Over The Top Video Threat Less Than The Hype

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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.

Strong Hints Jobs is Back Working at Apple

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Yesterday morning on Twitter I noted that Steve Jobs was quoted in Apple’s press release announcing 1 million sales of the new iPhone 3Gs. I quickly completed a scan of Apple press releases going back to late March and found no other instance of Jobs being quoted.
This morning, AppleInsider.com reported the same and stated that this is the first time Jobs has been quoted in an Apple press release since he began his leave of absence in January. I think this is a very strong signal that Jobs has in fact returned to Apple. The extent of his participation is still up in the air as no one knows how much stamina he has following his recovery from his latest health issues. As widely reported, Jobs apparently had a liver transplant a few months ago.
Also worth noting it that there have been several sitings of Jobs on the Apple corporate campus.
Overall, Jobs leave of absence has diffused the impact of his health on the stock. Tim Cook and Phil Schiller both raised their profiles and were easily accepted by investors. Furthermore, the company performed well in Jobs absence on a fundamentla basis with product introductions and strong quarterly results.
I trimmed Apple a few months ago at $133 as I felt the risk-reward was more balanced following the 60% recovery in the shares. I maintain my 2009 target of $150 plus based on the assumption that reported earnings growth resumes in 2010.

Apple as Religion

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SNL Kagan, which publishes the Dow of Steve blog, recently had an article discussing lower prices initiated by apple in the Mac and iPhone product lines. The article fairly noted that the price cuts were in response to the weak consumer environment and tough competition while also noting that Apple still maintains its premium pricing strategy.
I think Apple’s go to market strategy remains smart and still believe upside remains in the shares. Nevertheless, I trimmed positions at $133 as the risk-reward is less attractive following the surge in the stock this year (up more than 50%).
The reason I mention the SNL Kagan is because it contained a really cute quote that made me laugh. The article quotes Martin Lindstrom, brand consultant and author of “Buyology” comparing Apple brand loyalty to religion. “He said that when a study he helped conduct scanned the brains of both Apple fanatics and people who professed a strong faith in Christianity, the same regions in both groups’ brains were activated.”
Kagan wen on to note that “Lindstrom polled 2,0000 consumers and asked if they would tatoo an Apple logo on their arm. ‘And 6.7% of Apple fans said yes.’
Lots to chew on there for Apple lovers and haters and there are plenty of both!

Liberty Media Entertainment: New Long Position Provides Cheap Play on DirecTV and Other Goodies

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I took a new position in Liberty Media Entertainment Group (LMDIA) today. LMDIA is being acquired by DirecTV (DTV). LMDIA owns 54% of DTV along with several billion dollars in other assets composed primarily of the Starz movie channels, three regional sports networks, and cash. When the deal closes near year end, each LMDIA will have turned into 1 share of DTV and a stub containing the majority of LMDIA’s non-DTV assets. I think the stub is worth at least $4 per LMDIA share, so buying one share of LMDIA today at $23.65 nets you $26 (one share of DTV at $22.10 plus the $4 stub).
That is a pretty nice discount on its own but I think there is more upside as both DTV and the stub could have upside. DTV could rise to the upper $20s if my current expectations for earnings and cash flow growth in 2009 and 2010 are met. In addition, although I do not anticipate it will happen there are persistent rumors that DTV will be sold to AT&T or Verizon. The stub, which will consist primarily of Starz and cash, could be undervalued by a few dollars depending on valuation assumptions for the movie channels. I believe my $4 assumption is conservative, representing just 6 times operating cash flow for an asset forecast to have double digit growth for the next five years.
The bottom line is that purchasing LMDIA today provides a nice combination of offense and defense. Offense comes from the fact that LMDIA’s primary assets (DTV and Starz) are undervalued. Defense is in the form of the 10% discount at which LMDIA can be purchased compared to today’s price for DTV and a conservative assessment of the value of Starz.
I’ll post a more complete analysis next week. In the meantime, here is an analysis of the merger I wrote in February when it was just a rumor. Click on the “download file” link to see a full listing of LMDIA’s assets.

June 2009 Model Signals Still Favor Small Cap and Growth

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There are no changes to Northlake’s Market Cap and Style models for June. The signals remain small cap and growth. As a result, client positions in the Russell 2000 (IWM) and the Russell 1000 Growth (IWF) will be maintained.
The Market Cap and Style models provide monthly signals projecting relative performance of small cap vs. large cap and growth vs. value over the coming six months. Each model uses a combination of economic, interest rate, and stock market indicators that have historically shown predictive ability for identifying future relative performance of the market cap and style themes. The models use a weight of the evidence approach so that the signal generated is determined by the majority of the indicators.
The small cap signal has been in place since September 2008 and continues to register very strongly. Eight of the ten indicators are flashing small cap for the third consecutive month. The only holdouts are bond momentum and relative forward P-E ratios. Small caps often struggle when interest rates are rising over the prior three months. Presently, large caps have much lower P-E ratios.
The overall message of the Market Cap model is that we are near the bottom of economic and stock market cycle. The model has a contrarian aspect. When the economy and market get to the point that they are so bad the next move is likely to be up, small cap stocks typically perform well as their business operations are more sensitive to economic trends and their stock prices are more responsive to market trends.
During May the small cap signal proved inaccurate as the IWM gained 3.4% against a 5.5 % gain for the S&P 500. For the second quarter, the signal has proved accurate, with IWM gaining approximately 3% more than the S&P 500. Year to date, the small cap signal has been neutral, with IWM trailing the S&P 500 by less than 1%. Since the current small cap signal began in September 2008, IWM has lagged the S&P 500 by about 4%. The extremely rapid deterioration in the economy and stock market last fall moved many of the indicators to extreme readings and triggered the small cap signal early. As the economy has stabilized and hopes for recovery have grown, small cap stocks have begun to perform much better over the past few months.
The Style model has been showing more movement over the last few months even though it has flashed a growth signal since February. The current growth signal has been weakening and could now be classified as weak. Both models use the two month average to determine the current signal. The June only Style model reading is right on the border line between growth and value so it could change next month.
Two indicators moved in favor of value for June, the consumer/cyclical ratio and insider activity. Consumer/cyclical measures the performance of consumer stocks vs. cyclical stocks. Consumer stocks are a proxy for growth while cyclical stocks are proxy for value. As investor sentiment toward the economy has improved over the past few months, cyclical stocks have rebounded strongly, outperforming consumer stocks. The gains for cyclical stocks in April and May were enough to shift this indicator to value. Insider activity had consistently been more favorable for growth stocks over the last few months but insider transactions became more balanced in May so this indicator moved from growth to neutral.
The Style model now has four indicators favoring value, three favoring growth, and two neutral with the most recent signal having been growth. There is no clear message from the current set of indicators. Rather they represent the somewhat muddled view of the outlook for the economy and stock market now that it appears the worst has passed and the doomsday scenario is off the table.
Last month, the growth signal was inaccurate as IWF gained 5.2% while the Russell 1000 Value (IWD) gained 6.7%. Since the current growth signal began in February, it has proved extremely accurate with IWF producing a return almost 6% higher than IWD.
As always, thanks for Ned Davis Research for originally developing and continuing to maintain the Market Cap and Style models.
Disclosure: IWM and IWF are widely held by clients of Northlake Capital Management, LLC including Steve Birenberg’s personal accounts.