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Big Four Look Small In the Margin Column

Conventional wisdom has it that media giants treat their broadcast networks the way supermarkets price 75-cent Wonder Bread as a loss leader. Networks are relatively unprofitable, but they make up for it on their much more lucrative owned-and-operated stations.

But, as often is the case, the conventional wisdom is wrong. A new study by Morgan Stanley media analyst Richard Bilotti forcefully argues that the strength of the O&O groups can't come close to offsetting the huge drag that even successful broadcast networks put on earnings, and earnings of the combined divisions pale compared with those of TV station groups owning local affiliates without owning a network. And the new, controversial 45% station-ownership cap is no solution.

There's a reason Viacom President Mel Karmazin, who counts CBS and UPN in his portfolio, recently told a Senate hearing that, "when I die, I want to come back as an affiliate instead of a network owner."

Bilotti just completed an analysis of broadcast-network and station economics bluntly titled "Decomposing Television Profitability." He contends that the soaring costs of TV programming have badly crunched the value of network companies. Even though broadcast networks are the sexy part of the TV business, he sees them as a black hole. "In aggregate, the network industry generates zero cash flow; accordingly, the industry as a whole should have zero intrinsic value."

One very obvious conclusion that can be drawn from the study is that networks should simply buy more stations. That would allow them to spread the costs of their capital-intensive networks over a bigger base of 40%- to 50%-margin stations.

The problem, Bilotti said, is that station prices are too high. Even paying 13 to 14 times annual cash flow—moderate compared with prices in recent years—can easily result in low returns on capital. Bilotti estimates that Viacom's $650 million acquisition of KCAL-TV Los Angeles is generating a return of just 4% to 5%, even though it gives CBS a duopoly in the market.

"You're going to find a 30-year bond at 4.4%," Bilotti said. "You need to have a wholesale repricing of television assets for station deals to make sense again. None of these guys should be buying television assets."

Bilotti is particularly harsh on the cost of rights to pro sports, a recurring theme in his year-long series of studies of network profitability. Network executives often justify their heavy spending on football and baseball by pointing to brisk local ad sales by their O&Os during the games. But he disagrees, saying that total TV profitability of sports-heavy networks CBS and ABC is worse than that of NBC and Tribune Co. (which owns part of sports-free WB). "NBC hasn't lost a beat by losing sports."

But even the strongest gets pulled down. NBC has both the most profitable network and the strongest stations. Bilotti estimates that NBC's O&O group generated a massive 59% cash-flow margin last year, far above that of other networks' O&Os or of affiliate stations.

But the network's $515 million in profits were extracted from $4.4 billion in ad sales. That left a margin of just 13%, huge by broadcast network standards but not impressive compared with other media sectors.

So, on a combined basis, NBC's network and O&Os margin came to just 20% last year. Meanwhile, affiliate groups like Hearst-Argyle, Gannett and Sinclair generated 40% to 50% margins. Scripps and Belo were at 30% or so.

"Owning a network and owning the major O&Os, the blended average margin goes down," Bilotti said. "Owning both helps your stations but not enough to justify the damage that you take on the network."

He estimates that the major networks' O&O stations on average will generate strong operating cash-flow margins or about 43% in 2003.

But their network parents pull them down. As a whole, the profits of the stronger networks—NBC, CBS and The WB—are wiped out by the losers. So, out of $15 billion in ad sales this year, Bilotti expects the six major broadcast networks to generate a mere $19 million in profit. That means combined network and O&O margins could total just 13%.

By comparison, the four affiliate groups Bilotti examined could post margins around 40%. (Gannett stations have often exceeded 50% but may only hit 49% this year.)

The math is no secret to network executives. While the likes of Viacom and Disney have to pay for all their prime time programs, affiliates generally don't.
Networks are phasing out compensation, but most affiliates are still getting paid to carry their network's programming. The president of one major affiliate group said that network comp totals around 4% of revenue for a station group operating in major markets, like Hearst-Argyle, but 20% of more for stations in smaller markets. "That goes straight to the bottom line," the executive said.

In the classic Washington-Wall Street shuffle, networks eagerly poor-mouth to Congress. But they had no interest in elaborating on their woes in this study aimed at investors. No network would comment in detail on Bilotti's study. The president of one network passed word that he disagreed with some of the numbers but did not explain further. A spokesman for one network—who asked not to be identified—said, "We're happy with our business."

There is one big hole in the study: Bilotti doesn't account for any syndication profits. Conglomerates increasingly can create their prime time dramas and comedies in-house because all but NBC have corporate tie-ins with studios. If they order series from an outsider, they invariably demand equity. The second round of syndication of Everybody Loves Raymond
this year yielded a lot of cash to Viacom, but it did not hit the books of CBS.

Bilotti acknowledges that problem and said he's working on incorporating syndication's profits (and losses) in a future report. "The backend, that's the next step. I'm sort of skeptical. The prices series have been fetching aren't all that great."

He crunched an analysis rarely seen in public, combining the financials of the broadcast networks and their stations and stacking them against affiliate groups. They're hard numbers to come by because only Fox clearly details the separate results of its stations and networks. Other conglomerates like to muddy the results.