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August 15, 2006

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.

Posted by Steve Birenberg at August 15, 2006 11:18 AM in Media