Description

Time Warner is a media conglomerate that derives the vast majority of its profits from its domestic cable networks. I believe the cable network business in countries with a high penetration of broadband is entering terminal decline, and profits from this business will wither away over the next decade. Time Warner currently trades like a stable business, at 10x EBITDA, when in reality it should be trading like a business in runoff (less than 5x EBITDA). Given its significant debt load, and its propensity to use free cash to buy back its overvalued stock, I think Time Warner has limited equity value, no more than $20 per share.

The TV Business

First, a few definitions:

People have many methods to categorize TV, but for the sake of this discussion we can keep it relatively simple.

Scripted content is the stuff we consume most of the time we sit down to watch TV: sitcoms, dramas, movies. Scripted content usually requires a lot of money to produce, and has a relatively long shelf life.

Live sports of course includes what is produced by the major sports leagues, collegiate and professional. Live sports usually only has value if consumed live, or very near live. Live contests like American Idol, DWTS, and The Voice arguably also fall under this rubric. This accounts for most of the rest of what we consume on TV.

There are a couple of other meaningful categories. There is unscripted content, like Shark Tank or The Real World, which is cheaper to produce than scripted but typically has a very short shelf life. And there is of course news, which is cheap to produce and is consumed live.

Also, within these categories, content is either premium or linear, or on a spectrum between the two. Premium content is the stuff you will actively seek out, once you become a fan. Think Game of Thrones, or a game being played by your alma mater’s football team. You will hunt down that content, wherever it is, even if it’s on channel 589 at 2am on a Wednesday.

Linear content is the “good enough” content you watch when you’re bored and you just want something to occupy your mind. It’s 7:30pm, Jeopardy! is the best thing you can find, so you let that wash over you. And maybe you watch whatever airs after that too. Probably the majority of TV viewership today is still of the linear nature.

Of course, one man’s premium content is another’s linear content. My neighbor is from Virginia, so on Monday night he and his friends were yelling at the Redskins game loudly enough for me to hear through the wall. That’s premium content for them. However, Kirk Cousins isn’t my cup of tea, and if I had that game on at all it would have been linear content for me. Still, you can usually tell what programs are designed to be premium and what programs are designed to be linear.

Historically, most content was linear. There were only 3 licensed VHF stations in every market, so there were only 3 networks. You had to watch whatever was on. Networks would churn out cheap, inoffensive crap (the “vast cultural wasteland”) because they needed to appeal to the widest possible audience. At least it was free.

In the late 1970s, we had the beginnings of cable. Back then cable could carry 40 channels, though now with digital cable it’s more like 300. Even though the content was low budget, cable caught on relatively quickly. Instead of having only three or four fuzzy options at any given time, you could have dozens of clear channels. Pay-TV covered 56% of households by 1990 and 85% by 2000.

Remember, a large part of what drove pay-TV adoption was a lack of other options. There were no DVDs, no Netflix, just the major networks. People were desperate for any choice at all.

It was the cable networks, not the cable operators, who ended up really cashing in on the revolution. The cable operators faced competition from satellite (DBS) by the mid-90s, and the telcos later on (collectively, the MVPDs), and that end of the video business is now a fairly competitive market.

The cable networks were usually organized around themes – MTV had the youth market, Nickelodeon had kids, CNN had news, ESPN had sports. Many of them developed real barriers to entry and had real bargaining power with suppliers and customers. They were destinations for their audiences, and the most successful ones had no meaningful competitor in their category.

For example, if you were the creator of a kids’ show, you really had no one you could sell to that could bid remotely as much as Nickelodeon. No one else had that kind of targeted audience, no one else could promote a kids’ show as effectively.

Furthermore, cable networks had a lot of leverage over customers, via the MVPDs. DirecTV knows that if they lose a key cable network, some of their customers will defect to Time Warner Cable. Thus, they are forced to pay up for the most valued channels. There is a limit to what they will pay, as we saw with the Dodgers, but usually everyone can calculate expected churn versus affiliate fee and come to a price that makes sense. In the end, everyone does the same math and the MVPDs have broadly similar programming lineups.

Successful cable networks ended up dominating their categories, making it very difficult to build competitors. They would lock up a lot of the top content and top talent in their category, and more importantly they had a focused audience that was tough to pry away. New successful cable networks have largely been in nascent or growth categories, like AMC in dramas.

Interestingly, broadcast networks aren’t remotely as profitable as cable networks, even though broadcast accounts for 40% of viewership. Cable networks today average 40% EBITDA margins, and broadcasters have margins closer to 10%. Many cite the dual revenue stream nature of the cable business for this discrepancy – cable networks get affiliate fees and advertising revenue, while broadcast networks mostly rely on ad revenue. While this is certainly a factor, certainly the lack of differentiation between broadcasters is a factor as well, as is the relative ease of entry (we’ve added FOX and the CW in recent years).

You can draw a parallel between cable networks and magazines. In their heyday, the top specialty interest magazines were titles like Sports Illustrated, People and Time. They captured a target audience, had leverage over their staff, and earned huge margins. ESPN spent a lot to compete with SI in the magazine space and failed pretty miserably. The general interest titles, like the Saturday Evening Post, Harper’s, and Life, actually initially had the largest circulations but went out of business once the specialty magazines came along in a big way.

Here is how the cable TV ecosystem works today, in very round numbers, and greatly simplified: If you subscribe to cable, you probably pay about $75 a month to Comcast (or the equivalent MVPD). Comcast keeps $40 and passes $35 to the cable networks in the form of affiliate fees. The cable networks take this $35 and couple this with the $20 a month of ad revenue they bring in. So they have $55 a month coming in. Of this $55 a month coming in, $25 is profit, $15 goes to overhead, and the remaining $15 gets spent on content – about half on sports and half on scripted content.

So, to summarize, $95 a month goes into the top of the system, and $15 of that gets spent on actual programming. Remember that the next time Comcast complains about the growing cost of sports rights. Now, $15 a month isn’t nothing – multiplied across 100mm households, that’s about $20bn a year. But it’s less than 20% of what the system takes in.

Now, enter Netflix. Netflix looks around and sees they have a lot of advantages over cable. First of all, and most importantly, they can use the broadband connection that most households already have. Also, they don’t need an expensive set-top box to decode the signal, or a DVR, or a technician to install it. Most people can access it with equipment they already have – their smart TV, or gaming system, or tablet, or at worst they buy a cheap Fire stick or Roku. Meanwhile other MVPDs are spending $900 to acquire a sub, and a lot of it goes to things like set-top boxes and truck rolls and satellite dishes. This is where a lot of Comcast’s $40 of monthly margin goes.

When it comes to scripted content in particular, they have even more advantages. Everything is on-demand, so they don’t need to spend heavily on marketing to remind viewers to tune in at 9pm or set their DVRs. They have an interface that’s much better suited to scripted content than the traditional program guide, and they built a recommendation engine so you’re likely to find something you like, even though they have thousands of titles. You can even go from device to device if you like, and it will remember where you left off.

So, Netflix focused on scripted content. A focus on scripted content encouraged them to toss ads, which are extremely annoying when inserted into movies and dramas, both for writers and viewers. Dumping ads also allowed them to include content that isn’t advertiser friendly. They figured they could make up for the lost revenue with more subscription and lower churn.

Netflix charges $10 per month. My guess is that their model has them spending $5 of this on content, $2 on marketing, technology and overhead (as they do today), and keep $3 as profit. Of course they’ll likely continue raise prices over time, so I think their content spend per sub will keep going up, and so too will their profit. And right now they’re spending a bit more on content per sub because they’re growing.

Maybe $5 a sub doesn’t sound like a lot, but remember from earlier, all of the premium and basic cable networks combined probably spend $7.50 a month on scripted (half of $15). And that’s just $5 a sub for Netflix – we have Hulu and Amazon as well.

Next year, Netflix is going to spend $5 billion globally on scripted content, the majority in the US. Hulu and Amazon will spend $1.5 billion each, mostly in the US. My guess is that all of the cable networks combined will probably spend not much more than $10 billion domestically on scripted next year. Already, SVOD is catching up to cable.

The good news for cable is that Netflix is only in 42 million of the 120 million US households (35% penetration). By comparison, 100 million households have the cord, though probably only 93 million have fat basic (85% and 78% penetration respectively). Hulu is in 10 million households, and Amazon is supposedly in 30 million, but Netflix has more than 10x the internet traffic of the other two players so we can surmise it’s the dominant part of the OTT market today.

The bad news for cable is that Netflix is growing fast. They’ve publicly said they’re aiming for 60 million to 90 million households, or 50%-75% penetration. (80% of households have broadband today, so that’s probably a near term cap). Also, viewers are rapidly being trained to go to Netflix first when they want to watch TV – Netflix households watch around 2 hours of Netflix a day, up from 30 minutes a few years ago. TV ratings among the 18-34 set are down over 30% over the last five years, probably mostly the result of OTT.

There is really nothing the cable networks can do to fight this. In the modern universe, they’re clearly a massive unnecessary layer of cost. They don’t add one iota of value. Before, you needed the cable networks to sort content into categories so you could find something you wanted to watch at any given time. Now the Netflix has software that gives you a personalized list of things to watch. The studios just sell directly to Netflix (or Amazon or Hulu) and avoid the middleman.

If this movie sounds familiar, it’s because this happened in publishing, where now instead of visiting our favorite publications to read the news or watch short-form video, we mostly visit Facebook or Twitter or YouTube, which give us personalized feeds of content we might be interested in. Most publishers get something like 70% of their traffic from these news feeds, if not more.

Cable networks are quite rationally dealing with this by publicly denying the problem, and privately de-investing in scripted content by licensing their shows to the OTT operators in ever-shortening windows. They will continue to make a lot of money in harvest mode, though those that continue to focus on scripted will eventually have to accept lower ad revenue and affiliate fees. But in 5-10 years, the jig will be up, and profits will decline precipitously.

One common objection is that maybe the media conglomerates will realize they’re killing the golden goose, and stop licensing their content to OTT? First of all, at this point, Netflix has cherry picked most of the existing content worth licensing, and Amazon and Hulu have gotten to most of the rest. These contracts are exclusive and there’s no getting them back. Also, refusing to license new content is hugely expensive because not only are you sacrificing revenue, you still owe the talent the residuals they would have gotten if it had been licensed. Finally, the conglomerates can see that the OTT guys will be the long-term winners, and good relationships are in their long-term best interest if they enjoy being gainfully employed.

This brings us to live sports and news. Netflix, Amazon and Hulu have mostly stayed clear of this for the time being. They don’t have the same huge advantages in the live space, and at any rate, there are very few live events on at any given time, so an app with the program guide is likely to be just fine in the longer-term. You don’t need a fancy interface that can sort through thousands of options.

We have seen some entrants in the live OTT space already. Sony has wrapped up deals with all of the major players now, and by next year you’ll be able to get the entire cable package on an app on your PlayStation or Fire stick for $50 a month (vs $70+ for fat basic through your MVPD). Sling is going with a skinnier package, with all of the Disney and Turner channels and AMC (i.e. all of the sports on national cable) for $20 a month. Apple has a long-rumored service coming out which is likely to be focused on live as well.

Longer term, the cable operators are going to be the main force to contend with in the live “OTT” space, as they reduce their focus on scripted channels. They’ll cut costs by tossing the cable boxes and truck rolls – they’re totally unnecessary these days. TWC is already mailing out Rokus with the TWC app preloaded. That should allow them to compete with upstart OTTs like Sony and Apple.

Cable networks focused on sports will likely become much less profitable. There are too many networks chasing too little content, which is why we’ve seen such rapid inflation in sports rights. The sports leagues all have their own networks, and their own popular apps. Sports is generally very premium content, so fans will seek it out wherever it is, and the top leagues don’t need much promotion from the networks (who are losing audience anyway). It wouldn’t be a surprise to me to see the leagues put their rights in joint ventures – national versions of the local RSNs we’ve seen where the local baseball and basketball and hockey teams show their games.

If the MVPDs and cable networks concede most of their margins – and I think they will – then we keep a system similar to what we have today. If they screw up their negotiations, some of the leagues will go direct-to-consumer, probably in a joint venture. Either way, cable network shareholders will lose.

The channels focused on news may do ok. News is cheap to produce, gets good ad revenues, and there are surprising barriers to entry. Local news especially has been a good business – a lot of viewership is based on habit. CNN and Fox News and MSNBC will probably be ok as well. Certainly viewership will continue to decline because of we all have smartphones to get our news and we will watch less traditional TV. But at the same time, ad rates will keep going up because we are no longer consuming ads with our scripted content.

The last thing to note is that the actual level of cord cutting doesn’t matter in this analysis. As long as Netflix and its competitors keep growing subscribers and viewership, the incumbent cable networks are screwed. Cable networks earn their affiliate fees by contributing to subscriber acquisition and retention. This is the reason they make so much today. If they are no longer contributing to retention, because no one is watching them, they will either have their fees cut or get dropped completely. One can envision a scenario where the cable operators manage to forestall a lot of cord cutting, but they do so at the expense of the incumbent cable networks.

Time Warner

Overall, Time Warner is heavily exposed to the headwinds above, with 80% of operating income derived from its cable networks, and the remainder coming from its WB studio. I will go through each division below, and wrap up with a valuation discussion.

HBO - $5.5bn in revenue, $1.9bn in operating profit, 25% of total operating profit

The HBO division operates HBO and Cinemax, which probably need no introduction. HBO and Cinemax are premium channels that offer ad-free blockbuster movies and original series, both in a linear format and on-demand. Programming spend is split about 50/50 between originals and film licensing.

The way it works is that if you have the bundle, they try to sell you on a premium bundle that includes Showtime and Starz and Encore. You can of course choose the channels a la carte, too. The MVPD takes a piece for themselves and passes on a piece to the premium channel – HBO has a retail price of $15, but the network only nets about $8 per month. The other channels get significantly less per subscriber, maybe $3-$4.

HBO has 30 million paid domestic subs, and accounts for most of the profit of this division. HBO also gets 25% of its revenue from overseas, both from international licensing and from its overseas channels.

HBO seems to be the most misunderstood part of Time Warner. Superficially, it seems to be quite similar to Netflix in terms of content, so people have the misguided notion that it’s similar as a business. In reality, Netflix initially focused on HBO-style premium scripted content because that played to its advantages as an on-demand, ad-free service, but that’s where the similarities end.

This is not to say that HBO could not have competed with Netflix. HBO had a big head start in terms of exclusive content. Had it been able and willing to invest in a compelling stand-alone SVOD service, it might be a competitor today. But that didn’t happen, probably because management was focused on EPS growth and not cannibalizing the bundle.

Today, Netflix has a huge lead over HBO. It has 43 million domestic SVOD subs over which to spread its content costs, and HBO has only 30 million. They have similar net revenue per sub, and Netflix is of course growing much faster. Netflix is also bigger and growing faster overseas.

HBO charges $15 a month for its new SVOD service, to avoid conflict its MVPD distributors, and HBO’s offering is much thinner than Netflix’s $10 a month service. Most likely, the gap will continue to grow.

Netflix is spending $5 billion globally on content next year ($6 billion on a cash basis), while HBO spends less than $2 billion. Again, that gap is only going to widen as we go forward.

The fundamental issue is again that HBO’s model has too much fat in it. They’re spending less on content per subscriber ($3-$4 per month vs Netflix’s $5+) and charging more. They fundamentally can’t compete head-to-head with Netflix with a cost model like that. The lower subscriber base compounds the issue. They’re in a gunfight, and they have at best a dull, rusty knife.

The mistake I think people make is that they look at the content HBO puts out today, and conclude that HBO is on par with Netflix.  But the top content HBO has today was largely derived from a time when the SVOD players didn’t really exist. They won the bidding for Game Thrones back in 2006, for example.

There was a time in HBO was pretty much the only game in town for anyone who wanted to create great non-ad-friendly entertainment. They got the top talent – for example, they got Spielberg and Hanks to create Band of Brothers. They got the top IP, like Game of Thrones. That day has long passed. Now we have Netflix, Amazon, AMC and FX. Top talent and top IP go to the top bidders, and there’s no way they’ll be able to compete with the big boys going forward.

Futhermore, HBO was the only game in town for people who want to watch great non-ad-friendly entertainment, and that’s why a lot of people signed up. As people realize they’re not really using it anymore, they will lose subscribers.

I think HBO management recognizes this, and that’s why they’re milking the service for cash. They sold their non-exclusive SVOD library rights to Amazon for $300mm a year (which excludes GOT and anything less than 3 years old). They’re pricing their OTT offering at an uncompetitive $15. And so on and so forth.

Again, there’s no need for an extra middleman between a destination SVOD app and a studio. If HBO isn’t going to try to create a mainstream destination SVOD app (and at this point they shouldn’t), it will have to evolve into a niche SVOD app and/or simply a studio, neither of which are particularly profitable businesses.

Either way, its current profits are destined to decline tremendously. A big chunk comes from monetizing their existing library through Amazon and home video, a stream that will inevitably decline. Most of the remainder comes from the cable channels, which will lose subscribers as more households get into the habit of going to Netflix for TV and realize they’re paying a lot for a service they don’t really use.

Turner Networks - $10.5bn of revenue, $4.1bn of operating profit, 55% of total operating profit

The Turner networks are led by TBS and TNT, two of the top five channels on cable, which offer a mix of syndicated entertainment, some original series, and sports. Sports rights include part of the NCAA tournament, MLB, and NBA packages. CNN is also a major contributor to profit. Finally, Turner also owns Cartoon Network, Adult Swim, and TruTV, and a number of overseas channels including the WB channel.

Turner spends around $3.4 billion a year on content, of which $2 billion goes to TBS and TNT. I reckon a bit more than half of that today goes to cover sports rights, but that proportion will jump massively when the NBA contract gets reset for the 16/17 season from $445 million a year to $1.2 billion a year. As scripted content viewership shifts to SVOD, TBS and TNT will probably have to try to evolve into sports channels.

The massive reset of the NBA contract for ESPN and Turner illustrates the problem for ESPN and the other sports channels. The cable networks are losing whatever leverage they had, and suddenly they’re paying more than twice as much for the same product. At the same time, they have to contend with lower subscriber counts and stagnant ad revenue. Higher affiliate fees fix part of the problem, but only part.

The current contracts won’t be up for another 7-10 years, but the TV world will look much different when that happens. At that point, the legacy cable networks might not have enough reach to offer the leagues, and the leagues may pursue their own offerings.

I think CNN is in a better situation, but at last report it only made $600 million a year globally – not bad, but a tiny percentage of overall profit. CNN has its own challenges, but I expect it will hold up better than the rest.

Finally, the other domestic and international channels are focused on scripted, and they face the same challenges outlined previously in this writeup.  

WB Studios - $13.5bn of revenue, $1.5bn of operating profit, 20% of total profit

WB operates by most measures the largest single studio in Hollywood, producing films, TV shows and games.

Generally, broadcast and cable networks don’t own shows, they rent them. More accurately, it’s more of a short-term lease, or anchor tenant type of situation. A studio like WB puts together a show and shops it around, hoping a network will pick it up. If it gets picked up, WB produces the show, and eats an upfront loss, as the initial license fee from the network won’t cover the cost of production. To make it up, they have to monetize it in all of the other windows – off-network syndication (including streaming), international broadcast and syndication, and home video (DVD).

All of the broadcast networks have their own studios, but WB and Sony are independent and probably are the biggest individual producers of shows. In practice, no one is picking up a show solely based on the studio it came out of, which is why a show produced FOX’s studio sometimes ends up on ABC.

This model will probably continue to be the norm, as it enables specialization. HBO produces and owns all of its original content, but it is the exception. Netflix is building its own studio, but for now it buys from outside studios, as do Amazon and Hulu.

WB has long been a successful studio. They have some valuable IP, including DC Comics, which they’ve used to make dozens of Batman and Superman related shows and movies. On the TV side, they still own Friends and ER, and they do the Big Bang Theory and The Voice.

The studio business is traditionally a fairly low margin, low ROIC business. WB does a bit better than the rest because they own some IP that became valuable, and they have some value in their content library. As a rule, however, running a studio is a capital intensive business with low barriers to entry – anyone with a checkbook can play.

WB is running close to peak margin right now, but with the surge in demand for scripted content, I think they’ll do ok for at least the next few years.

Valuation

Time Warner has a $55 billion market cap, and $21 billion in net debt. So that’s an enterprise value of $76bn, against LTM EBITDA of $7.8bn or LTM operating income of $7.1bn. I believe that 10x EBITDA or 11x operating income for a company whose profits are about to be swallowed by technology is completely insane. It’s reminiscent of the newspapers circa 2000-2006, when people thought that “hey, the internet is here, this won’t be so bad, this is totally manageable…” It just takes time for habits to change, and habits are certainly changing.

I think the combination of debt load and secular headwinds make this a clear short. I don’t think we need to run a precise valuation to know that. If you insist on a valuation, read on:

I think of the company in two parts. First, we have the pieces that are less challenged, like WB and CNN. Combined those probably do $2bn in operating income after overhead. They aren’t the greatest businesses in the world but in today’s market I could see a multiple of 10x pretax income, so those are worth $20bn.

The remaining cable networks, which do about $5bn in operating income, are probably ok for the next 5 years. The headwinds from sub losses and lower viewership probably are just about offset by the tailwinds from higher CPMs and affiliate fees and streaming monetization. I think for the 5 years after that (2021-onward), profits in that division decline toward zero. A DCF of that pegs the present value at about $15bn, or 3x operating income. Remember, this is a very challenged business.

Anyway, this would give us a fair current equity value of $17.50 a share. I think this is on the high side since management is committed to using free cash flow to repurchase stock at the current, inflated valuation.

Risks: Fox stupidly tries to buy them again, or Bewkes somehow comes up with a great acquisition.

Catalyst

Continued growth from Netflix.