Veteran analyst Spencer Wang, at Bear Stearns, Monday lowered his rating on the sector to market underweight on the bet that the terminal free cash-flow growth rate for the group will drop from 3% to 2%. With digital revenues and international growth inadequate to offset the economic risks to their anchor television networks and film studios, media conglomerates will have less profit to offset cyclical and permanent revenue losses.
The difference from past cyclical downturns is such incremental risks to 2008 earnings that are now part of the entertainment and media industries' new economic reality--to which they are struggling to adjust their legacy infrastructures, costs and expectations. They just haven't adjusted their legacy infrastructures, costs and expectations. Wang said the industries have reached a "tipping point" that poses a key question: Whether broadband is killing the TV star. "In our view, there are emerging signs that growing online usage is beginning to cannibalize core television viewing," he said.
Until now, flat-to-rising household TV usage was no real threat to earnings. "However, recent data points on TV viewing and HUT are more disturbing," Wang said. In calendar 2007, HUT is down 1.2% from 2006 for the first time--without a change in the Nielsen measurement sample. TV's core selling demographic (adults ages 18 to 49) has seen HUTs drop 2.5% from a year ago, even when adjusting for the new live, same-day and DVR ratings, that collectively underestimate the erosion. "We find it more than coincidental that declining TV usage is occurring in tandem with broadband Internet penetration reaching mass market levels" of more than half of U.S. homes, he said.
Broadband's mass-market adoption is why there are no guarantees that former advertiser spending and viewership levels will ever be restored or sustained. "As usage declines, media companies have fewer units to sell to advertisers, which offsets unit price increases," Wang explained. Historically, traditional media have simply suffered losing share as a percentage of total ad spend. Today, the steady growth of emerging online media is increasing its share of overall ad spending at the expense of more traditional media. That means any decline in TV usage now could permanently reduce its share of ad budgets as those dollars shift to new media.
Although the impact of this negative swing will be blunted by increased ad spending driven by the Beijing Olympic Games and the presidential election in 2008, the fundamental changes in consumer and advertiser support across all media are set in motion.
If that weren't enough, the media conglomerates are about to sustain a major blow with the waning of the home video business, which has been the single biggest revenue and profit contributor to filmed entertainment growth during the past decade. Wang estimates the home video typically accounts for 50% of a studio's total revenues, and an even higher portion of profits, given 60%-plus cash flow margins and most of the related marketing costs going to the theatrical exhibition window.
In fact, it is ironic that the DVD market is undergoing the same decline and shift phenomenon that is beginning to roost in network television. DVD hardware has close to 90% penetration of U.S. TV households, making it a mature market. Fewer new DVD homes and a steady decline in existing ones will inevitably put pressure on unit pricing as consumers shift spending to new content alternatives. High-definition DVDs are not likely to re-accelerate growth, since Hollywood remains fiercely divided on a format, which causes more consumer confusion and defection. As a result, Wang estimates that the $24 billion domestic home video market will decline as much as 4% annually over the next five years. Wang estimates that U.S. consumer spending on home video through the first three quarters of 2007 declined 3.5%, totaling about $15 billion for the major studios combined.
Another important dynamic that makes this economic downturn different is that sources of future growth revenues are not yet geared up enough to compensate for losses. Recent moves by film studios and television networks to widely disseminate their content on the Internet won't offset slowing growth in their core businesses.
Wang points out that digital revenues are minimal compared to overall sales, and not likely to move the needle in the next several years. Generating digital ad sales for repurposed content online "has not materially changed the top-line growth rate, given the conglomerates' large base of legacy revenues," Wang said. Even as digital revenues grow annually at a compounded rate of 20%-plus, entertainment companies will strain to achieve an overall 5% to 6% annual growth rate over the next five years. For instance, newspaper companies have successfully grown their digital revenue base, yet have been unable to offset erosion in their core print advertising business.
Moreover, the international expansion that entertainment and media companies are working on is not materializing fast enough, given the higher risks of execution and competition. While international revenues currently account for about 26% of the total revenues for the four major media and entertainment conglomerates (with News Corp. as the most prominent presence), the rate of annual growth remains modest, Wang said.
All things considered, the entertainment group is selling at an average 8.2 times earnings multiple, with the entire entertainment sector lagging the overall market, he said.
Wang is not alone. In September, Goldman Sachs analyst Anthony Noto downgraded the entertainment sector to cautious, betting that a greater-than-expected domestic economic slowdown will negatively impact advertiser spending and corporate debt. His recession risk scenario anticipates as much as a 10% decline in advertising revenues--which would hurt all entertainment companies, and especially players like CBS, with a 70%-plus revenues dependence on traditional advertising. For those still wondering how bad it can get, consider this: Neither analyst's report factored in the potential hit to revenues and profits that entertainment companies will sustain from a protracted writers' strike.