Is cable television about to bite the dust? Some analysts have been predicting that will be the ultimate result of consumers’ enthusiasm about digital alternatives: every new subscriber to Hulu, Netflix (NFLX) or Amazon’s (AMZN) streaming services increases the probability that that individual’s local cable company will soon have one less customer.
Nonetheless, it came as a shock to find one of cable’s giants putting forth the same point of view in an interview with the Wall Street Journal earlier this month. “There could come a day” that Cablevision Systems (CVC) stops offering traditional television transmission and relies on broadband Internet as its main source of revenue, the company’s CEO, James Dolan, said in the interview.
Does that mean that it’s time to dump your holdings of conventional cable television companies and snap up shares in the handful of businesses that already have established positions in the business of delivering entertainment content to us digitally? The temptation is strong to do just that, especially given the performance of Netflix – the main ‘pure play’ in this space that is publicly traded – over the last five years and year-to-date, on both an absolute and relative basis. Momentum is a wonderful thing – as long as the direction of the change is positive.
The scenario looks compelling in another context, too. While Dolan is preparing for the day that video content moves entirely onto the Internet, and hoping to offset the loss in revenue and profits from a decline in cable television revenues by improving its broadband offerings and expanding the roster of on-demand productions available to subscribers, the fact remains that Cablevision and its peers will be on the defensive. Even if, as Dolan insisted in his interview, he doesn’t like to “fight trends”, the fact remains that if he is correct in his analysis, he and other cable industry CEOs will have to reinvent their business model. That’s not a very attractive position to be in, as traditional newspaper publishing companies have discovered, to their dismay, since the turn of the century.
That’s one reason that Cablevision appears to many as an overvalued industry laggard, trading at about 22 times trailing earnings, more than Time Warner Cable (TWC) and Comcast (CMCSA), at 15.4 times and 17.4 times, respectively. The company’s most recent earnings release didn’t do much to restore confidence among skeptics: even though its earnings doubled, the gain came in part on proceeds from the settlement of a legal action with DISH Network (DISH), and the number of subscribers actually dipped. The uptick in the company’s stock price in the wake of the earnings announcement had more to do with Dolan’s comment that he would “never say never” to future merger discussions, fueling takeover rumors.
TWC Revenue Annual YoY Growth data by YCharts
The fact remains that cable is less and less about television and broadcasting – a fact that Time Warner Cable seems not to have recognized in its battle with CBS Corp. (CBS) over the price that the former should pay for the right to rebroadcast CBS content. For now, CBS may need Time Warner more than the cable company needs it (especially given the oligopoly structure that has left many frustrated cable subscribers unable to dump Time Warner and turn to another cable company in order to watch their favorite CBS shows), but it seems likely that won’t always be the case.
Apple (AAPL), Google (GOOG), Amazon and Netflix – to name only a few publicly-traded companies – all have demonstrated a keen interest in shaking up the way we consume “television” content. For now, advertisers are sticking to the classical model, even as they keep a close eye on these changes, so it’s not likely that the world will change overnight.
But the future for cable companies clearly lies in their ability to convince their customers and their investors that they have a business model that will continue to provide for growth in a rapidly changing universe.
For now, the only way that investors can play the opposite scenario – the triumph of one of these disruptive new models – is via Netflix. True, there are other companies making big investments in the area, such as Apple, but new television concepts make up only a small portion of their business thus far. Google’s new Chromecast device may be a fascinating new way to shift content from your smart phone to your television, but it was only introduced to the market last month. Investing in Google means you’ll get exposure to that part of the company’s business – and any other nifty new ideas its brain trust devises – but it’s not a pure play on this particular kind of disruptive technology.
Amazon comes closer to meeting this test. The company proved it had the ability to shake up another kind of old media business, offering book addicts e-readers and digital book content, and then broadened the functionality of those early Kindle e-readers to the point where they now also serve as ways for their owners to consume music, television and movies – sold, not at all coincidentally, by Amazon. But investing in Amazon also means taking a stake in a more conventional retail business, and one whose management has shown a willingness to invest heavily in such bricks and mortar operations as warehouses, even at the cost of growth in profits.
That leaves Netflix, a company that seems to have successfully navigated its own move from a company on the defensive to one on the offensive against old-model media companies. Launched as an alternative to bricks-and-mortar DVD rental stores, Netflix endured a painful transition and emerged as a threat instead to cable companies, offering a mix of movies and television shows and even showcasing its own productions. The cost of acquiring all that content is an issue, as it is for the ‘conventional’ cable companies, but that simply puts Netflix on a level playing field with its old-model rivals.
Where it has an edge is in its ability to appeal to customers across all geographies, without having to build up a massive infrastructure. True, in some cases, a Netflix customer will be streaming a movie through a cable internet connection – but it will be Netflix, and not the cable company, that gets the additional ‘content’ related revenue.
NFLX Forward PE Ratio data by YCharts
The problem, of course, is that Netflix’s shares have soared as investors have recognized this status. It trades at an almost laughably high forward PE ratio of 162, and an even more surreal level relative to trailing earnings, making the classic PE ratio almost worthless as a valuation metric. That said, while the company’s stock is up 181% so far this year, as seen in a stock chart, earnings per share have quadrupled over year-earlier levels, as of the end of the second quarter, while revenue growth was a healthy 20%, reflecting an increase in subscribers. Analysts have been reluctant to rate the stock a buy – the number of “hold” ratings has soared to 20, from 17 only a month ago – but they’re equally reluctant to recommend that investors sell.
In other words, analysts aren’t going to endorse a momentum investment – one terribly difficult to justify on traditional valuation metrics – but they’re not going to recommend you step in front of a bus and short the thing either. Viewed against Amazon, a fellow disrupter, Netflix can at least claim to have grabbed its market share using service and convenience first. Amazon, which offers plenty of service and convenience, too, has seemed far more reliant on price-cutting to keep its sales growing. Some company with a very deep pocket could, conceivably, decide to buy Netflix, and perhaps that notion adds lift to the stock. So, Netflix may be in that Amazon-Salesforce (CRM) zone: wildly overpriced but likely to keep rising if it keeps growing at a reasonable pace. Go figure. And watch out when bad news hits. 162-times forward earnings leaves a long way to fall.
Disrupters don’t always win in the end; they destroy value, after all. But if you don’t suffer from vertigo, and don’t mind monitoring what is likely to be a long-lasting industry shakeup that could be full of sharp twists and turns along the way, Netflix – however pricey it appears today – may end up feeling like good value down the road. Even some of the analysts who didn’t boost their rating on the stock did increase their earnings estimates, meaning that the outsize PE ratio could contract slightly. And the industry trends suggest that even as companies like Cablevision see subscriber growth dwindle, Netflix is likely to be a big beneficiary.
Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.
