|Shares Out. (in M):||114||P/E||0.0x||0.0x|
|Market Cap (in $M):||3,100||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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I apologize in advance because I know that a STARZ write-up was recently submitted. This is a readmission write-up. I will try to offer a different perspective on why I like it.
STARZ is a subscription video business that shows run first run film output, library film output and original programming. Between STARZ and its sister network, Encore, STARZ has ~56MM North American subscribers. The channels business makes money by licensing its content to cable, satellite and telecom companies (“MVPDs”) that distribute STARZ programming as part of premium pay linear video package.STARZ also has a distribution business with rights to distribute STARZ original content and Weinstein Company films. The distribution business makes money by selling the rights to distribute STARZ content into different markets around the world.
The objective of a subscription video business is to increase a customer’s perception of the value of the overall subscription. The more people that find value in the subscription, the more people that will pay for the subscription. The more people that pay for the subscription, the more money that the business will have to fund content to please more subscribers. At scale, this cycle creates a durable, high-barrier to entry business. It is partucularly advantageous to the economics of the subscription business if the content is very expensive to buy and is also exclusive to the service.
This does not mean that a subscription video business must turn out commercially popular programming to be successful, although it helps. Instead, the business must consistently add programming that broadens the appeal of the subscription to as many people as possible to induce them to pay a monthly subscription fee. This is why HBO has politics, sports, documentaries, period dramas, and comedy specials. Expect Netflix to follow by methodically broadening the content offerings in its subscription over time.
There are four large barriers to entry that prevent most content companies from building a large subscription video business: 1) they do not have an economical way to fund investment in desirable content distribution rights; 2) they are unable to secure distribution for their content; 3) they do not have a team of good programmers that understand how to nurture and develop content; 4) they are partially captive to advertising supported business models that force them to program for ratings, rather than subscriber satisfaction.
Premium pay-video subscription businesses are not constrained by these barriers. Affiliate fee revenue derived from a large installed base of subscribers provides a high-margin, visible source of content distribution rights financing. The premium pay video cost structure benefits from the MVPDs role as the packager, marketer, and customer service representative for the channels. The result is ~30% operating cash flow margins that allow for consistent, concentrated reinvestment in a broad suite of desirable video distribution rights.
Broad distribution is crucial because it attracts content creators seeking to monetize their intellectual property across the widest possible audience. The author of a best-selling book adapted for television wants as many people as possible to see the program. Wide distribution can make copyright more valuable. Broad distribution perpetuates a virtuous cycle of attracting talented content creators to disseminate their content to the biggest audience possible, which attracts more viewers, which then attracts more good creators. Conversely, without broad distribution, it is difficult to secure valuable rights, which makes it more difficult to secure distribution.
Content creators can be an irascible brood. It is crucial to have a management team that understands how to nurse big egos and create a safe environment for creative risk taking. STARZ CEO Chris Albrecht has a great reputation, a deep rolodex, and the trust of his peers. It was Mr. Albrecht who midwifed The Sopranos, the Tao Te Ching of scripted serialized drama.
Advertising supported content must generate sufficient ratings for the programmer to justify its distribution. There is a real opportunity cost for a programmer if its loses ratings share in a desired time slot. Consequently, advertising supported shows often get canceled before they have an opportunity to find an audience. A canceled show is immediately devalued, lowering its library value and weakening the competitive position of the channel.
Subscription video businesses are not beholden to ratings. This allows them to program for niche audiences without worrying about mass commercial appeal. Programming for niche audiences can serve the objective of broadening the appeal of the overall subscription for as many people as possible. Certainly, it helps if the program turns out to be a cultural and critical smash; the most favorable outcome is to deliver a show that transcends a niche audience and becomes a popular phenomenon. But The Sopranos, Homeland, and Breaking Bad are rare gems. The thoughtful, measured approach is to economically increase the velocity of diverse original programming over time to make the subscription appeal to as many people as possible.
One of the prominent bear arguments is that after nearly five years, STARZ has failed to deliver a brand-defining hit show. In the mean time, AMC has had Mad Men, Breaking Bad and The Walking Dead, Showtime has had Dexter and Homeland, and Netflix has House of Cards.
This can be explained by one of two factors: 1) STARZ is not capable of producing a hit show; 2) content production is an unpredictable business and STARZ needs more bites at the apple. I believe the second explanation is true. There is no formula for success in content production. It is impossible to know in advance how an audience will react. What matters is not that the content business can consistently turn out hits, but rather that it can economically absorb the inevitable disappointments.
Subscription video businesses are uniquely suited to economically absorb disappointments. Even if a show has bad ratings, it may still improve the economics of the subscription business if it enhances the value of the overall subscription to a new constituency of customers. The Wire was a not a commercial success, however it is has become an important component of the HBO cannon and has enhanced different constituencies’ perception of the value of HBO. By 2016, STARZ should ~65 hours of original programming on air per year, up from ~25 hours in 2011. HBO has nearly 125 hours of original programming. The greater density of original programming should improve the value of the STARZ subscription, even if no single show is a smash hit.
Without a brand-defining hit show, it may be difficult for a public company CEO to convince shareholders that it is worth spending a few billion dollars to buy STARZ. Conversely, AMC Networks is frequently mentioned as a ripe acquisition target because of its recent run of hits. But AMC does not possess an inborn advantage in cultivating hits. AMC also relies in part on advertising revenue, which increases the risk associated with each content investment.
Almost all content depreciates immediately. Current popular content, or an owned library of content, do not guarantee good economics for a content business. Dreamworks owns a dense library of what would generally be considered “quality” content. Dreamworks has a market capitalization of $1.7B and is struggling. Netflix owns virtually no content; it has a market capitalization of $25B and is thriving. What matters is not that the content company is a “hit” factory or owns an extensive film catalogue. What matters is that the business has an operating model that provides a strong financial foundation upon which to keep investing in content that is likely to be of value to customers as tastes, consumption habits and technologies change. The subscription video models are structured to do this. If STARZ had one hit program, it would immediately become a palatable acquisition target.
The biggest risk to the investment is that the incremental investments in original content do not broaden the appeal of the STARZ subscription enough to retain current subscribers and add new ones. If the core STARZ channel starts showing sustained losses in subscribers, adjusting for seasonality and normal rates of involuntary attrition, the investment will not work well. STARZ may not need a hit, but it also cannot afford a string a critical and commercial failures. It cannot produce a slate of programming that in aggregate taints the perception of the STARZ brand or devalues the overall subscription. If that happens, it will show up in the subscriber numbers.
HBO and Showtime came of age in era when a subscription video business did not have to compete for attention and dollars with Facebook, Youtube, Netflix and Instagram. Cable Networks like AMC and FX were not yet producing compelling original programming. It was likely easier for a video content business to differentiate itself without so many competing entertainment choices. The quality threshold needed to attract and retain subscribers is increasing. Amidst all the competition, STARZ must distribute enough differentiated and impactful content to continuously justify charging more people more money for a subscription. The ability to tell edgy, uninterrupted, on-demand, cinema-quality stories is a good foundation upon which to define the point of differentiation.
In the mean time, the business has favorable financial characteristics and a great management team. STARZ affiliate fee deals consistently reset at higher rates. The management team will return a substantial percentage of free cash flow in the form of share buybacks. Higher affiliate fees + growth in distribution revenue should add ~5-7% in revenue growth per annum. Another 8-10% in share repurchases should yield earnings growth of ~15% per year. This does not account for any growth in paying subscribers that would accrue from the release of a hit show. It also does not account for any new distribution deals that STARZ might sign to monetize its streaming rights through new broadband distribution platforms. The current valuation of ~9x EBITDA does not reflect a control premium.
A Quick Comment on a Good Scenario for STARZ
As a shareholder in both STARZ and Time Warner, I am going to offer a comment on some wishful thinking. I believe that Rupert Murdoch’s interest in Time Warner was mainly was about HBO. John Malone once said that selling content directly to a customer is “nirvana” for a content owner. HBO is the anchor programming asset that puts a content company in the best position to have a chance to build and sustain a global, direct-to-customer, digitally delivered content business over the next twenty years. HBO has an unrivaled brand in programming quality. HBO is known all over the world. HBO GO is far ahead of any competing premium digital content ecosystem. HBO could have turned Rupert Murdoch from a wholesaler into a retailer.
Eventually, HBO will be valued on the basis of its addressable global subscriber market for a direct-to-customer business. In North America, Netflix is targeting 60-100MM subscribers. There is no reason that HBO would not have the same addressable market. HBO has ~130MM worldwide subscribers.
Right now, it would be incredibly difficult for the executives at Time Warner to voluntarily opt out of the linear distribution model. HBO has predictable, growing revenue, high EBITDA margins, and the ability to redeploy all excess capital back into content development (unlike Netflix, which must invest heavily in technology and marketing).
The problem for HBO is that it cannot grow subscribers because it has hit a plateau in the linear video market. Even with Game of Thrones, the most popular show in its history, HBO is not materially growing subscribers. This means that HBO is not efficiently monetizing it content; consider what Game of Thrones would do for Netflix.
Before HBO goes direct to the customer, I believe Time Warner may face pressure to spin-it-off. HBO has an entirely different economics and growth prospects than the other Time Warner businesses. In 2015, HBO may earn between $2.2-$2.5B in EBITDA. HBO would almost certainly trade near the high-range of all publicly-traded comparable companies-likely at ~15x EBITDA. If HBO traded at 12x EBITDA, a strategic would buy it.
As a standalone company, HBO could make acquisitions that would broaden its portfolio of exclusive distribution rights and improve its competitive position in the direct-to-customer market. HBO’s stock would be a valuable currency, unlike Netflix, which probably cannot use its stock as currency. This may provide HBO a funding advantage as it aims to acquire valuable content assets. This is one advantage of remaining in the current linear video model. HBO can leverage the financial strength that this model provides in order to strengthen its competitive position for an eventual entry into the direct-to-customer business.
STARZ might make a good acquisition target for a standalone HBO. STARZ owns the pay-tv distribution rights to the Sony first-run film output through 2021, including streaming rights. These rights are appreciating in value because Netflix and Amazon are bidding ferociously to secure high-value, exclusive SVOD rights for first run films. HBO and Netflix cannot count on hit original shows to fund and sustain subscriber growth. The business is too fickle. It is safer to control a large, diverse body of high-value, exclusive distribution rights that broadens the appeal of the service to as many customers as possible. Buying STARZ would give HBO ownership of the Sony rights, as well as 56MM North American subscribers and a growing body of original programming. The low marginal cost of distribution would create favorable economics for a large subscription business that can leverage its distribution rights over a broader subscriber base. STARZ could also be positioned as a different type of programming brand within the HBO subscription, thereby giving the subscriber more choice.
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