results and decide to take a hard line in negotiations on a new deal. Cruise is insulted and has advisors whispering in his ear that hedge funds will pony up $100 million if he self produces. Despite his bad press, in Hollywood Cruise is known as a hard worker when it comes to promoting his films, even if he is increasingly difficult to work with on the set because of his religious beliefs and star treatment requirements.

What makes the most sense for all concerned? Cruise and Paramount go their separate ways. Cruise banks on his enduring popularity and gains a greater degree of control. Redstone spouts off about how Cruise's erratic behavior reflects poorly on Paramount and Viacom (VIA). Redstone has an excuse if Cruise hangs his shingle with another studio and produces a few more $500 million plus global blockbusters. Everything works out fine for all concerned.

Except that if I were a Viacom shareholder, I'd sure be hoping that Sumner is right about Cruise's future. Cruise was the only bankable star on the Paramount lot prior to the arrival of Spielberg, Dreamworks and Brad Pitt. Pitt has brought in $1.4 billion domestically on 22 pictures, or $64 million per film. Cruise has brought in $2.7 billion on 27 films, or $100 million per picture. Spielberg has brought in $3.4 billion on 23 pictures, or $150 million per film. Sumner thinks Cruise has peaked but since 1998 Cruise has grossed $1.3 billion, while Spielberg and Pitt have each grossed $700 million.

Cruise-Paramount Split, Part 1

Given all the publicty created by the split between Tom Cruise and Paramount, I thought I'd offer some impressons from the perpsective of the stock market. The following post is my first impressions, while a second post due to go up later this week provides greater detail on the economics of Tom Cruise as a "subsidiary" of Paramount's owner, Viacom (VIA, VIA.b).

It is hard to say much that is relevant to stock prices as far as the Tom Cruise-Paramount split is concerned. I do think that this is much more about money than Tom Cruise's behavior. The two are linked, apparently tightly linked in the mind of Viacom (VIA, VIA-B) chairman and controlling shareholder Sumner Redstone. Redstone and many others think that Cruise's bad press led the latest Mission Impossible film to fall short of box office expectations. It is hard not to agree with that assumption. The bigger question is whether future Cruise films were likely to suffer the same fate. And that is important because despite his hefty paydays, prior to this film Cruise has been a huge money maker -- arguably the only huge money maker -- for Paramount.

Cruise appears to have had a very generous deal at Paramount, providing his production company funds for overhead and a percentage of the worldwide box office gross. Importantly, the gross points came whether Paramount made a profit on the film or not. Consequently, the real problem here is not Cruise's behavior but the fact that production and marketing costs have gotten completely out of control. Mission Impossible III grossed $400 million worldwide at the box office and is likely to bring another $150 million to $200 million plus in DVD revenue and TV rights. A project with up to $600 million in revenue likely won't make any money for Paramount because the studio allowed the production budget to go over $150 million and spent another $100 million on marketing....

Remember studios only collect about 55% of each box office dollar. So for Mission Impossible III , Paramount's share might be around $215 million. Subtract the off-the-top take of Cruise's production company (rumored at anywhere from 10%-20% of total box office), and Paramount is left with $155 million against a production and marketing expense of $250 million plus. Oops. And with a slowdown in the DVD profits due to higher marketing and distribution expenses and a falling ratio of DVD revenue to box office revenue, Paramount's hopes of making decent profits on Mission Impossible III look bleak, while Cruise's production company walks away with $60 million or more.

Thus, despite press reports playing up Cruise's "behavior," I think the split was a business decision by both sides. The contract between Paramount and Cruise was up. Paramount wanted a better deal. Cruise felt the deal being offered wasn't good enough. End of story -- except that Redstone took it to another level with his aggressive comments about the split.

Does this episode represent a change in how studios will deal with stars? Maybe. Will Cruise's new, self-financing strategy represent the future? Maybe. Will studios finally attempt to better control budgets so that $500 million or more in worldwide gross isn't break-even? Maybe.

Is there a lesson for investors in stocks of companies that own movie studios? Yes. It's a tough business with erratic profits, high risks and impossible-to-analyze financials. So the next time you see an analyst report that puts a premium multiple on EBITDA produced by a studio, be skeptical.

Cable Networks Growth Is Slowing

I have been bearish on stocks with heavy exposure to the cable networks business due to concerns that growth was slowing dramatically while the industry was accorded a significant premium valuation. Last Thursday's positive surprise from Viacom (VIA) and stronger-than-expected July revenue report from E.W. Scripps (SSP) is a strong challenge to my thesis, so let's take a closer look at the fundamentals.

Rise in Number of Households Has Offset Affiliate Fee Inflation Thus Far

The revenue line for a cable network is a combination of growth in affiliate fees and growth in advertising. Affiliate fees are what your cable or satellite company pay each month to the owner of the cable network for the right to send that network's signal into your TV. A cable network can generate affiliate fee growth by annually raising its fee and by increasing the number of households it reaches. Historically, affiliate fees have risen at an upper-single-digit rate for major networks with most deals under long-term contracts with price escalators. Since there has been a steady increase in the number of multichannel homes, cable networks have leveraged affiliate fee inflation with a growing number of homes passed....

But Content Buyers' Bargaining Power Has Grown, As Household Growth Slows

My concern on affiliate fee growth has been twofold. First, as the cable industry has consolidated and the satellite industry has grown, the bargaining power of the content buyers (cable and satellite companies) has grown relative to the bargaining power of the seller (cable network companies). For example, bearish analysts on Disney (DIS) often cite the risk that affiliate fee pricing gains will moderate when ESPN has to renegotiate with Comcast (CMCSK) and Time Warner (TWX). Second, as multi-channel TV penetration has approached 90%, growth in the number of households has to slow. At full penetration, for a fully distributed cable network, the number of households served can only grow by the 1% rate of household formation.

Ad Revenue Also Seems Poised to Slow Sharply

The story on cable networks other, and larger revenue stream, advertising sales, is similar. Historically, cable network advertising growth has been double-digit driven by increasing ratings relative to broadcast networks and the growing number of consumers reached as household penetration rose. Today, ratings growth across the cable network has stagnated which is restricting ad pricing, or the cost per thousand (CPM) viewers reached. This year's very sluggish cable upfront currently is witnessing CPM growth of low single digits at best. Facing a much slower growth rate of viewers reached due to the same penetration issues cited above and stagnating ratings, the advertising revenue stream seems poised to slow sharply even before the loss of effectiveness of TV advertising and the shift of ad budgets toward the internet are considered.

Increased Content Costs Will Squeeze Margins Even More

Making matters worse is that the best way to combat the slowing of the fundamental growth drivers is to invest in more and better programming, whether it is sports rights at ESPN or original dramas at TNT or original movies at Lifetime or broader news coverage at CNN, to raise ratings requires investment. Combine increased content costs with slowing revenue growth and the possibility that margins will be squeezed is real.

Time Warner, Viacom and E.W. Scripps Are Most Impacted

The companies most impacted by eroding fundamentals for cable networks are Time Warner (TNN, TBS, Cartoon, CNN), Viacom (MTV Networks), and E.W. Scripps (HGTV, Food, Fine Living, and DIY). Disney is also impacted although ESPN is an unusual network in that it is able to recoup much of its increased sports rights costs through large affiliate fee increases. News Corp. (NWS) has significant cable network exposure but is insulated in the near-term as Fox News reprices its contracts sharply upward to reflect its success over the past five years.

Recent News Seems Contrary to My Thesis

The reason that I revisit this topic today is that last week Viacom reported better-than-expected earnings driven by growth in its domestic cable networks. Additionally, E.W. Scripps announced its July revenue report which included 20% growth for Scripps Networks, well ahead of current expectations for 2H06. Both stocks reacted very well to the news, with Viacom rising 9.6% and Scripps rising 4.9%.

Both stocks were trading at or very close 52-week lows, so it is understandable how good news could lead to such large gains. Further, the premium valuations on both stocks had largely disappeared in 2006 as the shares fell much more than most other media sectors.

Second Half of the Year Will Tell the Tale

All of this makes me wonder whether my view of cable network fundamentals is unduly bearish and/or whether recent valuation levels fully discount my bearish view. The rest of 2006 will tell the story as we see whether better results at Viacom and Scripps can be maintained and reflect a bottoming of industry trends.

I suspect yesterday's euphoria may last a short while but I think the larger issues outlined above will win out and that growth rates will continue to moderate, keeping a lid on any recovery in the stocks of companies exposed to the cable network industry.

Upfront Moving Slowly So Far For TV Networks

So far, the results of the upfront selling season for network TV advertising have been slow. The upfront occurs every May and June when the broadcast and cable networks introduce their lineups and cut deals with advertisers for advertising over the new TV season that follows in the fall.

FOX Ahead of Other Broadcast Networks in Selling Its New Season

According to an article in the Wall Street Journal late last week, the pace of deals between advertisers and the broadcast networks (ABC, CBS, NBC, and FOX) is lagging well behind last year's weak upfront, and pricing is worse than expected. FOX is the only network that has completed the bulk of its upfront deals, selling 70% of its inventory at price increases of 2%-3%. FOX is coming off a strong season for ratings when "American Idol" was more popular than ever, and several other shows -- including "24," "Prison Break," and "House" -- had higher ratings.

ABC And CBS Will Have to Accept Ad Pricing Bar Set By FOX Deals

ABC and CBS each had some ratings success but have been slow to cut deals. Both networks appear to be looking for price increases ahead of what FOX accepted. So far, that is a no go with advertisers. ABC had a good season in terms of ratings growth but failed to add any new hits following the turnaround driven by "Desperate Housewives," "Lost," and "Grey's Anatomy." CBS led last season in total ratings across the broad demographic, but ratings have not grown in a couple of years. FOX has probably set the bar, and ABC and CBS will have to accept lower price increases. Both networks may hold back inventory, selling less than the 70% of FOX, hoping to meet ratings guarantees and then sell ads in the scatter market this fall at premium prices to the upfront.

NBC Continues to Cut Prices to Attract Advertisers

NBC, like FOX, has sold a lot of advertising time. In NBC's case, however, the sales have been made at lower prices than a year ago. This was also the case last year when NBC first felt the pain of its ratings collapse. Another down year of ratings, and the network is again cutting prices to attract advertisers. This is probably a good strategy for NBC as it can earn some good faith from advertisers in the hopes that ratings have bottomed out.

Advertisers Moving Money Online and Committing Closer to Start of Their Shows

Overall, it appears that this year represents an acceleration in the trend away from an upfront-driven TV advertising market. Advertisers are moving more money online and prefer to make commitments closer to airing of their ads. So far, the impact on the networks is felt more in their loss of leverage vs. advertisers than a loss of ad dollars. Advertisers have more places to go and want better measurement of ad effectiveness such as that seen on the Internet.

Erosion of Network Power Hurts Stocks of Network Owners

In the long run, the gradual erosion of network power is a negative for the owners of those networks, which include Viacom (VIAB), Disney (DIS), News Corp and General Electric (GE). This issue has been recognized by investors and is one reason for the steady erosion in multiples that has occurred over the past few years. The bottom line is that growth rates in broadcast and cable network advertising business are likely to remain below the levels they have been in the past when compared to GDP growth. That is a negative for stocks, but it is also conventional wisdom. To me, that means it is largely incorporated in stock prices. And that is why I have spent a lot less time analyzing the upfront this year.

New Outlets Possible for Products From Media Conglomerates

Is there a potential positive out there to offset the network's reduced negotiating position? If there is, it is likely the development of new outlets for all the programming these entertainment conglomerates produce. Whether that will be enough to offset lost revenue from the traditional industry is to be determined.

I remain long DIS, looking for strong earnings the next two quarters to drive the stock back into the low $30s.

Why Traditional Media Companies Don't Get The Internet

Can you name a single big success on the internet that was built off an already established brand? I suppose news sites like MSNBC.com, CNN.com, and NYTimes.com might qualify but even there the younger demographics that are driving the net are increasingly getting their news from blogs or links in the communities they call home.

So, why is AOL going to compete with MySpace by launching AIM Pages? I just saw a TV ad for iVillage that ended by telling viewers that iVillage is owned by NBC Universal. Does that help iVillage?

I think the biggest successes on the internet have been fresh brands. Google in search is the best example. MySpace and Facebook in community sites came out of nowhere. In video, YouTube seems to easily beating Google. Shopzilla is winning in comparison shopping not Amazon or Yahoo. It almost seems as if success on the net is driven by being (or pretending to be) anti-corporate and anti-mega-brand.

So why is it that established traditional media companies and increasingly established internet companies feel they should throw their corporate brand on everything they do online? I suspect that the executives see economies of scale for themselves, ease of use for their customers, and believe in studies that show consumers like their brands.

I think they are making a big mistake. The internet revolution is being completed from the bottom up, not the top down. It is democratic with a little d. Lots of companies have shown that you can build a hugely popular site and generate loads of traffic with no prior branding. I think the experts call it viral marketing or viral networking.

From my traditional media perspective, I would advise the companies to stop being married to their brands. Build standalone businesses with their own brands and their own users. Then worry about incremental montetization opportunities that come from synergies within the corporate umbrella.

Traditional media companies are trying to build their online revenues or diversify away from slow growth assets. Many companies are generating 2-10% of their revenue online. Look for companies that are thinking outside their brands or willing to challenge their own business models and try different things. I'd say News Corp (NWS, NWSA), Disney (DIS), and E.W. Scripps (SSP) have done the best jobs. It's no coincidence that NWS and DIS are hitting new highs. SSP has struggled recently but pull up a long-term chart and compare it to Gannett or New York Times or Tribune. The evidence is clear.

How the Internet is Impacting Traditional Media

Several interesting tidbits regarding traditional media and the internet were included in the collection of stories in the latest MediaWorks email I received from AdAge.com:

• I've recounted how the shift of auto advertising to the internet has really hurt newspapers. AdAge.com reminds us that magazines are taking a serious hit as well. In 2005, auto advertising in magazines fell by $100 million. Magazine advertising totaled over $11 billion last year, so loss of almost 1% of the total really hurts at the margin. The trend is continuing so far in 2006, although February did see a 4% increase in auto advertising, breaking a string of six straight down months that included a drop of over 20% in January 2006. At Ford, the share of total advertising dedicated to magazines fell from 23.5% to 21% last year. Smaller but significant declines were evident at GM and Chrysler. Among the major media stocks, Time Warner (TWX) is the only company with a significant exposure to magazines. Last year the company received 13% of its revenue and 12% of its EBITDA from its publishing division which is primarily magazines including titles such as Time, Sports Illustrated, and People.

• An editorial in MediaWorks took the New York Times to task for eliminating stock tables from the daily paper. The writer was not mad that the company dropped the tables but rather wondered why it took ten years of the internet age for management to see the waste of paper. The Chicago Tribune just announced it would stop carrying stock tables as well. The writer didn’t mention how the launch of Google Finance and the end of stock tables at NYT occurred so close together on the calendar.

• CBS (CBS) made a big splash with its online streaming of the first four rounds of the NCAA basketball tourney. The experiment was a big success with over 1.4 million people signing up for a VIP pass to avoid standing in line. Unfortunately, for the potential viewers, demand overwhelmed CBS' decision to offer 260,000 simultaneous streams. Advertisers and media buyers were thrilled, however. CBS is already selling advertising for next year's online streaming coverage. This year, most of the advertising was in the form sponsorship. It is not clear if there will be more CPM based pricing next year but the idea that a big event can be streamed with sufficient demand to underwrite much of the costs received another big boost on the heels of AOL's success last summer with the streaming of the Live8 concert. One issue that is raised by the success of the hoops streaming is the availability of bandwidth.

A few observations. First, in its fight to hold market share against internet advertising, each form of traditional media needs to remember what it does best. For example, newspapers are local and magazines are niche targeted. Traditional media must capture these advantages and remember that if challenging your own business is necessary it is a risk worth taking. Second, regarding streaming of TV content, as the article notes, hypothetically, bandwidth supply is limitless but there are bottlenecks related to server capacity. Those bottlenecks only go up as more HD TVs are in living rooms and viewers get used to the quality of the picture. Downloading full length TV shows or movies takes a long-time already and without solving the bottlenecks, the download times will stretch to hours in HD format. This is one reason why the internet won’t replace your cable or satellite subscription anytime soon. As Rob Martorana recently pointed out TV downloads will create new stars. With the NCAA tournament, CBS showed us that some of those new stars will be traditional media companies willing to take some risks.

Positive Sentiment Change For Media Stocks?

Breakup Time Warner! Univision for sale! Knight Ridder up for auction! Viacom splits in two! Clear Channel spins off its billboards and concert business! Cablevision is paying a special dividend – maybe not! Disney sells radio! Disney buys Pixar! Liberty Media splits off QVC! DirecTV is buying back $3 billion of its shares, Comcast is buying $5 billion, Disney is buying another $5 billion, Time Warner is buying $5 billion, Viacom is buying its shares, CBS is paying a decent dividend.

What the heck is going on? Obviously, big traditional media is under pressure and in some cases responding with asset sales, share buybacks, or dramatic corporate restructurings. I've been following media stocks for 20 years and one thing that has always been bullish has been merger and acquisition activity. Until recently, all the media M&A has been in Europe. Not coincidentally, European media stocks have performed much better than their U.S. peers.

So the question becomes will the flurry of M&A in the U.S. finally capture the attention of investors and lead to a rally in the shares or will overwhelming concern about future growth rates and the sustainability of free cash generation keep valuations depressed?

I mention this today because Wednesday was the first time in a long while that pretty much every media stock on my monitor, almost 50 of them, was up on the day. The stocks were up all day, even in the morning when breadth stunk and the major averages were barely up or underwater.

Yesterday morning marked the simultaneous reporting of the Icahn breakup plan for Time Warner and the potential sale of Univision. Did this represent the bottom? Will the shares see better performance in the months ahead?

I think the answer might be yes. Recent days also saw a great response to a good quarter by Disney and a nice bump for DirecTV after a decent quarter. Disney offers solid double digit growth. DirecTV is transitioning to a controllable growth strategy, trading subscriber growth for sustainability. Is the market's response to the quarters of these two companies a sign that a change in sentiment is at hand? I think so but the names that will lead are those that combine M&A potential, free cash flow dedicated to shrinking the capital base, and most importantly a growth profile over the next few years. DIS is the best of the big caps, while Central European Media Enterprises (CETV) is the best of the small and mid caps.

Thinking About The Movie Business

I wrote the following for StreetInsight.com while vacationing last week in chilly Bayfield, WI on the shores of Lake Superior:

I've been working "lightly" this week, spending time with my family at our place in Northern Wisconsin on the shores of Lake Superior. We have a blanket of snow about a foot deep and since there are only a few hundred people up here this time of year the environment is best described as pristine. Even better, we don’t have to go anywhere unless we want to, so commuting in the snow is not an issue.

The closest movie theatre is 25 miles away in Ashland, WI. It is an old theatre with a half dozen screens. Tickets are just $6 and popcorn and candy will only cost you $1 each. Our teenagers will actually go to the movies with us while we are up here since they don’t have to worry about bumping into their friends at the mall, so we decided to take in the two big blockbusters of the holiday season: King Kong and The Chronicles of Narnia: The Lion, The Witch, and The Wardrobe. Both films were very well reviewed and in our family both actually exceeded expectations. I think it was the simple stories with special effects that didn’t come across as technology. Each film reminded us of something that would have been made in Hollywood decades ago....

Of course, I can’t go to the movies without thinking about the movie business. Both these pictures have huge production and marketing budgets. I believe King Kong cost over $200 million to produce and Narnia around $150 million. Marketing budgets for each film will exceed $50 million. With this in mind, while sitting in the theatre, I began thinking again about movie industry accounting and remembered a post I recently found on a Yahoo! Finance Message board. I contacted the poster and got his permission to reproduce it, so here is the best explanation I've ever read about movie accounting with my clarifications in parentheses:

Say Box office of $100M (for Lions Gate Entertainment production Saw II). Theatres keep roughly half, plus or minus adjustments for co-op advertising, advertising credits, etc., leaving $50 million for LGF to divvy up as manager of the clearinghouse. LGF takes out a 30% (plus or minus) distribution fee, plus all out of pocket print and advertising (P&A) costs. Assuming $20 million P&A, this puts $15 million (net) in LGF pockets and leaves $15 million in the pot. There could be participations from this $15 million for producers, writers, directors, in front of the camera, behind the camera, under the executive producer, who knows. Say $5 million. LGF then would get its costs advanced for the negative costs, plus an interest factor. Say another $5 million. This leaves $5M to divvy up (with producers as "profits").

Next is DVD/ home video. This is where the industry is still in lala land. Even though it costs $2 max for the DVD production, packaging, and artwork, generally the contracts provide for a cost of sales allowance of 50% or more. Sometimes it is as little as 20% that goes to the profit split from the sale of DVD's.

Other ancillary revenue steams include say $5 million from cable (and broadcast TV) licensing. Right off the top to LGF is a 20% to 30% distribution fee. Then more allocated marketing costs, more participation costs, plus, of course, the residual deals with SAG (Screen Actors Guild). Wait until they start packaging Saw, Saw II with other films in marketing deals. Allocations have to be made to each film.

What is amazing to me is that some of these analysts say they can figure it out before hand. Right! All the contracts are confidential, unless it goes to court. Of course, they never go to court as the attorneys meet at The Ivy, cut a deal, and no one knows.

So there you have it. No wonder my major screw-up this year was LGF, a pure play movie and TV studio. Thanks to my Yahoo poster buddy who I can vouch for as someone who knows what he/she is talking about.

NBC and CBS VOD Deals Not Such A Big Deal

I don't share the view that some tipping point was reached and the TV network model was changed forever by the announcements that NBC and CBS would sell individual programs for 99 cents via DirecTV (DTV) and Comcast (CMCSA/K), respectively. I believe these deals just will just reinforce trends already in pace by accelerating DVR penetration. In fact, the DirecTV-NBC deal requires a DVR to work. If a household has a DVR, it can record any NBC program with the push of a single button. If you've never used a DVR, all you do is pull up the guide, move the cursor over the program you want to record and hit the record button. NBC wants you to pay an extra 99 cents so you can watch it commercial free. I record "Seinfeld" five times a day via my DirecTV Tivo and we buzz through the commercials with the fast forward button. A typical commercial block takes less than 20 seconds to fast forward past....

The CBS-Comcast deal is more interesting to me because Comcast already gets massive usage off its free VOD platform. CBS will offer TV shows for 99 cents via the platform. Again, if you have never used it, it is a breeze. Simple menus take you to genres and you can choose your VOD program with a click of a button. I'd imagine the new TV programs will get a prominent front-of-the-guide button. The problem I see with this deal is that all the benefits seem to accrue to Comcast. It has improved its VOD offering, which can only help in attracting new subscribers and retaining current ones. More importantly, any Comcast subscribers that make regular use of the new TV programs are going to quickly add several dollars to their monthly bill. If they don't already have a DVR, the incentive to add one will be high. Once a DVR is in the house, then you can just record the original showing of the program without paying 99 cents. And in this case, you don't even get the benefit of eliminating advertisements.

Networks Deserve Credit for Sampling New Distribution Channels

NBC, CBS, and ABC with their iPod deals deserve credit for sampling new distribution methods. The handwriting is on the wall that control of TV watching is shifting to the viewer. Any attempt to try new distribution shows that the TV executives have learned something from the music industry experience (from Napster through iTunes).

But Advertisers Know the Game Is Up

However, TV still faces a big obstacle as viewers fragment among channels and different entertainment options. Worse is that advertisers know the game is up. An article in Wednesday's Wall Street Journal contained the following:

The nation's biggest advertiser, Procter & Gamble (PF), which spent roughly $2.5 billion on TV ads last year, indicated it would cut its broadcast upfront commitments for the current prime-time season by about 5% and its upfront commitments on cable by as much as 25%. Media buyers say advertisers, faced with more options and splintering audiences, want to experiment with new forms of promotion that are often cheaper than TV.

Multiple Compression for Ad-Supported TV Stocks Is Permanent

So give the TV networks credit for trying but remember the wave coming over them is too large to reverse for anything more than a strong cyclical advertising upturn. The implication for the ad-supported TV stocks is that the multiple compression we have seen is permanent.

The Impact of Internet Advertising on Media Stocks

In my recent reading of Street research on traditional media companies I have noticed two trends. First, analysts are beginning to adjust their multiples downward in their sum of the parts valuation multiples, finally reflecting the actual trading multiples of media stocks in the current market environment. Analysts are really just catching up to the multiple compression that has been going on all year and accelerating recently...

Second, I've noticed increasing discussion of the impact of the internet on the growth rates of traditional advertising-supported media such as newspapers, television, magazines, and radio. I am not being critical of traditional media analysts, rather just noting that the volume of discussion of traditional media vs. the internet has kicked up a level.

In that vein, I wanted to mention something that hit me as I was reading this weekend. According to reports on Google (GOOG) and Yahoo (YHOO) written by ThinkEquity analyst John Tinker, internet advertising (search and branded) should grow 30% in 2006 to $16 billion. This means absolute growth will be about $3.7 billion. John's work on the internet stocks appeals to me because earlier in his career he was a well-regarded media analyst.

Even in the good times, advertiser-supported traditional media is a GDP plus growth business. This year the traditional media businesses of newspapers ($47 billion), magazines ($13 billion), television ($63 billion), and radio ($20 billion) will generate about $143 billion in advertising revenue. Direct mail is another $55 billion and Yellow Pages around $14 billion. Add in over $50 billion in miscellaneous advertising and excluding the internet you have around $270 billion in total advertising.

Certainly, some internet advertising budgets are incremental to traditional media ad budgets. However, internet advertising clearly is stealing a decent percentage of its total volume from these traditional media sources. Focusing on just newspapers, magazines, television, and radio, if they had 2006 advertising growth tracking nominal GDP of say 6%, they would enjoy around $8 billion on incremental revenue.

This means that if 25% of the $3.7 billion in incremental growth comes from budgets that otherwise would have been dedicated to newspapers, magazines, television, and radio, the growth rate in these traditional advertising categories is reduced by 1%. Look backwards at disappointing growth rates for traditional advertising and you get a better feel for the impact of the internet. Look forward and even if you assume slower growth for internet advertising you've got a 1-2% reduction in the growth rate of traditional advertising relative to its historical trend.

On Wall Street, multiples are directly related to growth. Is it any wonder that multiples for traditional advertising supported stocks have compressed?

M&A Might Drive Interest in Media Stocks

Monday's close on the S&P 500 was the lowest since May 18th. That is not what I wanted to talk about today but I was a little surprised as I scanned back that I had to go back almost five months to find the last lower close. Ouch. Bye-bye to all those summer gains.

I received a note from Aryeh Bourkoff, the excellent cable analyst at UBS, yesterday which noted Belgium's largest cable company, Telenet, completed an IPO. While the pricing was at the low end of the range, the multiple was a healthy at 10 times 2006 estimated EBITDA. This marks the second deal in European cable since I posted last week about European media M&A. Late last week, bankrupt German cable company PrimaCom sold its Dutch cable business to Warburg Pincus for over 10 times projected 2006 EBITDA. Previously, I noted that Liberty Global (LBTYA) paid over 10 times EBITDA for leading Swiss cable outfit Cablecom. And of course, the long awaited NTL-Telewest merger was announced on October 3rd. While UK cable trades at just 6 times EBITDA and the NTL deal was greeted with a shrug by investors, a deal is a deal....

....Last week on Street Insight, I noted that along with activity in broadcast TV assets, the European cable deals were supporting valuation for European media assets such as Central European Media Enterprises (CETV). I am beginning to wonder though if Comcast might catch a bid off all this M&A activity. The company should report seasonally strong 3Q05 earnings shortly and the rollout of VOIP ought to provide excitement for a good 4Q as well.

This summer I recommended Comcast which worked its way about 10% higher before giving back all the gains over the past month. Comcast trades at less than 8 times 2006 EBITDA, and while somewhat growth challenged relative to less mature European cable, it seems to me like the discount has grown too large. If I am right that the Street will like Comcast's 3Q05 numbers and 4Q05 guidance then now might be a good time to step up to Comcast shares again.

I am looking for a media name or two to replace SBS Broadcasting (SBTV) in my portfolios. The SBTV buyout should close by the end of OCtober. I am not in a big rush as I remain worried about the very short-term in the market but all this deal activity in Europe gives me hope that Comcast and some other media stocks could catch a bid before year end. Besides Comcast, I have my eye on LBTYA and its former parent Liberty Media (L). L is trading at the low end of its multiyear trading range, at a level form which it has often bounced. I also continue to like TWX where I think upcoming earnings news, particularly the advertising numbers at AOL, could provide catalyst. The bottom line is media stocks perform best when there is M&A activity. So far the activity is abroad, but in a shrinking world full of global private equity firms flush with cash and borrowing power, it seems like some U.S. assets with near-term catalyst are worth another look.

Media Stocks

I am a long-time investor and analyst in media stocks of all shapes and sizes. I like media stocks becuase the business is fairly simple, free cash flow capabilities are excellent, and US companies have an unrivavled global competitive position. Presently, Northlake's model portfolio contains two media stocks, Central European Media Enterprises and NTL, Inc. Those stocks have performed well in the last 18 months but most media stocks have not.

One of my key Wall Street contacts in the media sector is Lauren Fine, newspaper and ad agency analyst at Merrill Lynch. Lauren had a peice out last week from which I excerpted the following:

� Advertising Week in NYC has fueled a variety of discussions regarding the health of advertising, the growth of Internet advertising (up 43% in Q2), and the imminent changes in the network TV model due to increased penetration of broadband and PVRs.

� We maintain the view that advertising is still a vibrant field and believe that creativity is improving rather than worsening. A proliferation of media outlets combined with muted demand (stemming we believe from a combination of modest economic growth and questions regarding return on investment) are limiting the gains of traditional media relative to past cycles.

� On the margin, underlying demand for advertising is not improving, notwithstanding comments made by Unilever and Colgate that increased marketing is constraining their earnings performance or GM's accelerated advertising efforts to further its incentive program.

I agree with Lauren's assessment and this is the reason that Northlake is not presently using traditional large cap media stocks like Time Warner, Viacom, Clear Channel, Tribune, or Comcast. I am starting to look a little more carefully at these stocks, however. Traditional media stocks are trading at their lowest multiples of cash flows in years suggesting that Lauren's and my viewpoint is becoming widely held. The key to making money on Wall Street is to recognize when conventional wisdom is fully reflected in stock prices and taking the opposite side of the trade. We may be nearing that point on broadcast television, radio, and cable stocks so our antennae are up our research efforts increased.