The Media sector is more or less evenly split between three different sub-sectors: Publishers; Media Agencies; and, this article’s focus, Broadcasting & Entertainment.

The International Monetary Fund’s decision to downgrade global economic growth forecasts for 2014 and 2015 is not good news for media stocks given the historic correlation between gross domestic product and advertising spend. Accordingly the sector as a whole has crashed in recent weeks and is down 6.1% year-to-date.

With shares in British Sky Broadcasting (BSY) - the largest constituent of the broadcast space - looking short of catalysts in the near-term we take a cautious stance on Broadcasting & Entertainment. Yet we do see some bright spots in the second tier, most notably UTV (UTV) where the market appears not to have picked up on the company’s near-term opportunity in the Republic of Ireland.

Over-saturated UK market

We have long been fans of the visibility provided by Sky’s pay-TV model but to quote Peel Hunt analyst Alex DeGroote the business now looks ‘maxed out’ in the UK. It has already driven up earnings by offering customers more than one core service (many taking so-called triple play services of broadband, phone and TV) or signing them up to additional add-on subscription products. Average revenue per user (ARPU) - a key performance indicator for the business - stands at a record level of £576.

If the business becomes more of an ex-growth utility (and earnings per share growth for June 2015 is forecast at just 3%) a prospective price-to-earnings (PE) ratio of 14 looks more difficult to justify. Particularly when you factor in a growing debt pile and costly battle with BT (BT.A) for rights to screen live Premier League and Champions League football in the UK.

The premium afforded to these rights reflects the fact that sport remains one of the few types of broadcast content which guarantees a substantial live audience. The price for the latest rights deal - covering 2013-16 - rose 70% to £3 billion when it was announced in 2012. Given the intense rivalry between BT and Sky the price is likely to be substantially higher again at the next auction in 2015. Virgin Media, which has asked media regulator Ofcom to investigate the spiralling cost of rights, expects a 60% bump.

Given that backdrop, the group’s expansion into European markets with much lower levels of pay-TV penetration (and cheaper domestic football rights) makes sense and on 4 October shareholders gave the nod to a £7.4 billion consolidation of its sister companies - Sky Italia and Sky Deutschland - to create Sky Europe.

According to research group IDATE only one in five German households pays for premium TV channels compared with one in two in the UK and both Sky Italia and Sky Deutschland have much lower ARPUs than their British counterpart.

But it could take several years for the group to fully execute on this opportunity given the regulatory and administrative obstacles. We see little reason to get excited about Sky and believe it is vulnerable to a de-rating- even if it remains fundamentally an excellent and well-run business.

The European expansion will notably involve substantially-elevated gearing - with the company expecting a net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio of 2.9 to 4.0 times for the enlarged group against 0.75 times in the June 2014 financial year. A first quarter trading update covering the three months to 30 September is scheduled for release as this issue of Shares hits the shops (16 Oct).

Retransmission opportunity

Having increased 11-fold on its March 2009 low and with its stock trading on 14.2 times 2015 consensus earnings per share (EPS) of 14.5p it is reasonable to ask if there is anything left on the table for investors in ITV (ITV). For now we think the £8.3 billion cap is fairly priced, though a pledge alongside interim results (30 Jul) to increase the dividend by 20% over the next three years may go some way to maintaining investors’ interest.

The company has clearly executed on the ‘Transformation Plan’ unveiled in 2010 which included aims on international expansion and exploiting content across multiple platforms as well as the usual cost-cutting agenda.

The next leg to the ITV story could be provided by the retransmission opportunity. It is arguing the likes of BSkyB and Virgin Media should pay to show its channels ending what it describes as a ‘multi-million pound subsidy’ to pay-TV providers. A report commissioned by the broadcaster looked at the US example and the chart shows the increasing contribution retransmission fees play across the Atlantic and the relative stability of this revenue stream compared with TV advertising.

As Liberum noted in a piece of research last year: ‘Retransmission revenues are effectively 100% margin, so even a relatively small amount of revenue can create a disproportionate impact on the bottom line. There is no extra cost associated with charging pay-TV operators for carriage of the channels - it is a pure subscription fee.’ Liberum analyst Ian Whittaker says: ‘£1 per month per TV subscriber for ITV1 could generate in the region of £140 to £150 million a year’.

Virgin and Sky have already signalled opposition - so will it happen? Investec thinks it will but only in a few years: ‘We assume retransmission fees can be a natural shift for the UK, but this will take time and must include BBC in the UK, so 2017 at least given the new BBC Royal Charter negotiation in 2016.’

Takeover chatter continues to fire ITV shares. Liberty Global (LBTYA:NDQ) - parent of Virgin - snapping up Sky’s 6% stake for £481 million in July, has prompted speculation it will bid for the rest of the group.

Expansion plans

More material upside is on offer at one of ITV’s offshoots - UTV which broadcasts the network in Northern Ireland. Probably better known in the rest of the UK for its Talksport radio brand, from January 2015 the company will have the rights to show premium ITV content - including shows like Coronation Street and Emmerdale- in the Republic of Ireland. It is worth noting the main rival commercial broadcaster in the Republic - TV3 - will retain the rights to shows like Downton Abbey and X Factor.

Investment in the launch of the new channel will constrain earnings and the venture will initially be loss-making. At 212p, UTV is on a 2015 PE of 13.4 based on Peel Hunt’s forecast EPS of 15.8p but this falls to 10.4 times for 2016 once this initial expenditure is out of the way.

Peel Hunt values the opportunity south of the border at £40 million with a recovering economy likely to have positive implications for advertising revenues. Alongside the recent headline downgrades to global GDP forecasts by the IMF there was also a notable upgrade to Irish growth estimates. The GDP growth number pencilled in for 2014 has been upped from 1.7% to 3.6% and in 2015 from 2.5% to 3%.

Operational gearing is also likely to have a positive impact as the company has significant fixed costs associated with its transmission equipment. In addition, in the event of ITV being bought, any potential acquirer is likely to want to gain control of the entire network making a take-out of UTV likely.

On this basis UTV’s Scottish cousin STV (STVG) may also offer some scope for a re-rating, particularly now the uncertainty created by the Scottish independence referendum (18 Sep) has abated. Trading on just 8.9 times 2014 earnings per share of 37.4p, half-year results (28 Aug) revealed pre-tax profits up by a quarter to £8.4 million and there was movement on the balance sheet with Numis forecasting debt will be less than 1.5 times EBITDA by the year end. This is allowing the company to be more generous with its shareholder payout.

STV declared a 2p interim dividend with guidance for 6p in 2014 as a whole and 8p in 2015. Outside of the revenue it derives from TV ads, STV continues to develop its digital businesses with revenues from these up 16% to £2.2 million in the first half. It wants to expand into adjacent areas (through local stations for Glasgow & Edinburgh and city-focused apps) and build its production offering.

Generating content

Obviously Sky, ITV and even, on a smaller scale, STV and UTV generate their own content but there are firms in the sub-sector which concentrate exclusively on the production or distribution of entertainment. The most notable name is Entertainment One (ETO). We highlighted the stock’s attraction early on - flagging the business at 29.5p in August 2009 (Cover, Shares, 6 Aug ‘09) on the basis of its UK and Canadian distribution rights to the hugely popular Twilight series.

The company, whose shares now change hands for more than 300p, has continued to choose well on content - securing a 50% stake in the lucrative merchandising rights to Peppa Pig and has notably forged a strong position in the film distribution market.

The group paid a maiden dividend of 1p in May and the development of its higher-margin TV arm positions it to take advantage of the number of viewers who stream content through subscription services like Netflix and Amazon Instant Video. Moderating growth - with Investec forecasting EPS expansion of 7.5% for March 2015 against nearly 30% in the last financial year - puts the stock on 14.1 times prospective earnings.

In the same article five years ago which featured Entertainment One we also highlighted the potential for studio operator Pinewood Shepperton (PWS:AIM). It has similarly enjoyed a significant re-rating in the interim - the shares up 250% to 522.3p as it has benefited from major films like James Bond title Skyfall and the upcoming Avengers: Age of Ultron being filmed on its lots in the UK.

The group finally has the green light to expand its filming facilities around London through the £200 million Pinewood Studios Development Framework after opposition from local residents held up a plan first outlined in 2011. The business enjoys significant barriers to entry, demand for its studio space continues to look robust, and its shares are underpinned by a substantial asset base but that is more than reflected in a rating of 43 times forecast March 2015 EPS of 12.1p. Anything less than a stellar set of interims on 26 November could prompt a sell-off in the shares.

Media - Broadcasting & Entertainment
[buy_or_sell s]

SUMMARY

We are cautious on BSkyB given the length of time it could take to execute on European expansion and - given its weighting in the quoted Media space - by extension take a negative view of the sub-sector particularly in light of a more uncertain economic outlook. There are some opportunities further down the food chain of which UTV appears the most compelling.

British Sky Broadcasting

(BSY) 893p

[buy_or_sell s]

Market value:£15.4 billion

Prospective PE Mar 2015: 14.0

Prospective PE Mar 2016:12.7

Pinewood Shepperton (PWS:AIM) 520p

[buy_or_sell s]

Market value: £256.9 million

Prospective PE 2014: 43.0

Prospective PE 2015: 40.9

UTV (UTV) 212p

[buy_or_sell b]

Market value: £205.9 million

Prospective PE Jul 2014: 14.0

Prospective PE Jul 2015: 13.4