The Destruction of TV Begins: British Sky Broadcasting

We believe British Sky Broadcasting (“Sky” or “BSY”) is an attractive short at current levels. We think BSY’s fair price should be between £5.50 and £6.00, or c. 25% below current levels.

Sky dominates the UK Pay TV market having enjoyed almost 10 years of nearly monopolistic position. There are approximately 25m households in the UK and Sky has over 10m DTH customers. Approximately 10m households in the UK don’t have Pay TV (they are on Freeview) and the other 5m or so are a combination of other non-Satellite (cable) Pay TV (like Virgin Media, BT and Talk Talk) and newly launched subscription DTT / OTT (Netflix, Lovefilm and Now TV). Sky therefore has c. 40% market share of UK TV market and c. 72% of UK Pay TV market.

Sky basically doubled its number of customers in the last 10 years, from ~5m in 2002 to over 10m today. The long investment thesis on BSY in the past was (rightly) predicated on the following virtuous cycle that the company managed to ride year after year: A growing number of customers joining Sky looking for better content compared to free to air (FTA) television. BSY growing in size, therefore allowing it to invest incrementally more into content. In financial terms, this meant on the one hand sustained ARPU inflation and on the other hand continuous content cost deflation. This economic model led to ever expanding margins and high cash flow generation that was either used to reinforce this virtuous cycle or returned to shareholders.

We believe that this virtuous cycle is now broken and we are about to enter a vicious cycle for BSY that, in our mind, will play out in the following way:
(1) DTH net additions is about to turn negative. This is due to the market being saturated on the one hand combined with increased competition from OTT
(2) Content cost deflation is over. We expect both sports and movie content cost to accelerate going forward
(3) Increased competition means price pressure. We expect ARPU to significantly decelerate going forward
(4) The combination of the above would lead to fall in margins and to a de-rating of the stock, which in our mind should lose its premium valuation to the sector.

No Growth
We estimated that this current year (FYE June 2013) net additions will be approximately 50k and will turn negative from next year. There are 2 main reasons for this. First of all, we think the UK DTH market is very mature and near saturation. The second, and more important, reason is that competition from OTT will take market away from Sky. Google TV, Apple TV, Netflix and Lovefilm (owned by Amazon) were all launched in 2012 alone.

Content Cost Inflation
Sky recently renegotiated its Premiership rights for the 3 years 2013-2016. The new negotiated price represented a 40% inflation compared to previous 2010-2013 prices. This massive price inflation was caused by BT bidding for the same content for its OTT YouView product. In the past, Sky was virtually the only buyer of these rights (in 2007-10 a few channels went to Setanta and in 2010-13 to ESPN) but never like in 2012 we have seen such competition for content. In fact BT managed to secure rights for 128 Premiership games. We see this trend continuing as more entrants to the UK market will compete for premier content. Al Jazeera and Google were both rumoured to be potential bidders and we wouldn’t be surprised to see more names to the bidders list in 2015, as the 2016-2019 rights are sold. We see this trend to continue also in movies.

Broadband
We believe the notion that broadband customer growth will in some way mitigate the loss of DTH customers is completely erroneous. Sky has over 4m broadband customers and has been the fastest growing cable provider in the UK in recent years, doubling the number of subscribers in the last 3 years alone. The bulls would want to have broadband additions to replace DTH losses. The problem with this theory is that the economics DTH and broadband are completely different and, unfortunately for SKY, DTH is a significantly more profitable business than Broadband.

Cracks Appear
We have already seen the first signs of cracks in the Sky model. For the first time ever, we expect potentially flat TV ARPU this year since discounting has become rampant. Subscriber Acquisition Cost (SAC) are going through the roof as management is struggling to attract customers (note that Sky needs to find c. 1.2m customers a year just to stay still, due to relatively high churn). Anecdotal evidence points to desperation on the side of Sky (apparently if you decide to cancel the contract that has 1 month notice, on the 30th day Sky will call you offering you ½ price on your contract to stop you from leaving).

Valuation
BSY trades on 8x EV / EBITDA 2015 estimates, where we see downside to estimates. Consensus is above us with EBITDA at £1.8bn against our £1.7bn. Comparable company VMED, that we’d argue should trade at premium to BSY, trades on equivalent (i.e. adjusted for different year ends) EV / EBITDA of 5.1x.

To be conservative, we attribute a premium to BSY valuation with fair 2015E fair EV / EBITDA multiple of 6x. Using such multiple we get to a valuation in the £5.50-6.00 range. We therefore see 25-30% downside from current levels.