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TV Unbound

By Elliott H. Gue, on Oct. 27, 2017

Despite the S&P 500’s strength in the back half of the year, shares of television entertainment companies have pulled back significantly in response to several challenges.

The growing trend of cord-cutting—replacing expensive cable packages with streaming services, so-called skinny bundles and, of course, pirated digital content—has resulted in subscriber attrition at AT&T (NYSE: T) and Comcast Corp’s (NSDQ: CMCSA) pay TV businesses.

Falling subscriber numbers, in turn, pressure affiliate fees, ratings and ad revenue, creating a headwind for cable TV networks like The Walt Disney Co’s (NYSE: DIS) sports-focused ESPN franchise. Other challenges for traditional media players include the ongoing transition to digital platforms, which complicates the process of measuring viewership levels—a key metric for pricing advertising.

Media consultancy Magna Global projects that TV ad spending will increase by only 1.6 percent in 2017—the lowest growth rate since the Great Recession. A lack of marquee events after last year’s Summer Olympics and contentious election season explains this slowdown.

Caught up in this maelstrom CBS Corp’s (NYSE: CBS) shares have given up almost 15 percent of their value since the start of August, a degree of underperformance that doesn’t reflect the company’s business results or growth prospects.

For one, CBS doesn’t face the same challenges as cable-TV networks when it comes to retransmission and reverse compensation agreements, all of which come up for renegotiation over the next three years.

As the leading national network in terms of total audience and revenue (life at the top historically has lasted for a decade or so), CBS has significant leverage in these negotiations, especially when you consider that pay TV providers didn’t start paying the national networks until 2010.

For example, whereas ESPN collects about $7 per monthly pay TV subscription and accounts for a low-single-digit percentage of viewership, CBS receives a rate of roughly $2 per subscriber for 10 percent of the viewership. A popular programming lineup gives CBS the upper-hand in renegotiating these agreements, giving it plenty of upside leverage over the next three years.

At the same time, the cord-cutting trend has turned into an upside driver for the company. CBS has agreements with all the major providers of so-called over-the-top (OTT) digital distribution platforms—Hulu, YouTube TV, DTV Now, etc.—that pay the company an average of $4 per subscriber.

Even better, the media giant charges a monthly subscription rate of $6 for its CBS All Access service, which includes 6,500 episodes from its content library, NFL football and 98 percent of its affiliate programming in local markets.

CBS has also sweetened the deal by developing web-only series, including “Star Trek: Discovery,” which started airing in September—a potential upside driver for third- and fourth-quarter results. The company plans to produce about five new series of original content for CBS All Access each year to attract new customers and retain existing subscribers. Management expects the service to hit 4 million subscribers by year-end.

The company will expand this platform to Canada in early 2018 and Australia thereafter, with the latter rollout assisted by the recent purchase of Ten Network Holdings out of administration. The third-largest broadcaster trails Australia’s No. 1 and No. 2 players by a significant margin, but its ratings have improved in recent years and CBS’ financial backing should help it compete for sports rights and locally produced content.

CBS’ Showtime division (14 percent of revenue and 30 percent of operating income) also runs a successful OTT offering that should benefit from the recent success of “Twin Peaks: The Return” and the strategic shift to roll out a new show every three to four weeks.

All told, management expects CBS’ domestic OTT offerings to reach 8 million subscribers by 2020. Given the breadth of content on CBS All Access, the company could also juice revenue by instituting a price hike at some point.

The media company’s record of producing popular content in-house creates a valuable library of newer and legacy shows to monetize via syndication and licensing to the popular digital platforms that have cropped up. And more competition for this content leads to higher syndication and retransmission fees.

For example, CBS more than paid for the entire production cost of “Star Trek: Discovery” by licensing the international rights to Netflix (NSDQ: NFLX) for $4.5 million. Near-term upside catalysts on this front include the impending first-run syndication of “NCIS New Orleans,” “Madam Secretary” and “Scorpion.”

Despite a tough year-over-year comparison, CBS’ second-quarter content licensing and distribution revenue increased by 12 percent, as the company continues to monetize its library.

In mid-September, CEO Les Moonves told attendees of Goldman Sachs’ (NYSE: GS) annual Communacopia Conference that CBS has about 66 shows in production for its own channels and outside platforms, including two for Netflix and one for iTunes.

Volatile advertising revenue remains a concern for traditional media companies, especially with traditional ratings metrics on the decline—the live audience continues to shrink relative to the seven- or 35-day viewership numbers. CBS isn’t immune to these fluctuations, a point underscored by concerns about the 11 percent decline in viewership for NFL games aired on the network this year.

However, CBS’ success monetizing its deep content library and rolling out OTT offerings reduced advertising revenue to 40 percent of its overall sales, down from 70 percent a decade ago. Next year should also be a stronger period for advertising on its station group (the largest in the US), thanks to midterm elections.

Although advertising-related headwinds and the slippage of some syndication deals could constrain revenue growth this year, CBS’ content library and production capabilities position the media giant to do well as consumers cut the cord and consume more media on digital platforms.

The sale of CBS Radio to Entercom Communications Corp (NYSE: ETM) for $1.2 billion disposes of a noncore asset and provides capital to step up share repurchases—another upside catalyst for 2018. CBS Corp rates a buy up to $60.

Peter Staas is managing editor of Conrad’s Utility Investor and Energy & Income Advisor.

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