Analysts Warn of Sky Deal "Pitfalls"

While Morningstar analysts believe the 21st Century Fox offer for Sky is fair, there are some vocal shareholders that believe the price is too low

Allan C. Nichols, CFA 20 December, 2016 | 3:16PM
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Despite these potential problems, we expect the deal to succeed

While Sky (SKY) has agreed to accept 21st Century Fox's offer for the 61% of Sky it does not already, own there are potential pitfalls to the consummation of the deal. As a result, we are maintaining our fair value estimate for Sky's shares at £10.10. While we believe the deal is fair, as it's about 6% above our fair value estimate, there are some vocal shareholders that believe the price is too low.

As the deal requires 75% of votes that are not affiliated, the deal could be voted down. We think most of the disgruntled shareholders acquired their shares in 2015, when the stock was trading at what we believed were very high prices. The current offer is particularly difficult for ADR holders, as the weakness of the pound has hurt the ADR share price. The deal could also be referred to regulators, where some politicians have stated Rupert Murdoch is not fit to control so much of the news market and thus believe the deal should be stopped. Despite these potential problems, we expect the deal to succeed.

Investment Thesis

Sky has succeeded in aggregating some of the best content available and marketing its services. More than a decade ago, the firm began to enter exclusive deals to carry major sporting events in the United Kingdom. In addition, it acquired rights to many first-run movies and U.S.-produced television series, which are becoming increasingly popular in the U.K. While it resells the majority of its purchased content to other television carriers, it also produces its own shows to distinguish its product.

The completion of a new production facility in 2011 enhanced the company's content-creation capability. The new building contains several studios, including one that is large enough to hold an audience and produce live shows, such as game or talk shows with a live audience. With the acquisitions of Sky Italia and Sky Deutschland, Sky is also producing and airing its own shows in these countries. This further distinguishes the firm from its competitors. It is also selling additional services, such as high-definition television, DVRs, second set-top boxes, and video on demand. All of these services increase average revenue per user and profitability.

The firm also offers broadband and phone service. These businesses have grown rapidly and are now similar in size to Virgin Media and TalkTalk, though they are still smaller than those of BT Group, the incumbent telephone operator. While BT's new-subscriber growth in the U.K. has been increasing since it began offering BT Sport for free to its broadband customers, Sky continues to increase its broadband subscriber base.

While the firm does not have the scale in broadband and telephony that it has in pay-TV services, the incremental business is improving the firm's margins and free cash flow. The Italian and German markets are far behind in their development of pay-television services versus the U.K. By acquiring the firm's sister companies in these countries, management hopes to replicate its British success in Italy and Germany.

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About Author

Allan C. Nichols, CFA  is a senior stock analyst and international investing specialist with Morningstar.