BBH InvestorView. The Death of Cable?

BBH InvestorView The Death of Cable? 1

Marla Sims Senior Vice President Core Select Analyst Over the past two decades, the Internet has redefined our lives, providing us access to an ever increasing amount of information, entertainment options, accessibility and flexibility. In doing so it has led to the emergence of new business models and enabled new companies to flourish, while at the same time to the demise of many others. Perhaps no industry has been more impacted than media. Once thriving newspaper and magazine businesses have steadily declined, while an only fifteen-year-old company like Google is now the fourth largest publically-traded company globally. As digital technologies continue to evolve, providing us access to an increasing amount of content over an increasing number of platforms, some contend that the next media business to be overtaken by the Internet will be the cable industry. Specifically, they fear that user behavior is changing, leading consumers to spend less time watching traditional television. At the same time cheaper or free alternatives have emerged that are rendering the traditional cable video package uncompetitive, prompting consumers to cancel their cable subscriptions, or cut the cord. As a result they expect revenues and profits to decline and for cable to eventually go the way of the typewriter. While we agree that consumer behavior has and will continue to evolve, and that new distribution platforms have and will continue to emerge, we believe the death of cable has been greatly exaggerated. The More Things Change, the More They Stay the Same Despite fears that consumers will cut the cord in droves, causing video revenues and margins to erode at a quickening pace, video subscribers and revenues have been and we believe will continue to be quite stable. In order to demonstrate our point we must first address consumer viewing habits and subscriber trends. The common view is that consumers, particularly those in younger demographics, are increasingly spending more time online and less time watching traditional TV. Despite this belief, the amount of time spent watching television is higher now than it has ever been (see Exhibit 1). One reason for this phenomenon is that technology has enabled an increase in multitasking, allowing consumers to email their friends, check their Facebook page and search on Google or Amazon at the same time they watch TV. Moreover, TV is often no longer the lean back experience it used to be. Younger consumers in particular are increasingly interacting with social media related to what they are viewing on TV. This high level of social media activity arguably indicates a heightened level of engagement with TV content and confirms that programmers are increasingly drawing viewers into a deeper relationship. Another key reason TV viewing has continued to increase is that the amount of quality, professionally-produced content has continued to increase, and technology has provided more opportunities to view this content. Exhibit 1 9:36 8:24 7:12 6:00 4:48 3:36 2:24 1:12 0:00 1952 1955 Source: Nielsen. Average Time Spent Watching TV 1958 1961 1964 1967 Per Household, All Day 1970 1973 1976 1979 While it is true that linear viewing of television content has decreased, digital video recorders (DVRs) and video on demand (VOD) have enabled consumers to watch TV content in a timeshifted manner on their own schedules. They have also allowed consumers to watch multiple programs aired at the same time, so a consumer no longer has to choose between his favorite programs and can now watch both. As a result, consumers utility, engagement and satisfaction have all increased. At the same time, these services are providing new sources of revenue to cable and other pay TV operators, which are offsetting subscriber weakness. This steady to increasing level of viewing demonstrates that there is still a strong demand for TV content. Additionally, many fear that as online alternatives such as Netflix and Hulu have increasingly become available, more consumers, especially younger, more tech savvy ones, have and will increasingly cut the cord. They point to video subscriber losses at cable operators to support this contention. In reality, the majority of video losses seen by cable operators reflects shifts in market share amongst pay TV providers and not actual pay TV losses. Most 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2

BBH InvestorView subscriber losses were in fact absorbed by telecommunications companies ( telcos ), Verizon and AT&T, who only launched their pay TV products in 2005, as well as by a continued shift to satellite operators, which has been occurring for many years (see Exhibit 2). As the telcos built out their networks, marketing to a larger portion of the U.S. population, there was natural share shift as a result of the increased competition. However, as Verizon and AT&T near the end of their build outs, we are seeing a slowdown in their subscriber acquisitions, and along with it, stabilization in cable video subscribers. Exhibit 2 Subscribers (million) 100 90 80 70 60 50 40 30 20 10 - Pay TV Subscribers 78.1 2007 2012 Cable Satellite Telco Note: Companies include: Comcast, Time Warner Cable, Charter, Cablevision, Direct TV, Dish Networks, Verizon, and AT&T. Source: Company Reports, BBH. 85.0 There have surely been consumers that have given up their pay TV subscription or never opted for one over the past few years; however, the actual numbers appear to have been surprisingly small, representing an indiscernible portion of the pay TV subscriber base, which has continued to grow. While it is impossible to fully know the rationale for why consumers have cancelled their pay TV subscriptions, we contend that the main reason is economic, though substitute technologies are certainly playing a role. The U.S. consumer has faced over six tough years of economic challenges. Many are still unemployed or underemployed, others have taken pay cuts and many have exhausted their savings. As a result, many Americans have had to tighten their belts and cut back on any and all forms of discretionary purchases, pay TV amongst them. However, in an environment such as this, it is perhaps a testament to the utility of television that there have not been greater defections. The truth is that despite rising cable bills, television remains perhaps the cheapest form of entertainment on an hourly basis. A family of four can enjoy a month of cable television for roughly the same price it costs to see a movie less if you throw in popcorn and soda. This utility also derives from the fact that what is available online is not truly a substitute for television. While easy to find some content online, it is not all in one place as it is with TV, requiring viewers to go to multiple sites to find what they are looking for. Also many cable networks do not put their content online at all, and if they do, it is generally not until the end of the season or through a subscription service like Netflix or Hulu Plus, requiring viewers to wait to view their favorite cable series and to pay to watch, although admittedly at a much lower price than with a cable subscription. While the major broadcast networks generally make most of their entertainment content available free online, it is usually not available until the next day or, in some cases, eight days later, which makes it difficult to stay up to date with one s favorite shows. It also negates the water cooler effect of being able to discuss your favorite shows the next day. After all, it s no fun to see all your friends and colleagues talking about the finale of Grey s Anatomy or who got booted from American Idol while you have to wait one to eight days to see it. Perhaps one of the biggest draw backs though is that live events such as sports or awards shows are not generally available at all. While you can always go out to a bar to watch your favorite teams, it does not compare to the convenience of being able to sit back in your own living room, flip between games and actually hear what the announcer is saying. In part, the decision to cut the cord is also a matter of one s stage in life. Much has been said about college kids opting not to get a TV for their dorm rooms, preferring instead to watch online video. But with that said, they are watching online video. While it is still too early to know their future media consumption habits, we believe that once many of these tech savvy college students graduate, find jobs and move into their own homes, one 3

of their first major purchases will be a big screen TV, and they will likely get a pay TV subscription to go with it. For those that don t subscribe at this point, there is still an opportunity for cable companies to capture them when they get married and especially have children, lest their kids grow up without SpongeBob or Dora the Explorer (the merits of which are outside the scope of this article). For all these reasons, and despite subscriber losses to telco and satellite players, pricing power has remained relatively strong, and cable s video revenues have remained stable to slightly increasing over the last five years (see Exhibit 3). As telco expansion tails off and given that we do not believe cord cutting will occur to a large degree in the near to medium term, subscriber losses should stabilize, especially if the economy improves and leads to some housing growth. Given the utility of pay TV and the fact that no true substitute exists, especially for live sports and events, we would expect pricing to remain resilient and for video revenues to remain stable to slightly positive. Exhibit 3 US$ billion 39 38 37 36 35 34 33 Cable Video Revenue 2007 2008 2009 2010 2011 2012 Note: Companies include: Comcast, Time Warner Cable, Charter, and Cablevision. Source: Company Reports, BBH. CAGR = 1.9% Cable Is More Than Just TV When thinking about cable, the first thought that often comes to mind is TV or video. Historically video was the core of cable s business, but that is no longer the case. Broadband and telephony now represent 41% of cable s revenue, and broadband in particular has accounted for the majority of the growth (see Exhibits 4 and 5). Moreover, operating profits from broadband and telephony are greater than from video. We estimate that EBITDA 1 margins on broadband and telephony are over 65%, whereas margins on video are closer to 25%, given the need to pay content owners substantial programming fees. In other words, cable is swapping lower margin video subscribers for higher margin broadband and telephony subscribers; in contrast, telcos are gaining lower margin pay TV subscribers and losing higher margin broadband and telephony subscribers. It is generally much better to be a cable company than a telco in this scenario. As content owners, particularly broadcasters (ABC, CBS, FOX and NBC) and those with sports programming, demand higher and higher fees, pay TV operators are not likely to be able to fully pass these increased costs on to consumers, which will cause the margin differential to increase further. Exhibit 4 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2% 3% 5% 5% 7% 13% 22% 29% 63% Cable Revenue by Product 28% 51% 2007 2012 Note: Business Services revenues allocated to High Speed Data and Telephony. Source: Company Reports: Comcast, Time Warner Cable, Cablevision and Charter. Exhibit 5 US$ billion 90 80 70 60 50 40 30 20 10 - Cable Revenues by Product $56.6 1.3 2.9 4.0 12.7 41% $74.8 35.6 38.3 Other Advertising Telephony High Speed Data Video 2.5 3.8 9.6 20.6 2007 2012 Video High Speed Data Telephony Advertising Other CAGR 5.7% 12.8% 5.8% 18.8% 10.2% Note: Video includes franchise fees. Business Services revenues allocated to High Speed Data and Telephony. Source: Company Reports: Comcast, Time Warner Cable, Cablevision and Charter. Further, despite what many consider to be a relatively mature business, broadband continues to exhibit strong growth as demand for broadband and for super fast speed remains robust, which plays to cable s advantage. In the majority of the country, cable is able to offer speeds of 100 mega bits per second (mbps) or more, and in some areas has recently started to offer speeds over 500mbps. This compares to the average speeds offered by DSLbased 2 telcos of 25mbps or less. In fact only Verizon, which has upgraded a portion of its network to bring fiber all the way to the home, is able to beat cable speeds. This is however limited to roughly 60% of its footprint, or 25-30% of the country, where it is economical for Verizon to lay fiber. AT&T opted to roll out cheaper VDSL 3 technology, which is not as robust and cannot match cable s speed. Given that consumers are increasingly using bandwidth intensive applications like streaming video and online gaming, the need for speed is increasing. As a result, cable has been taking the lion s share of broadband net additions for quite 1.4% 4

BBH InvestorView Even if consumers decide that they can do without their pay TV video subscription in favor of watching content online for free or through Netflix, they must have a broadband subscription in order to access this online content. The more streaming video consumers watch, the greater speeds they will demand, and in the majority of the country cable is the only provider capable of offering consumers a truly fast broadband connection into the home. some time (see Exhibit 6). We would expect this trend to continue as both Verizon and AT&T are nearing the end of their fiber roll outs. Exhibit 6 90% 80% 70% 60% 50% 40% 30% 20% 10% Share of Broadband Subscriber Net Additions 0% Q1-06 Q1-07 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Source: Bernstein Research, Pivotal Research, BBH Analysis. Cable Telco Apart from being a growth driver, cable s strong position in broadband also provides it with a hedge against the threat of cord cutting. Even if consumers decide that they can do without their pay TV video subscription in favor of watching content online for free or through Netflix, they must have a broadband subscription in order to access this online content. The more streaming video consumers watch, the greater speeds they will demand, and, as noted above, in the majority of the country cable is the only provider capable of offering consumers a truly fast broadband connection into the home. Further, given that consumers readily accept the fact that they are getting a discount for taking a triple-play bundle of video, broadband and phone, cable can price a double play broadband and phone package, or even a single play broadband product, in such a way that it is agnostic to whether a subscriber takes video or not. Therefore, even if cord cutting becomes a reality, cable will continue to have a robust business. Satellite on the other hand will be in trouble as, without the ability to offer a broadband product, their business would erode. New Business Opportunities Emerging We have demonstrated that cable is more than just video. It is also, however, more than just a consumer product. The cable network passes a large number of small- and medium-sized businesses. Until recently, the only option these businesses had for their telecommunications needs were the telcos. Given that telcos had a near monopoly in this market, the service provided was often poor, and the cost was high. Several years ago, cable woke up to the potential to address this underserved market. By offering a superior service at a good value relative to the telcos, cable has started to capture significant share in the small- to medium-sized telecommunications market, but it still remains underpenetrated. Both the small- and medium-sized business markets are multibillion dollar ones, and share remains relatively small in the former and even smaller in the latter. Given that much of the network infrastructure and marketing costs are already reflected in cable operators cost base, as this business grows, cable should see solid operating leverage and margin expansion. The opportunity to provide cellular backhaul 4 services within cable s footprint for wireless telecommunications operators further increases the size of the pie. These contracts tend to be very long-term in nature with steady growth anticipated due to growing mobile data usage. Growth in these small- and medium-sized business segments is over 25% for some large cable companies currently, and while growth will inevitably slow, we would expect to continue to see strong double-digit growth from this business for years to come. Additionally, cable is finding other new ways to leverage their robust physical network. Recently cable operators began offering home security monitoring. Home security has been around 5

for decades but has remained a relatively underpenetrated product, attracting roughly only 20% of households. However, by bundling home security in with their other telecommunications products, cable is lowering the cost and effectively the barriers for many consumers. While it is very early days for this product, so far cable operators are reporting solid demand. Over time, as the connected home becomes more of a reality and the Internet becomes even more pervasive in our lives, we believe cable will find even more opportunities to leverage its network to serve consumers and businesses with new products. This will enable it to continue to grow well into the future. Separating the Winners from the Winners As we have demonstrated, cable is far from dead. In fact, as a whole we believe cable is an attractive, competitively-advantaged business with far fewer risks than its telco and satellite competitors. However, given that cable companies operate in discrete footprints and, therefore, do not actually compete against one another, we are often asked what differentiates one cable company from another as an investment. While valuation is always an important factor, we do feel that some operators are positioned better or have stronger competitive advantages and more upside opportunities than others. In particular, and in line with our Core Select investment criteria, we look for those companies that have scale, market power, competitive advantages and less exposure to competitive threats, are innovative such that they stay ahead of technological changes, are financially disciplined and have strong management teams. We discuss these traits in detail as follows. Scale and Market Power: Scale in the cable industry is important, as it gives operators advantages in procurement, network management, research and development, and marketing, to name a few areas. Additionally, scale provides operators more leverage over content owners in programming negotiations, as it would be very costly for a programmer to be blacked out on the systems of a large cable provider. Scale also enables management to exert significant market power, thus assuring they always have a seat at the table. In fact, it often allows them to direct the discussion and potentially to push their own agenda, and it gives them a strong voice in setting cable industry technical standards. Competitive Positioning: Different cable operators are at different stages of development than others. Some that were early to pursue the broadband and telephony opportunity have seen strong growth from it but are now at a higher level of penetration, which makes it harder for them to grow at the same pace as cable operators that have more runway. Additionally, while to some degree all cable operators are exposed to the same competitive threats, the degree of exposure varies. In particular, some are more exposed to telco fiber builds than others and would therefore face greater competition, particularly those with greater exposure to Verizon s FIOS service, which, as noted previously, is realistically the only technology that is more robust than cable. 6

BBH InvestorView We look to align ourselves with management teams that demonstrate strong execution capabilities, focus on innovation and are disciplined financially. We believe that over time management teams that focus on these key factors will create the most value for their shareholders, enabling us to create the most value for our investors. Innovation: By nature of the cable network all cable operators are capable of launching the same innovations, but some have been more innovative than others. For example, those that decided to roll out new technologies such as DOCSIS 3.0 5 or to go all digital earlier have been able to offer much faster broadband speeds, provide an expanded range of services and channels and realize significant cost efficiencies. In addition, some have been more proactive than others at amassing large libraries of content rights such that they can offer their subscribers a greater assortment of on demand content on more platforms than their cable peers and their competitors. Finally, while still early days, operators vary in their efforts to exploit emerging technologies such as mobile applications and cloud-based services to offer a true anytime, anywhere experience, or in leveraging their network to pursue new growth opportunities such as home security or other services related to the connected home. We feel that those cable operators that are more innovative will see improved customer satisfaction and lower churn rates, be better able to fend off competitors, and be better positioned to stay ahead of technological changes and threats. Financial Discipline: Financially speaking, not all cable management teams have been as disciplined in their capital allocation policies, and some have stronger balance sheets than others. We believe that those that make returns-focused capital allocation decisions and maintain a prudent level of debt and/or sufficiently manage the term and duration of their debts will realize better financial returns and be better able to sustain market dislocations. Management: While cable is an attractive industry and operators do not directly compete against one another, many of the factors described previously separate some management teams from others. We look to align ourselves with management teams that demonstrate strong execution capabilities, focus on innovation and are disciplined financially. We believe that over time management teams that focus on these key factors will create the most value for their shareholders, enabling us to create the most value for our investors. Conclusion In summary, despite popular sentiment, we continue to believe cable is far from dead for multiple reasons: Time spent watching television is up, and the increase has been aided by technologies like DVRs and video on demand, which have made it easier for viewers to consume TV content. Video subscriber losses have been primarily absorbed by telcos, not online alternatives, which are near the end of their cable video build outs. Other subscriber losses are more likely cyclical in nature, as the recent economic woes have taken a toll on consumers. Online content is not a true television substitute. Cable operators offer broadband and in much of the country at faster speeds than their telco peers and telephony, so even cutting the cord doesn t eliminate the ability of cable operators to capture customers. Finally, cable companies are continuing to leverage their robust network to diversify into new businesses. So, as you can see, cable is alive and well. In this digitally-driven world, cable s fiber rich network will keep it relevant and provide new business opportunities well into the future. From an investment perspective, we believe that the combination of our criteria outlined in the previous section and the positive industry factors outlined in this article will help us identify strong cable opportunities that we can take advantage of on behalf of our clients.f 1 EBITDA is earnings before interest, taxes, depreciation and amortization. 2 Digital subscriber line refers to Internet services that are provided digitally via telephone lines and are faster than a conventional modem. 3 Very-high-bit-rate digital subscriber line is similar to DSL, but faster because it uses a higher frequency. 4 The ability to provide telcos with the infrastructure to link smaller subnetworks with their core networks. 5 Data Over Cable Services Interface Specification or DOCSIS enables cable companies to add high-speed data to cable television systems. DOCSIS 3.0 is the latest version of the technology. 7

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