FOXA, CBS, DISCA, VIAB, DIS: Updates Ahead of 3Q18 Earnings -- Pivotal Research

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In this report we are modifying our financial models for video-centric media companies we cover, mostly leaving valuations and recommendations unchanged. Commentary on companies and the sector follows.

Ahead of 3Q18 earnings, we continue to see weak longer-term fundamentals for video-centric media owners. Cord shaving and cutting is eroding sub bases by around -2% annually, constraining affiliate fee growth. Viewing of video is still expanding, although mostly for newer SVOD services and YouTube. Advertising is relatively strong at the moment -- meaning it's non-negative -- but we think it continues to look weaker over longer time horizons as the large brands who dominate it are generally limiting growth or reducing spending. High-single digit pricing gains in the recent Upfronts won't flow through to revenues as a result. For similar reasons, advanced audience targeting initiatives will only slightly curtail the decline. By contrast, retransmission-consent-related fees, international content licensing and the D2C platforms are sources of growth, although the latter type of revenue will likely be much lower margin than traditional activities given needs to acquire and manage customer relationships while paying for the storage and physical delivery of content (an absence of net neutrality may be negative here, too). Content costs are also likely to cause higher spending as networks and OTT platforms find that they must increase their investments in original programming. Top-tier sports costs are going to rise at even higher rates -- double digit annual increases, we think -- given the unique value that this type of content has to traditional networks as well as to Facebook, Google and Amazon. If there is one positive trend at present, it is the strength of political advertising, helping station owners in battleground states in the upcoming election.

At a company specific trends and issues to monitor include the following:

  • At Fox, we see a company positioning itself to be much more dependent on news-related programming and sports. While initiatives the company takes to improve those business are worth monitoring, our guess is that there will eventually be more M&A activity for the company, such as a deeper investment in the broadcasting business or possibly a recombination with News Corp in some form. For the present time the core business won't matter much to valuation as the bulk of its value remains tied up in the value of Disney stock and cash.
  • At CBS, there have been managerial changes in the past couple of weeks as the interim CEO has appointed new (non-interim) heads of HR, corporate communications and a CFO. The changes are understandable in context of an organization that is looking to distance itself from the past and move itself forward. However, putting aside the merits of the individuals in those roles, the appointments are also unusual considering the interim nature of the CEO role at this time. Another wild card in governance and management relates to the changing of the interim Chairmanship of the overall company over the weekend. In the short term we don't think anything should get in the way of anticipated operating trends, but we are mindful that the company may yet go through further organizational changes, whether with the current team in place or another one.
  • Discovery's stock has been holding up well as investor concerns around Discovery's future on vMVPDs have generally abated. However, those concerns always seemed overblown, and so recent announcements weren't particularly meaningful beyond the boost we now expect in next year's affiliate fee revenue expectations. Discovery should do well on the advertising front in the current quarter, especially as like-for-like share of ad impressions have grown significantly, driven both by viewing share gains and by increases in ad loads as well as general pricing increases. Generally, we still view Discovery's long-term position as weaker than owners of broadcast networks (whose positions we see as relatively more durable) but also recognize that its international activities should be viewed as a positive attribute for the company.
  • Viacom faces many of the same negative issues impacting Discovery, but it under-invested in growth opportunities -- especially on digital media -- for a significant amount of time and supported a non-profitable studio for an extended period as well. Its recent resumption of managerial normalcy and focus on opportunities to drive growth should support superior bottom line growth relative to peers over the medium term. A downside remains in the company's sub-optimal ownership structure, but upside probably exists for Viacom if that same ownership structure ultimately leads it to control CBS at some point in the future.
  • With Disney we have incorporated into our model our first pass at crude assumptions around the revenue and profit impact from the launch of ESPN+, the Disney-branded streaming service and the consolidation of Hulu. There are many, many wild-cards to consider in these estimates, which are much better characterized as "starting assumptions." As a best guess, we think that Disney will manage these businesses for overall profit growth rather than for margins and that there will be significant costs incurred -- especially in 2019 -- in exchange for slightly faster long-term growth. The overall effect on our DCF-driven valuation is relatively neutral. Overall, while we continue to believe that Disney is the best positioned among peers on a strategic basis, on a relative basis vs. other companies we cover we continue to see the stock as relatively overvalued.

Accounting for these factors and changes in costs of capital, price targets and recommendations are mostly unchanged, with Hold ratings on CBS, Fox and Viacom and Sell ratings on Discovery and Disney.

VALUATION. We value companies on a DCF basis. Key variables include long-term costs of capital ranging from 12.4% for Discovery to 14.2% for Disney. Long-term growth rates range from 2.5% for Viacom to 5% 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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