The Business: The Slippery Slope of Cord-Cutting

Issue 55 - The Slippery Slope of Cord-Cutting: Illustration
Josh Tulman

As pay TV subscriptions decline, a top analyst explains how media stocks could suffer — and how bad the revenue loss to basic cable networks could be.

It’s official: The pay television industry lost nearly 130,000 subscribers during the third quarter. That’s on top of a second-quarter slide that marked the first contraction in U.S. history. These modest losses of cable and satellite customers might be attributable to the weak economy and a sluggish housing market, but there is growing concern that the numbers also might indicate early signs of “cord cutting” — the industry’s feared phenomenon of consumers canceling pay TV service in favor of alternatives, including online offerings like Netflix. In reality, cord-cutting and the economy are not mutually exclusive; less disposable income could be prompting consumers to check out and ultimately adopt cheaper online alternatives, for example. The result could be an overhang on the stocks of major entertainment companies, which are heavily dependent on the value of cable networks. Here’s why:

1. The Root Cause

What makes the pay TV business susceptible to disruption is a declining value proposition for consumers. The average number of TV channels available in homes has more than doubled from 63 in 2000 to 128 in 2009. But the average home still watches only 38 channels a week, compared with 28 in 2000. Moreover, the monthly cost of pay TV has risen 7 percent annually during that time, well above the general rate of inflation. Thus, the growing gap between the cost of pay TV and actual usage might be creating a vacuum at lower price points, causing a segment of the population to reconsider its options.

2. 'Good Enough'

At the same time, inexpensive online offerings have emerged, and services like Netflix have the hallmarks of a disruptive technology: They’re cheaper (Netflix unlimited streaming costs $9 a month, and Hulu recently dropped its prices to compete), simpler (a clean user interface, recommendation engine) and more convenient (access through multiple devices including TVs, iPads and PCs). These Internet video offerings also don’t have to be perfect substitutes for pay TV’s thousands of hours of content; they just have to be “good enough” to satisfy what consumers want at a particular moment. In the near term, streaming services like Netflix probably appeal to modest-income homes or light TV viewers, but disruption usually starts at the fringes, and “good enough” can get better over time.

3. The Hidden Risk

The risk to pay TV distributors such as Comcast, DirecTV and their competitors from lost subscribers is well understood. The hidden danger, though, is that this phenomenon could be problematic for such basic cable networks as Viacom’s MTV, Time Warner’s TNT, Disney’s ESPN and News Corp.’s Fox News. Fewer pay TV subscribers means lower affiliate and advertising revenue for these channels. Fixed operating costs also could exacerbate even a moderate decline in subscribers. For instance, we estimate that a 10 percent decrease in subscribers and revenue for a cable network could negatively affect cash flow by about 20 percent. Networks that own the TV shows they air and that focus on scripted content, which has a longer shelf life, are likely best positioned over the long run.

4. Wild Cards

We are still in the early stages of cord-cutting, and there are many variables that have yet to play out. Perhaps the media industry’s TV Everywhere initiative can blunt this risk. Maybe Netflix is just a complement to traditional pay TV services, and all of this could be much ado about nothing. Or possibly consumption-based billing for broadband could stymie online video usage.

Time ultimately will tell, but in the near term, stocks of the media conglomerates, which are highly dependent on the value of cable networks, might lag until there is more clarity.

Spencer Wang is managing director and head of U.S. media and Internet equity research at Credit Suisse. This article is a summary of his views in the published reports “An Uncertain Time for Big Media”and “The Innovator’s Dilemma and Pay TV.”