Traditional Media Playing Defense. Time to Short the Sector?

"There is little the media companies can do to stop the havoc that the Internet is wreaking on their traditional business. They can slow the drain of profits for a while. But eventually, the companies will have to come up with new business models a little more adventurous than what was unveiled on Wednesday." - Wall Street Journal, Heard on The Street.

That to me was the most insightful section of the Wall Street Journal article discussing the Time Warner / Comcast TV Anywhere proposal announced on Wednesday. However, it was insightful not for only what it said but for what it left out. That is, the havoc the Internet is having on business models of what I refer to as the "traditional Internet companies" - Google, Yahoo, eBay, Amazon, MSN, AOL, and IAC. Of the group of seven, Amazon's business model is the most exposed to massive disruption. That's a tease to an upcoming write up on what I foresee as a head-to-head competition by the Internet's two most stable companies with one coming up on the losing end.

But first, Time Warner and Comcast announced plans to test TV Everywhere with 5,000 customers starting in July. Comcast video subscribers will be able to access shows from TBS and TNT, with more added later, for free over the Internet or on demand. Time Warner has been testing authenticated online access to HBO shows in Wisconsin for the past year.

The offer of cable shows online without charge to existing cable subscribers is an obvious defensive move to stem what I see, and as the article points out, as a huge consumer shift from cable/satellite pay TV in favor of content delivered online. I believe that the current recession/depression has permanently changed consumer consumption patterns with many trading down to less costly retail and media purchases. Add to that the 10-15 million unemployed, and we have a scenario where many consumers will strongly evaluate their needs versus their wants and chose to alternate from convenient luxuries such as pay TV towards free alternatives on the Web.

My write-up and graph several months ago about an economic reset captures this scenario.

Clearly that scenario is not showing up in the subscriber numbers today. DirecTV delivered 1.2 million subscriber gross addition and 460K net additions in the first quarter of 2009, the most gross ads since the third quarter of 2004 and the most net ads since the first quarter of 2005. Rival DISH Network, delivered 653K gross additions but netted a loss of 94K subscribers, however most went to DirecTV due to DISH's challenges such as customer service, technical, marketing, and lost AT&T subs. On the cable front, Cablevision lost 6K basic subscribers but added 9K digital subscribers in the first quarter of 2009; Comcast lost 78K basic subs but added 289K digital subs; and Time Warner Cable bucked the trend by adding 36K basic subs and 121K digital subs. Verizon FiOS netted 299K video subs in the first quarter.

Solid as these numbers appear today, there is trouble ahead for all within the pay TV chain, including the cable/satellite operators, the cable programmers, and to a lesser extent, content owners. As the article points out, there is a plethora of free content options on the web today such as Hulu, YouTube, TV.com, the broadcast networks owned websites where they post free content, and Apple iTunes where consumers can purchase individual episodes. The article left out options like Netflix and Amazon VOD which offer cheaper viewing alternatives to pay TV. Piracy is also lurking in the background and is very prevalent but very much ignored by the press and the media companies.

What will occur in the coming years is the disruptive power of the Internet reducing the economics of the traditional media players. Cash flows will start to diminish. Pay TV operators will slowly bleed subscribers as these subscribers access the web through their television sets and see no reason to, in essence, pay for TV, i.e, eliminate in-home cable connections. I believe that Americans will access the Internet through their TVs, which will connect through Wi-Fi, Wi-Max, DSL, or through a broadband connection. Viewers will be able to surf the web options mentioned above from a remote control device while sitting on a couch in their living rooms, at their desktop at work, or on a mobile device while traveling. Cable programmers will in turn see their distribution/affiliate fees paid to them by the pay TV operators shrink. For the cable programmers (&content owners) there won't be enough online advertising dollars from the move online to offset lost advertising and subscription fees. Even DVRs will be unnecessary as one will be able to quickly find replays of content by surfing the web from their TVs, putting TiVo's business model at risk. The 45-day DVD-to-VOD window will eventually collapse.

You will see cable operators, who are the most at risk, step up their campaigns to push usage caps on Internet video usage to curtail the defections. However, their efforts will ultimately be in vain due to public opposition and the competitive threat from DSL and WiMax.

What happens now? I am not advocating blanket short position on all media stocks because the disruption will take time to play out. In the meantime, media businesses are likely to chug along largely un-phased.

The writer suggested that "Time Warner and Comcast should offer an online-only option for consumers, so channels won't automatically lose viewers among people cutting off their video subscriptions." That can work.

What I see more is massive consolidation in the media space. The satellite operators will likely disappear into the arms of the telecom companies like Verizon. If government permits (a big if under the anti-trust focused Obama administration) cable operators will see the need to merge. The big content guys like Viacom, Walt Disney, Time Warner, and NewsCorp, who are already reeling from the pain of Internet disruption on their hugely profitable DVD businesses, will feel more pain. The good news in media is that out-of-home entertainment such as movie theaters is defensive to the secular threat from the Internet's disruptive impact, because of the need for people to leave their homes and offices. Further, the 72 foot wide and 53 foot tall IMAX screen experience is difficult to replicate in the home.