FOXA, CBS, DISCA, TWX, VIAB, DIS: Focus on M&A -- Pivotal Research

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In this note we are slightly modifying our financial models for video-centric media companies under our coverage. Weak fundamentals are likely to be overshadowed by a focus among investors around M&A in light of reports about Scripps discussions to combine with either of Viacom or Discovery. Price targets and recommendations are unchanged, with a Buy rating on 21st Century Fox, Hold ratings on CBS, Discovery, Time Warner and Viacom and a Sell rating on Disney.

Ahead of 2Q17 earnings, we see relatively weak fundamentals for video-centric media owners. Cord shaving and (to a lesser degree) cord-cutting continues to erode subscriber bases for most of these companies in the United States, constraining affiliate fee revenue growth. Viewing of video-based content is evidently growing, indicating some healthy underlying elements to the industry, although much of the growth accrues to newer SVOD services and YouTube. Advertising is somewhat worse off, with the large advertisers who drive most of the industry's spending suffering somewhat, subject to limited growth in their businesses paired with more aggressive applications of zero-based budgeting and heightened influence of marketing procurement departments on overall advertising activities. Problems with digital advertising are now more widely appreciated, as is television's relative effectiveness in building and sustaining brands, contributing to shifts of spending back to TV for some advertisers (i.e. P&G). However, we don't think any kind of shift might be big enough to cause year-over-year like-for-like normalized advertising revenue growth for national TV any time soon. To point, we think the strong Upfront market reflects a shift of spending from scatter into Upfront markets and concerns about limited commercial inventory that will be available later in the upcoming broadcast year given high single digit (or worse) declines in commercial ratings.

However, fundamentals such as these are likely to be de-emphasized this earnings season in favor of a focus on M&A for companies in the sector, especially with news of Scripps discussing combinations with each of Discovery and Viacom coming to light on Tuesday. Combinations such as these should be positively received by investors given the potential to drive efficiencies into these businesses. We think that networks will require investments in programming that outpace revenue growth on an ongoing basis, limiting the opportunity for margin improvement without the synergies that might follow from this kind of M&A. Network owners who attempt to reduce growth in spending on programming will probably find that they lose audience share (and advertising budget share) as well as clout with distributors or the ability to sell directly through to consumers.

With all of that noted, each of Discovery, Scripps and Viacom are in particularly difficult positions, especially relative to owners of broadcast networks including Disney, Fox and CBS. Discovery, Scripps and Viacom each lack sports programming or much in the way of other high-end original content on their core US networks. Each of them will generally have a harder time persuading distributors to increase the fees paid by much, or to ensure carriage of every network. Each of these networks are also probably worse positioned vs. peers to create direct-to-consumer offerings. Consequently, it appears to us that the advantages that may be realized are probably less strategic than financial so far as we can tell. Further, whether or not any of these combinations actually occur is harder to assess.

At current levels, we remain relatively neutral (with a negative orientation) on the sector, and retain one Buy rating with Fox, where we retain our $36 YE2017 price target. We note that Fox remains the one large network group faring the best in terms of its cable network distribution, and continues to be the most aggressive among peers investing in growth opportunities. The Sky transaction, if it is eventually approved, will be helpful at a strategic level as well, to the extent that it may help in the long-run with a reinvention of Fox News and help provide Fox with a second approach (after Hulu) towards investing in SVOD services given Sky's efforts in this space. By contrast, Disney is the only Sell in the group given our $85 price target. One of the key factors supporting this view is that we think that margin erosion will occur at Disney's cable networks given advertising and affiliate fee revenue growth that is unlikely to exceed ongoing cost increases which are primarily associated with sports rights.

VALUATION. We value companies on a DCF basis. Key variables driving valuations across the agency holding companies include long-term costs of capital ranging from 6.8% for Discovery to 9.7% for Disney. Long-term growth rates range from 3.5% for Viacom to 5.0% for Disney.

RISKS. Risks to companies in the sector include the hit-driven nature of video production, threats to TV advertising and a pay TV slowdown.


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