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June 24, 2009

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.

Posted by Steve Birenberg at June 24, 2009 12:13 PM in Media