BSkyB - a cheap price to pay?

British Sky Broadcasting (LON:BSY) stands at the center of a storm sweeping the film and television industry. Consumers are using the internet to access content directly threatening the role of middlemen like BSkyB. The speed of this transition is only limited by the capacity of the UK broadband network. Although I am sure people do not read for my thoughts on industry trends I will try to briefly outline what I think as it is an important part of my view.

First, it is not worthwhile for the potential BSkyB investor to debate the business model of the so-called "over-the-top" (OTT) providers like Netflix or Lovefilm. These businesses work and will fundamentally change the industry. Distributing content over internet is effective, cheap, and hands a great deal of power to the consumer granting choices about what they have access to and when. Moreover, as these business add subscribers they will be able to pay up for more, higher-quality content. Or so the thinking would go. In reality, the trend towards internet distribution has handed more power to producers and set off a fierce competition for content.

The films and TV shows that a Netflix or Lovefilm offer OTT are not new and in the case of Channel 4 content, for one, rights are not necessarily exclusive. The sheer fact is that they do not have access a lot of content, especially the new stuff. Pay-as-you-go services like Apple and Sky have the latest films locked up. Rental services, like Lovefiilm, are also competitive here but they do not have fast access to content. Of course, we are leaving out sport. Sports leagues in the US are ahead of the trending offering OTT services in markets where the rights for certain fixtures have not been sold locally (for example, in the UK one can subscribe to NBA.tv). There is potential for this method of distribution to cause problems for companies like Sky however, no-one can pay up like a Sky or an ESPN for these events. New distributors like Netflix are doing a great job and offer a cheap, easy-to-use alternative however, these companies live and die by their access to content. In a lot of cases, it isn't clear if they can reach the number of subscribers needed to challenge incumbents in smaller markets like the UK.

Sky KPIs:

Sky fits into this picture as the dominant force in content. In 2011 Sky spent around £2.2bn on content. Pay TV competitors such as Virgin Media or BT do not have the scale to buy any content at all and have to pay Sky for access. It is worth highlighting this latter move was forced by a 2010 Ofcom, the UK communications regulator, ruling forced Sky to offer its programming to competitors. The core of Sky's advantage in content is the scale of the subscriber base. As of December 2011, Sky TV had 10.25m subscribers (and 4.38m wholesale subscribers) whilst Virgin Media had only 3.76m subscribers (some of these will be wholesale Sky subscribers). It is difficult to find accurate estimates of the number non-pay TV but it is probably somewhere between 10-13m. The non-pay TV offering in the UK is quite strong with Freeview and, later in this year, Youview. However, this base of subscribers mean that competition with Sky from pure UK companies is impossible (of course, companies like ESPN are involved in the market for UK sports).

BSkyB wasn't always this dominant and it just recovering from the rather turbulent conditions of rather decade. In 2001, the company was at its lowest point with net debt roughly 7x EBITDA and massive amounts of goodwill which subsequently proved to be worthless (Kirch PayTv being the 'headline' £1bn write-off). Over the next few years, it concentrated on paying down debt and wrote off the vast majority of goodwill. BSkyB also turned around its receivables account which proved to be a large source of cash through this period of retrenchment. The company appears to have learnt some lessons and has made better acquisitions and uses far less leverage. Shareholders are now set to reap the benefits of this move. BSkyB has increased dividend payments and has bought back roughly £400m of shares of the £750m program approved last November. For reference, net debt stood at roughly £615m as of December 2011 whilst free cash flow was £1.2bn (significantly above net income also).

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BSkyB has also shown a clear understanding of its competitive advantage and the way the industry is changing. It is cutting back-office costs to reinvest in programming. It has done this through transferring services online, attempting to resolve issues the first time they arise, and improving product reliability. The acquisition of its set-top box maker was an important part of this strategy however, this could prove to have been a step too far as this kind of technology could become redundant. Replicating BSkyB's figures is tricky but the company appears to have taken out around £200m of costs over the past three years which is very respectable give that sales/subscribers have grown significantly over that period.

The company has also displayed a clear understanding of industry changes by moving into the 'on-demand' area. The first product, SkyGo, is not as 'on-demand' as a Netflix but allows subscribers to access SkyTv anywhere, from mobile devices or online. What will prove to be more interesting is NowTV, this allows people who are not already subscribers access to Sky content 'on-demand' either on a pay-as-you-go or subscriber base requiring no contract or equipment. As already mentioned, this threatens a substantial portion of Sky's existing business and it also could cannibalize existing subscribers. What I like though is that this move utilizes Sky's key advantage, it has the fastest access to the best content. This move should allow further penetration and should strengthen Sky's advantage in content by growing the subscriber base. The question is whether "producers" of content will allow Sky to maintain the advantages it currently holds. If so, then the rest of the OTT industry is pretty much done. Regardless, I think this move shows management understands the industry and Sky. Change may prove painful but Sky is the leader.

The bear case for BSkyB could highlight two points. One, room for further growth. Two, the future of regulation. On the former, it is clear that the strong free offering in the UK inhibits payTv growth. What is more average annual growth in DTT homes over the past has been slow at roughly 2%. Sky's base has grown faster which suggests it is taking share but it is clear that Sky is never going to significantly outpace DTT growth. The company will benefit from increased HD penetration over time (or increased ARPU generally) but I would highlight broadband, and triple play, as another likely source of future growth.

Broadband is more competitive and is subject to constant changes in market share. At the moment, BT, the old UK telecoms monopoly, is the largest player with just over 6m subscribers. The other two major firms, besides Sky, are TalkTalk and Virgin Media which, unlike BT and Sky, have achieved little in the way of growth over the past few years with roughly 4m subscribers each. Sky is catching up with just over 3.5m subscribers however, what is notable is that this level was achieved from 0.5m in mid-2007. It is difficult to get exact figures due to constant M&A activity but we can assume that roughly 60% of the increase in the total broadband market over the past couple of years was captured by BT and Sky alone (Sky was obviously off a much smaller base). The industry is still developing with unbundling and the development of fibre being the most notable changes but Sky's advantage so far has been due to its "triple-play" offering. Again, Sky understands its strengths  in payTv and is now trying to exploit them in broadband. The development of NowTV may actually allow even more room to pursue this strategy.

The other point mentioned was regulation. My view is that the company has quite a bad reputation with regulators and Ofcom, UK regulator for communication industries. In particular, in 2007  the company became embroiled in a case with the UK Competition Commission after taking a stake in broadcaster ITV to block a takeover by rival Virgin Media. Cases like this have clearly damaged Sky's reputation. The News Corp phone-hacking scandal has given Ofcom a chance to scrutinize Sky and they are looking at whether the company is 'fit and proper' to hold a UK broadcasting licence. It seems unlikely that this will lead to anything but it is clearly not good. On better news, the Competition Commission in a probe of the UK film market concluded that Sky's position was not restricting competition. Regulation is a difficult area to understand but it is important for Sky's future.

The key point to highlight then, in conclusion, is that Sky has a strong position in the UK market in an industry which grants considerable economies of scale. It is exploiting this advantage in every area and although huge changes are sweeping the industry it may be that the case that Sky actually benefits from these changes. The question is then about how valuable this advantage in content will prove to be. A core assumption of this case is that most 'producers' of content will never self-distribute, whatever changes in technology I think this will continue to be so. Therefore, Sky can only benefit from increased competition for content as it is the strongest player with the most subscribers. The current valuation of around 14x earnings and 9x free cash flow seems like a cheap price to pay for this scenario.