Morningstar.com, a sister site of Morningstar.co.uk, takes a look at the changing face of the US TV market.
Predictions about the death of television have grown commonplace in recent years as new services like YouTube, Netflix (both DVDs and streaming), and legitimate video downloads from Amazon and Apple have come on the scene. The common belief is that these advances are making the current pay television model obsolete. Proponents of this view received another piece of supporting evidence this past quarter when for the first time, the firms we track--including cable, satellite, and phone companies--posted an aggregate net loss of customers. While flipping from growth to decline makes for great headlines, concluding that the long-anticipated shift in the television business is in full-swing is still premature, in our view. That said, we believe there is more downside risk than upside potential for the current status quo of the television market, and this imbalance of potential outcomes should shape investors' portfolios.
We've long held that new services and gadgets are changing the way consumers expect content to be delivered to them, and that content creators and aggregators will (if grudgingly) accommodate those expectations. However, we also believe the television status quo will change only gradually because consumers, despite frequent complaints to the contrary, still derive significant value from current pay-television services. Based on Nielsen data, we estimate that the average cost of pay television for the typical US household is about $0.25 per hour of content consumed. As evidence of this value, our coverage universe of cable, satellite, and phone companies consistently added customers right through the economic downturn.
So, what to make of the turn of events during the second quarter? We believe the drop in customers, which was very small at 0.1%, is a reflection of the industry's maturity, typical seasonality, and a pullback following the industry's solid performance during the downturn. Around 90% of US households with a television subscribe to a pay service, a figure that has grown slowly for several years. Customer growth was especially strong in 2009, but this spurt was likely a result of the digital broadcast transition that made it more difficult to get over-the-air programming and aggressive price promotion among service providers. In short, industrywide customer growth today is more a function of household formation than increasing adoption. Since the start of the downturn, household formation has slowed sharply, pressuring customer counts.
The second quarter also tends to suffer as college students and 'snowbirds' return home. By our rough calculation, the change in customer penetration during the quarter this year was comparable to 2008, a period of stronger household growth, and if typical seasonal patterns hold, the balance of the year should look a bit better.
While we don't think the industry's second quarter performance was alarming, there is little doubt that the rise of alternative television products and services still poses a threat to the traditional model, and the cable and satellite companies in particular. Among the more interesting products and services garnering attention are the revamped Apple TV, Hulu Plus, Netflix's streaming service, and Google TV. Each of these services has serious drawbacks relative to traditional television services--notably the lack of most live news and sports programming, especially cable channel content. However, the availability of alternatives will likely siphon away some customers and could reduce the amount others are willing to pay for traditional television.
The key question, of course, is how big the population of alternative adopters will be five or 10 years from now. Given the maturity of the traditional pay television market, even a small shift in preferences among customers would likely push the traditional television model into decline. If the group of potential customers shrinks too much too quickly, price competition is likely to intensify among the cable, satellite, and phone companies. The fear of a slowdown in growth prompted rounds of heavy promotion during 2009; a sustained period of actual decline would likely be worse.
We expect that pay television will remain a solid business for the foreseeable future, but the combination of a shrinking customer base and aggressive pricing would clearly hurt industrywide profitability. Given the threats to the industry, we believe investors' expectations for growth and margins should be muted. As such, we still favour the cable companies. We believe these firms have an advantage in providing Internet access across the majority of the US. In a world where alternative television services grow in popularity, the quality of Internet connections grows in importance.
On the other hand, we believe that satellite companies DirecTV and DISH Network face the greatest threat given their sole reliance on the television market. Despite both firms' exposure to changing consumer television habits, their current market valuations couldn't be more different, in our view. Not only does DirecTV trade at a significant premium to its satellite rival, it also trades at far richer multiples than its cable competitors.
