14 March 2014
By Jeff Thomson, Nick Griffin and James Tsinidis
“Content is where I expect much of the real money will be made on the Internet, just as it was in broadcasting.”
Bill Gates, 1996
After 25 years the internet continues to change all our lives, every day. Indeed it is no exaggeration to say that it is the most powerful structural change of our times, creating and destroying businesses on a daily basis regardless of the normal economic cycle. The implications for the media industry in particular are potentially profound.
Total media consumption continues to grow
Media consumption has been steadily rising ever since the launch of commercial television in 1941, however the internet has recently marked not only an acceleration in total consumption, but more importantly a significant change in the way media is consumed.
But the way we consume media is changing
The explosive growth of tablets, smartphones, and now “smart” televisions, combined with access to high speed internet, and new technologies such as video on demand and digital video recorders, mean that for as little as $7.99 a month (the cost of a basic monthly subscription to Netflix) you can binge consume an entire series (or more) in a single sitting…and increasing numbers of people are doing just this. Netflix recently took the decision to release all thirteen episodes of the second season of House of Cards at once and not only was it a huge success, but amazingly 16% of Netflix subscribers at one US cable company watched the first two episodes, and a further 10.6% watched the first three episodes, by 5:30pm on the first day of release!
Binge consumption of media is increasing
Moreover with multiple viewing devices in every household, there is no more fighting over the remote control. Every member of the family can enjoy their own personalised viewing experience, both inside and outside the home, at a time of their own choosing; and contrary to initial expectations this has not eroded the power of the encumbents. In fact with internet network effects and binge consumption the big winners are getting even bigger. Shows such as Breaking Bad, House of Cards and Game of Thrones are rivalling Hollywood blockbusters for audience and impact, which themselves continue to grow share especially with franchises such as Iron Man, of which Iron Man 3 was last year’s biggest movie and the fifth highest grossing movie of all time.
While there is a sense of inevitability about the shift towards a more flexible online-centric media world, it remains unclear how the new business model will work. The so-called “over the top” services such as Netflix, Hulu and Amazon Instant Video are often held up as “killers” of traditional media. We don’t believe this is correct. As long as content owners continue to successfully control and smartly allocate distribution rights, it shouldn’t matter how this content is ultimately distributed to the consumer. Content was at the heart of the traditional broadcast model and we believe it will remain at the heart of new internet media. This is demonstrated by Netflix’s recent decision to significantly increase their own investment in content; indeed they expect to invest $3bn in content in 2014 alone.
It also appears that if you own the best content then digital consumption provides additional revenues, rather than cannibalizing existing TV revenues. Witness the annual NFL rights (see chart above); on top of recently inking a $5bn p.a. deal with the major TV networks (an approximately 63% increase on the previous deals), Verizon is paying them $1bn over 4 years for exclusive rights to stream games to mobile. This comes just after signing a five year $400m deal with Microsoft for streaming to their Surface tablets. In short, increasing consumer choice of mediums to consume media, means that media consumption is rising and the best content owners are clearly beginning to monetise this opportunity.
The pricing power of premium content owners is best illustrated by looking at the growth in affiliate fees (which are fees paid by cable or satellite companies to the content owner/distributor, basically representing a share of the monthly subscription fee end consumers pay). Figure 6 below shows the growth in affiliate fees at Walt Disney over the last ten years; even more than the actual growth rate, it is the consistency that stands out; growing at an impressive 11% p.a. right through the financial crisis in 2008/9. This segment represents 50% of Disney’s media network revenues and 22% of total group revenues. It also means that the importance of advertising, an intrinsically cyclical revenue stream, has been diluted. While advertising has grown in absolute terms, its’ growth rates have significantly lagged those experienced in affiliate fees.
Walt Disney Company – Consistently high growth in affiliate fees has diluted the exposure to advertising
These secular changes have reduced the cyclicality of the industry and allowed large media groups to enjoy a positive feedback cycle of increased revenue visibility, investment in content and pricing power. We believe that this is a structural change which is currently underappreciated by the market.
All of the companies shown above are potential beneficiaries of these trends, although we believe the Walt Disney Company, a top three position for our funds, is one of the best plays on this. Synonymous with Mickey Mouse, Disney has now grown into a content bohemoth including ABC, ESPN, the Disney Channel and A and E Networks (including the History and Bio channels). Its studio division built around Walt Disney Studios, also includes Pixar Animation Studios (Toy Story, Finding Nemo, Monsters Inc), The Muppet Studios, Marvel Entertainment (Blade, X-Men, Spider-Man, Iron Man, Thor, The Incredible Hulk and The Avengers) and Lucasfilms (Star Wars; Indiana Jones). It also owns or licenses 14 theme parks around the world.
Moreover the significance of the acquisitions of Marvel (acquired in 2009 for $4.64bn) and Lucasfilms (acquired in 2012 for $4.04bn) have yet to be fully appreciated by the market. Not only have they enhanced revenue visibility for the group, (with Star Wars VII, The Amazing Spider-Man 2 and Avengers: Age of Ultron all due to be released in 2014/15); their back catalogues have also significantly enhanced the long term earnings power of the group.
After another strong set of results, analysts have recently upgraded their earnings estimates for Walt Disney again and the PE multiple remains relatively undemanding versus history, as well as given its strong growth and improved earnings visibility. 21st Century Fox is another large media conglomerate which is likely to benefit from the same trends and is also currently an investment in the K2 International funds.
The structural changes occurring in new media are likely to increase the pricing power and improve the revenue visibility of the large media content owners; and Disney is a primary beneficiary of this trend. We also believe that the market is only just beginning to appreciate this and consequently the PE multiple is likely to continue to re-rate further. Content currently makes up approximately 10% of both the K2 Select International and K2 International Opportunities funds. Investments such as these, which are leveraged to strong secular changes and growing somewhat independently of the normal economic cycle, are typical of our process at K2 International.
If you would like further information about the K2 International Strategies, please contact a member of our distribution team on 03 9691 6111 or visit k2am.com.au.
DISCLAIMER: The information contained in this presentation is produced by K2 Asset Management Ltd (“K2”) in good faith, but does not constitute any representation or offer by K2. It is subject to change without notice, and is intended as general information only and is not complete or definitive. Please note that past performance is not a guarantee of future performance. A product disclosure statement and additional information booklet or information memorandum or general information on the funds referred to in this presentation can be obtained at www.k2am.com or by contacting K2. You should consider the product disclosure statement before making a decision to acquire an interest in the fund.