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Broadband Complex?

It has been a tumultuous 12 months in the cable distribution and content business, with plummeting ratings across the board for cable networks, over-the-top offerings from Sling TV and Sony PlayStation Vue disrupting the distribution model, HBO’s standalone HBO Now threatening to usher in a new era of over-the-top delivery of individual networks and — the biggest disruptor of all — Comcast’s planned $67 billion merger with Time Warner Cable being terminated by the parties because of regulatory objections.

Operators are facing what could be the most onerous regulatory period since the 1992 Cable Act with the planned implementation of Title II regulation, which will treat broadband (cable’s most pro_ table and growing business line) as a common-carrier telecommunications service. While the Federal Communications Commission has promised it will forbear Title II’s strictest tenets — like pricing regulation of broadband — not everyone is convinced the agency can resist temptation indefinitely.

At the same time, operators are pushing back on rising programming rates, while content providers search for new outlets to distribute their shows. Dish Network was first out of the blocks with its Sling TV over-the-top video service, which offers a core of 21 channels (including ESPN) for $20 per month, but others and a mobile OTT offering from Verizon Communications are expected later in the year. Verizon’s FiOS TV has tweaked a few network noses by offering a “skinny bundle” — Custom TV — that at least three content providers (ESPN, NBCUniversal and Fox) claim violate their carriage agreements. ESPN sued Verizon in New York State Supreme Court on April 27 over the matter, and others are expected to at least consider doing the same.

Through it all, cable stocks, which have enjoyed an unprecedented run over the past few years — up 42% in 2012 and up 50% in 2013 — still outperformed the Standard & Poor’s 500 Index in 2014 with a 17% gain.

On the content side, a sluggish advertising market and fears that a bigger Comcast would crush affiliate-fee growth weighed heavily on some stocks, like Discovery Communications and Scripps Networks Interactive, while others like Walt Disney Co. soared as must-have network ESPN inked landmark carriage deals (Sling TV) that could help to change the overall landscape dramatically.

Many investors on both sides of the cable business admit to fear and loathing, and the need for a good (psycho)analyst.

With that in mind, Multichannel News senior finance editor Mike Farrell brought three pay TV analysts together for a digital conversation. Telsey Advisory Group media analyst Tom Eagan, Pivotal Research Group CEO and media & communications senior analyst Jeff Wlodarczak and RBC Capital Markets media analyst David Bank took questions about the changing industry climate and what they believe is in store for investors in both distribution and content sectors. An edited transcript follows.

MCN:Where do you see the stocks going this year? Does the fact there is no Comcast-TWC deal make a difference?

Tom Eagan: M&A, regulation, and company fundamentals have all played a role in the performance of the cable and satellite TV stocks in 2014 through mid-2015. Since news hit that regulators might block the Comcast purchase of Time Warner Cable, TWC is flat, testament to its improved fundamentals. Comcast offered $158.50 in February 2014, before TWC’s turnaround. The market appears to assume that Charter will have to bid even higher now. We agree.

The Charter decline of only 1% over the same period suggests that the market believes that Charter will be successful in its renewed attempt at TWC. We are less confident of that outcome, especially since TWC might be an acquirer itself. Not surprisingly, Comcast is down 2% after wavering back and forth since last week, reflecting the ambiguity of the incremental value that the TWC deal provided Comcast. Going forward, Comcast will trade more on its improving fundamentals than on deal speculation. Looking ahead, we remain cautiously optimistic on the Pay TV industry and are ‘Buy-rated’ on several stocks despite regulatory and OTT risk.

Jeff Wlodarczak: 2014 was actually a decent year for the cable sector as it modestly outperformed the S&P 500 while satellite TV handily outperformed on the backs of the AT&T bid for DirecTV and Dish spectrum investments. Looking forward, each cable stock has a fairly unique investment case, but overall I would say cable’s control of the dominant way consumers (and increasingly businesses) access the Internet is the key investment consideration for the sector. Cable should be able to continue to take share and price, and leverage the halo effect of broadband to help stem video sub losses and boost phone additions.

We are quite favorable on Charter (and Time Warner Cable, given we believe Charter will make a play for TWC at around $170) as we believe they will consolidate the balance of the non-Comcast U.S. cable industry. Comcast is attractively valued at 6.8 times ’15 EBITDA (earnings before interest, taxes, depreciation and amortization, a measure of cash flow). They are unlikely to do deals in the U.S. until we get a new administration and will likely focus for now on international deals. I think, longer term, Liberty Global is a logical acquisition candidate for them.

Cablevision has had difficult results over the last couple of years, given how aggressive Verizon has been in their footprint. To make a positive investment case here, I think you have to focus on the asset potentially getting sold. I don’t rule out Charter making a play, especially given that they likely control most of the New York City market if the TWC deal goes through. Last but not least I love Liberty Global, the largest European cable player, a high-quality asset, run by best-in-class management that is in the early innings of driving price hikes and attacking the business and wireless opportunities in their footprint.

MCN:Where do you see the content stocks going for the rest of this year? Does the Comcast-TWC deal have any impact?

David Bank: I think it is a double-edged sword. On the one hand, if they had combined, in time their scale would have been daunting to negotiate against in one sense. On the other hand, there probably would have been a fair amount of regulatory scrutiny around their interactions with the programmers. I think their behavior would not have been that unfriendly. I think they are in a better position to negotiate tougher now than they were before, in that they just won’t be as encumbered by regulatory watchdogs.

A year and a half ago, when this transaction was announced, the presumption was that carriers were getting scale, and that content companies would need to merge in order to match the scale of distributors. I think more recently, it’s gone in a different direction. The imperative is for relevance as opposed to scale. There are certain players with lots of networks that dwarf the size of other companies, but are viewed as not as relevant and are potentially droppable.

We might have thought this would have touched off a massive consolidation on the content side. I don’t really think that’s the result. It took so long for this to get sorted out that, I think, the ecosystem understands itself a little better and scale is not what we thought it was.

MCN:Do you think the declining ad market is still going to weigh heavily on the content stocks?

DB: I think that the business is not in the dire straits that investor sentiment sometimes seems to indicate. You’ve actually got a shockingly healthy business environment for both distribution and advertising, especially given all the fragmenting forces in the marketplace. While these segments are still growing, their rate of growth for the foreseeable future will not match what we have seen in the past. And that’s the challenge for media investors.

MCN:What are the biggest issues for distributors going forward — Title II, programming costs, over-the-top or something else?

TE: Title II, programming costs, and OTT are certainly the three main concerns for the sector. I would add integration risk should we see increased consolidation. It’s possible that a third of the pay TV subscribers will be undergoing system integration in 2015 and/or 2016. Sometimes it’s smooth; sometimes it’s not. Remember, don’t change the truck signage until the glitches are fixed.

Re: Title II, ISP company dialog with Congress (about pursuing bipartisan legislative solutions) coupled with FCC lawsuits are probably the best routes for now.

Re: Programming costs, continued dialog with Washington might help. I believe the FCC is looking more intently at the bundling issue.

Re: OTT, experimenting with slender bundles and improved screen navigation will help keep the pay TV offer fresh.

JW: Government regulation of the cable plant has always, in my opinion, been the biggest risk to the cable story given it could jeopardize the cable golden goose, their best-in-class data plant. Forbeared Title II was incredibly misguided policy from the FCC and, hopefully, the courts or a new administration will throw out these rules. Even though the [FCC chairman Tom Wheeler] says this has nothing to do with price regulation, he has left gaping holes that some FCC in the future could theoretically use to regulate cable data pricing. However, what Title II pundits miss is that we need to get a new administration that is willing to unforbear these rules, and looking at the current presidential candidates it seems unlikely that any are interested in price regulation, so we will need to revisit this potential issue possibly with the 2020 elections. Hopefully at that point this Title II regulation will have disappeared.

Programming costs are like rising jet fuel prices that are a problem for everyone in the distribution industry, although scale does offer somewhat of a cost advantage. I don’t see any end in sight to continued rising content costs, given large content players (and local sports rights owners) still have a lot of power and will likely try to offset their declining ratings by continuing to force pricing higher which will of course push an increasing percentage of lower per capita income households to pay TV alternatives.

The good news for cable is they have the data hedge and perhaps, at some point, the programmers buckle and allow much more interesting smaller packages. If I were a cable player I would try to hold the line on programming costs as much as you can but continue to offer the full suite of programming while offering data/OTT bundles aimed at consumers looking to save money.

MCN:What do you see as the big issues for programmers going forward — measurement, the sluggish ad market, new distribution outlets for content?

DB: You could say yes, period. On the advertising side, there is going to be a push toward the monetization of audience, as opposed to programming and targeting to make TV advertising, in a sense, more Internet-like. I also think there is a danger in moving too far in that direction in that you could marginalize some of your inventory.

One thing a Comcast-TWC merger would have done was standardize technology across a greater part of the footprint for things like ad targeting. I think that’s the challenge of the industry, to use targeting and use audience versus simple demo selling. TV advertising is measured and monetized on a C-3 ratings system, and while we think Nielsen probably measures C-3 relatively accurately, we just don’t know how relevant the metric is. As time goes on, we’re going to time-shift more and more and we’re going to platform-shift more and more. That’s a pretty big challenge for the advertising market. I think the measurement currency has to catch up with consumer behavior.

MCN:What do you think about the movement toward skinnier packaging? Is there going to be more pushback, along the lines of what seems to be happening with Verizon’s skinny bundles?

TE: I applaud the effort towards slender and skinner packages. Set-top-box data should help the MSO prove which channels the subscribers really care about. Perhaps, it’s by geographic market.

We expect Verizon was intentionally pushing Disney into a lawsuit — as we said, shining an unwelcome light on bundling.

JW: The large content players have seemed to have had their cake and eaten it too by aggressively jamming through price increases while at the same time putting a material percentage of their content online for free and sold to OTT players such as Netflix. Distributors continue to pay the increases because the U.S. is competitive enough that they will lose a material number of subscribers if you don’t carry certain programming.

Distributors have pushed back where they can at weaker content operators (generally those players that do not own broadcast nets, like Viacom and Discovery). In the end, you may get skinnier packages, but content players are likely going to have to charge a material premium to make up for lost revenue for their channels that are not being carried. Specifically on Verizon, I believe what they are doing is breaking their contract with programmers and I believe it is unlikely you will see other players move in this direction, at least until this is resolved in the courts.

MCN:David, what’s your perspective on skinny bundles from the programming side?

DB: There’s no cathartic “everyone is going to cut the cord,” and you can’t kid yourself and say there isn’t some segment of society, there isn’t one guy who might say, “Alright, I’ve got enough, I’ll pay less.” That is a kind of frustrating place for investors because investors want to either make a very bullish bet or they’re willing to make a very bearish bet. Even if the general sentiment is there is over-concern in respect to cord cutting and unbundling, you can’t deny that [the] major fully distributed cable networks [combined] over 2014 lost something like 2 million subs. Somebody’s lightening the bundle.

I think there is something going on here that’s more than just economics. We want to self-program. We want to self-bundle. There is a metaphysical, a psychic savings from that. It’s not purely economic. And that’s what worries me more than these simple economic analyses.

It almost feels like people in some cases are saying, “I don’t even care that I’m not saving money, I just want to put together the package that I want. I’m annoyed at turning that device on and knowing that I’m paying for something I have no interest in having.”

MCN:What’s your feeling about OTT?

TE: 2015 and 2016 will be important years for OTT as we see how successful the HBO, CBS, Sling TV and other launches are with viewers. There could be structural limits, however. With programmers putting customer ceilings on their involvement, they might never grow to material sizes. And because they’re “frenemies,” that structural limit might curb their overall appeal. In other words, for a cable subscriber, dropping pay TV can work if there are enough alternatives. But not if those alternatives can’t scale.

JW: I am actually more concerned with what content players and distributors might do as they run scared from the OTT boogeyman than OTT itself. Other than Netflix and [HBO Now], I don’t think anyone is doing anything interesting in OTT. Reselling fewer channels of linear television than traditional pay TV (at a much higher effective price given new players are likely paying a ~100% premium to traditional players) seems DOA.

This weak outlook is exacerbated by the fact that cable standalone data pricing is only likely to continue to increase. (Today Comcast, as an example, charges a total of $75 a month for standalone including the modem rental fee). This reduces the supposed cost advantage of OTT.

The last material issue with OTT is the lack of quality of service in the last mile. The FCC seems to have neutered the distributor’s ability to generate revenue from paid prioritization, and without paid prioritization distributors have no incentive to ensure OTT quality of service which is a particular issue with live HD sports. Netflix is an OTT success story with a unique commercial-free binge experience, but I view Netflix as more complementary to pay TV, and while for some households that experience is enough I doubt it is going to drive consumers en masse away from pay TV.

DB: There is a subset of the market for which it’s a terrific solution. But I don’t think it’s a substitute. The only product that is out in relative mass at this point is Sling TV. That’s a really narrow bundle; it’s almost like you’re buying ESPN.

MCN:So, is the bundle loosening? Some people think we may be facing a big showdown soon with a major programmer. Is that what it will take to turn the tide?

TE: With some programming available OTT, there is less need for the MSO to carry and pay for it. This will be an important issue for the MSOs to bring up with Washington. A programmer shouldn’t be able to keep a cable subscriber from streaming/accessing its content just because the programmer has pulled its signal from the operator

JW: I think what will turn the tide one day is the content players charge such a high price for their content and there are enough alternatives that they are finally forced to bite the bullet and create more affordable packages of programming. As mentioned earlier, if a content player does not own a broadcast net, they are at risk of being dropped but I don’t see Charter, Time Warner Cable or Comcast making the same moves as Suddenlink [Communications] or Cable One.

Both those players lack scale and, especially in the case of Cable One, likely make no margin on programming, so they are forced to effectively turn themselves into dumb pipes. I would rather have as many hooks into the customers as possible and would continue to pay up for content but would encourage consumers to take data/OTT bundles who are looking to save money.

DB: I would go back to [that] most major networks have lost a couple of million subs over the past few years. It’s not dramatic cord-cutting; it’s just that on the margins, it’s going in a different direction. You used to have a couple of hundred basis points of sub growth on top of pricing power to drive affiliate-fee growth, and now you’ve got pricing power that may or may not be sustainable and subs that aren’t growing and probably will modestly decline. There may be some offset from the premium that the new players pay, but we just don’t know yet.