Media is a cyclical industry
Media and entertainment services are part of the consumer discretionary sector. These are cyclical services, which directionally follow the economic trend and expectations. They’re affected significantly by the troughs and peaks of business cycles.
Media and entertainment aren’t core necessary services that consumers require. During economic downturns, they usually underperform the market. However, in economic upswings, they often perform better than the overall market.
Economic expectations and consumer spending
Investors who want exposure to media sector stocks throughout the business cycle should watch for key domestic and global economic and consumer spending indicators. Consumer confidence is a crucial driver for sectors such as media. It gets bolstered by declining unemployment rates and rising disposable income levels.
Economic conditions and expectations also affect businesses’ advertising expenditures. Advertising constitutes a significant portion of media sector revenues throughout its value chain, from media networks to distributors.
Advertising constituted almost half of Viacom’s (VIAB) fiscal 2014 revenues from media networks.
Look out for evolving media delivery models
Investors should keep an eye on traditional media companies with robust business models. But you should also keenly watch for service innovators in the segment. This is particularly important for investors who want to remain invested throughout the business cycle.
After the completion of the initial expansion in the business cycle, investors may experience declining returns due to the sector fundamentals we mentioned earlier.
Investors should look at key trends, especially in media companies’ evolving delivery models. Mobile and Internet solutions are increasingly delivering media content. This shifts a significant portion of revenues from traditional media distributors such as pay-TV providers Comcast (CMCSA), Time Warner Cable (TWC), and DirecTV (DTV) to new media distributors such as OTT (over-the-top) content players like Netflix (NFLX).
You can take a diversified exposure to these four media companies by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~11.5% in these companies as of March 2, 2015.
Media valuation metrics
In the earlier parts of this series, we learned how diverse the media sector is. We also learned about the high level of integration within the media industry. The media sector in the United States is dominated by conglomerates.
In this part of the series, we’ll look at some key metrics investors can use to compare values of media companies. We’ll specifically look at media valuation multiples, which may be used to value conglomerates.
Some of the usual valuation multiples for companies are PE (price-to-earnings), EV-EBITDA (enterprise value–to–earnings before interest, tax, depreciation and amortization), PCF (price-to-cash flows), and PFCF (price-to-free cash flows).
The price-based multiples take into account value from a shareholder perspective. The EV-based multiples help investors understand the value of the company from the perspective of a company’s holders of sources of capital. These are forward multiples based on expected values of the denominator after a year.
Pay-TV providers are trading at a discount
We prefer EV-EBITDA and PCF over the other multiples when comparing valuation of media conglomerates with different structures. One of the reasons we use these multiples is to take out the impact of various capital investments made by distributors such as cable companies and satellite TV providers.
As you can see in the above chart, cable and satellite providers are trading at a discount to media producers and aggregators. DirecTV (DTV) looks undervalued based on both EV-EBITDA and PCF forward multiples.
You can take a diversified exposure to DirecTV by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~1.9% in the company as of March 2, 2015.
Among the three media content producers, The Walt Disney Company (DIS), 21st Century Fox (FOXA), and Time Warner Cable (TWX), TWX appears undervalued based on EV-EBITDA. DIS looks undervalued based on the PCF multiple.
Investing in media
Now let’s look at a media investment opportunity for investors who want diversified exposure to the sector. We’ll also look at the composition of the media industry in terms of the largest players.
The Consumer Discretionary Select Sector SPDR Fund
As we’ve seen, media is part of the consumer discretionary sector. Investors who want to have an exposure to the overall media sector can invest in the Consumer Discretionary Select Sector SPDR Fund (XLY). It’s the largest and most liquid consumer discretionary ETF.
XLY had a net asset value of ~$9.2 billion and daily traded volume of ~2.2 million shares on March 2, 2015. It’s benchmarked to the S&P Consumer Discretionary Select Sector Index. It holds 17 large media companies, including Netflix, which together represent ~30% of the ETF’s holdings as of March 2, 2015. Overall, the ETF has 86 holdings.
The largest media companies
As you can see in the chart above, The Walt Disney Company (DIS) is the largest media company in XLY. It’s followed closely by Comcast (CMCSA). The other companies that make up the largest five media players in XLY are Time Warner (TWX), 21st Century Fox (FOXA), and satellite TV provider DirecTV (DTV). Together, these five media companies represent ~71% of the total media holdings of XLY, including Netflix.
The media industry’s leverage
So we’ve learned about the diverse members of the media value chain. We also learned about capital-intensive media content distributors such as cable companies, and that cable companies also provide voice and broadband services similar to telecoms. Like telecoms, they’ve invested significantly in growing their broadband networks throughout the United States.
Now we’ll look at the media industry’s leverage throughout the value chain. We’ll take into account media companies’ debt repayment capacities. We’ll use net-debt-to-EBITDA (earnings before interest, tax, depreciation, and amortization) metrics to evaluate these companies’ debt repayment capacities.
Debt repayment capacity is the number of years it will take a media company to repay its debt, excluding any cash and equivalent liquid securities it holds.
Walt Disney, the best debt repayment capacity
As you can see in the above chart, The Walt Disney Company (DIS) had the best debt repayment capacity among media companies in 4Q14. It was followed by another media content producer, aggregator, and broadcaster, 21st Century Fox (FOXA).
Among the large pay-TV providers and cable companies, Comcast (CMCSA) had the best repayment capacity. It was followed closely by DirecTV (DTV) during the period. Time Warner (TWX) had the worst debt repayment capacity in 4Q14, followed closely by Viacom (VIAB).
If the debt repayment capacity of Time Warner or Viacom affects you, you can take a diversified exposure to these companies by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~4.1% in these companies as of March 2, 2015.
The FCC, the key media regulator
The key media regulator in the media sector is the FCC (Federal Communications Commission). The FCC primarily regulates competition and protects consumer interest in the media and telecom sector.
In terms of content, media is a largely unregulated sector in the United States. However, in terms of distribution, the intensity of regulations is different for the various players in the segment. In this part of the series, we’ll focus on radio and television broadcasters, which are regulated by the FCC.
A regulated broadcasting space
Broadcasting is one of the most regulated media subsectors. We learned in the earlier parts of this series that broadcasters air content through television and radio stations. The FCC gives licenses to these stations for specific durations. It’s responsible for renewing or canceling these licenses at the end of their terms.
The FCC also regulates the number of broadcast stations a company or entity can own. It restricts ownership of television stations, radio stations, and newspapers in a particular area by a single entity. For entities that own a chain of television stations across the country, the FCC maintains a 39% limit on the total audience reach.
The FCC regulates many other cross-ownership rules for stations. Investors should be aware that the FCC prohibits a merger of the four prominent US broadcasters. These include NBC, CBS, Fox, and ABC. ABC is owned by The Walt Disney Company (DIS), NBC is owned by Comcast (CMCSA), CBS is owned by CBS Corporation (CBS), and Fox is owned by 21st Century Fox (FOXA).
You can take a diversified exposure to these four companies by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~17.6% in these companies as of March 2, 2015.
So far in this article, we learned that the US media sector is characterized by vertical integration. We also learned that content producers are often aggregators in the industry. This is due in large part to high media content production costs.
In this part of the series, we’ll look at media networks that are both content producers and aggregators. They include broadcasters and cable networks.
Broadcasters air television and radio content through owned or affiliated broadcasting stations. They often own some television and radio stations. Broadcasters make money largely through on-air advertising as well as fees to third parties for content retransmission.
Cable networks provide content to distributors, including cable, telecommunications, and satellite operators. They also make money selling air time for advertisements.
High competition among media networks
Media networks face stiff competition for acquisition and distribution of content. Quality as well as exclusivity of content add to the competition across the media value chain. Most networks seek content in categories such as sports with exclusive rights.
In terms of end users, or consumers, media networks compete for their engagement and approval ratings. As you can see in the above chart, The Walt Disney Company’s (DIS) ESPN network had the highest average total day audience among sports networks in 2013. These sports networks included 21st Century Fox’s (FOXA) sports channels, Comcast’s (CMCSA) NBC sports channels, and sports networks of major sports leagues.
You can take a diversified investment in 21st Century Fox and Comcast by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~9.3% in these companies as of March 2, 2015. You can take an even more diversified exposure to these companies by investing in the SPDR S&P 500 ETF (SPY), which held ~1.2% in these companies on the same date.
Investing in the media and entertainment sector
The media and entertainment sector includes companies engaged in radio, television, print, and film, to name a few. It also includes companies that provide entertainment through theme parks, theater, music, and online media content.
The value chain for the US media industry is made up mainly of companies that create, aggregate, and distribute media content. Media content includes audio and video. Some examples of audio content are recorded and live music and radio programs. Video content includes movies, documentaries, and television programs.
The media value chain starts with content makers such as television producers, film studios, and news houses and agencies. They create original content and sometimes participate in its production. They make money by selling rights to this content to aggregators. Film studios also earn money by exhibitions in movie theaters.
Aggregators such as broadcasters and cable networks buy rights of content produced by third parties. Examples of networks are The Walt Disney Company’s (DIS) ESPN network and Time Warner Cable’s (TWX) HBO network. The networks pack up the acquired content into programming services often called channels for scheduled transmission. An example of a channel is 21st Century Fox’s (FOXA) Fox News Channel.
Networks usually enter into long duration contracts with distributors who pay a predetermined fee to the networks for channel bundles, often based on the number of subscribers. They also make money through advertisements aired during the channel broadcast. Additionally, they sell content directly to consumers in various forms including DVDs, downloadable media, and Internet platforms.
Distributors provide the infrastructure through which media content reaches consumers. In television and radio, distributors include cable and satellite TV operators and telecommunication companies (or telecoms). They sell bundled channels to consumers for a monthly subscription fee. Cable companies and telecoms often bundle media content with other offerings such as voice telephony and broadband.
Now we’ll analyze the industry, taking into account the contribution of its larger players. The media industry is vertically integrated. The large companies are media conglomerates. Content producers are often aggregators. For example, The Walt Disney Company (DIS) is an aggregator of television and radio content. It owns film studios, which produce movies. These studios include Walt Disney Pictures and Marvel Entertainment. Similarly, Time Warner Cable (TWX) owns media networks such as HBO and produces movies as well.
Content producers and aggregators can also be distributors. Comcast (CMCSA) produces television programs. As an aggregator, it owns NBC, the broadcast network. As a cable distributor like Time Warner Cable (TWC), the company provides consumers access to this content.
You can take on diversified exposure to Comcast and Time Warner Cable by investing in the Consumer Discretionary Select Sector SPDR Fund (XLY). The ETF held ~8.4% in these companies as of March 2, 2015.
Now let’s look at one of the main reasons for vertical integration within the media industry.
High fixed content costs favor consolidation
One of the primary sources of costs for the entire media industry is content creation and production. As you can see in the above chart, even in the filmed entertainment category, Comcast’s programming and production costs were more than half the total operating costs and expenses of the division.
Programming and production costs include content acquisition, creation, production, and expenses to make the content ready for distribution to other networks.
High fixed content costs result in economies of scale for larger media players. This also gives significant bargaining power to content producers who are usually aggregators.