By James Faulkner and Richard Gill
“We’re going to be led by what we see the customer wants,” said Sky CEO Jeremy Darroch in 2014.
So far, his appraisal of the situation has been that the UK consumer is not clamouring for quad-play. However, clearly Sky only has one piece of the puzzle missing – a mobile phones operation – and it would seem foolish for the firm to leave this stone unturned for long, especially given that arch-rival BT recently re-entered the mobile space with its takeover of EE (subject to review by the competition authorities). Perhaps realising this, Sky announced a deal in January to piggy-back on TelefónicaUK’s O2 network via a MVNO (mobile virtual network operator) deal commencing in 2016. Whether or not this will be sufficient in order to compete with the newly merged BT/EE, which has the advantage of owning its own network infrastructure, remains to be seen.
Unsurprisingly, Sky’s core strength remains its unrivalled content offering. Its market leading position was recently bolstered via last year’s acquisition of Sky Deutschland (SD) and Sky Italia (SI), which makes it the largest Pay TV player in three of the four largest European markets. The principal opportunities created by the combination of these assets are, in Sky’s own words, an “enlarged growth opportunity”, “benefits of scale” and “significant synergy potential.” Clearly, Europe represents a major growth opportunity given its relatively low levels of penetration versus the UK; pay TV penetration in the German/Austrian and Italian markets stands at c.19% and c.28%, respectively versus c.50% in the UK. The enlarged business will also become the biggest content buyer in Europe with a total budget of £4.6 billion, giving it a clear edge when it comes to differentiation via content. In addition to these benefits, management expects the deal to generate c.£200 million of synergies by the end of the 2017 financial year (at a one-off cost of £150 million).
The flagship of Sky’s dominant content offering is its stranglehold over the UK Premier League, although this is increasingly being challenged by BT of late. The latest bidding round saw the two companies stump up a whopping £5.1 billion for the rights for the three years beginning in the 2016/17 season, versus £3 billion under the current agreements. Although Sky managed to slightly improve its offering, securing 70% of top pick matches (versus just 53% under current arrangements), there is a sense that this could prove to be a pyrrhic victory in light of the huge cost – a 69% increase in price per season to £1,392 million – which came in ahead of most analysts’ expectations. Although the enlarged Sky is certainly in a better position to absorb the extra cost, management certainly have a job on their hands if they are to meet their promise to offset this with efficiency savings through the “Digital First” initiative.
What’s it worth?
In terms of the fundamentals, the SD/SI transaction was financed through a placing (156.1 million new shares/c.10% of the company’s equity), new debt facilities and cash resources (recently boosted by the disposal of Sky’s 6.4% stake in ITV for £481 million and the £600 million proceeds from the disposal of a majority stake in Sky Bet) and is expected to be “at least” EPS neutral in the second full year of ownership (FY2017) and “strongly accretive” thereafter. However, debt has almost doubled as a result of the acquisitions, which has led to a downgrade from rating agency Moody’s to Baa2, the second lowest investment grade, albeit with a “stable” outlook. The current broker consensus is for earnings per share of c.55p for the year to June 2015, rising to c.65p in 2016. This implies a current rating of 19.7x (based on a share price of 1,087p at time of writing), falling to 16.7x for 2016. There is also a decent prospective dividend yield of 3.1%, rising to 3.4% for 2016.
While we don’t see these metrics as overly demanding given Sky’s obvious quality, competitive advantages and growth potential, the challenges are certainly beginning to stack up. First and foremost, BT now represents a serious competitor to Sky in the Pay TV market – an area where it had hitherto enjoyed a virtual monopoly – albeit with Sky remaining the clear leader in terms of content. In addition to this, Sky is now a more highly geared entity, which means that extracting the aforementioned cost savings and synergies is all the more imperative. And thirdly, it isn’t all that clear that growth in Europe will be pain-free, as German and Italian consumers have remained stubbornly reluctant to subscribe to Pay TV services for some time now.
Overall, we offer a ‘neutral’ view on Sky, but it’s worth noting that 21st Century Fox retains a 36% stake in the company and its president Chase Carey said at the end of 2014 that he could not rule out a new bid for full control of the company in the future.
The rise, fall, and rise of BT
As the FTSE reaches a new record high, not seen since 1999, it seems timely to remind ourselves of how BT has performed since those heady days of the dotcom boom.
At the turn of the century the firm was the second largest company in the blue-chip index, commanding a 7% weighting as telecoms firms were at their peak, investors willing to pay more for those involved in the internet revolution. The shares hit their all time high on exactly the same day as the previous FTSE high on 30th December 1999, being valued on a heady multiple of 31 times historic earnings. But as the technology bubble burst BT went with it, the shares losing 82% of their value over the next three years – the firm also announcing a monumental pre-tax loss of £1.6 billion for 2001 after writing off £3 billion of goodwill, a deeply discounted £5.9 billion rights issue and a halting of the dividend.
BT trundled on, making decent profits in the high £2 billion levels in the years leading up to the financial crisis but never retaining its high rating, investors being concerned by high competition, high levels of debt and the largest defined benefit pension deficit of any UK listed firm. But a number of recent developments, driven by CEO Gavin Patterson, have brought BT back to life from an investment perspective.
A new lease of life?
In 2012 BT, somewhat unexpectedly, took on rival Sky by snapping up the rights to 38 live Premier League games and launching its BT Sport channel. The rationale behind the deal was that consumers increasingly want to buy both broadband and TV services from one provider, thus providing huge cross selling opportunities within its existing customer base. BT have made the sports channel free to broadband customers – helping to reducing customer churn, attract new customers and encourage existing customers to buy more BT products.
This was a bold move, described by some as aggressive and costly, especially given that the cost of £256 million per season for the rights was expected to have a negative effect on short-term profits. The gamble looks to be gaining traction however, with the firm announcing in its 2014 results that the BT Sport service was in 3 million homes as part of a broadband package and in another 2 million via wholesale deals.
BT’s desire to further strengthen its content offering has been further demonstrated, with the company winning the joint rights to show the FA Cup from 2014-18 for a reported £25 million a season and exclusive rights for all UEFA Champions League and Europa League games from 2015/16 for three years, for £299 million a season. Then in February came the headline grabbing news that BT had bagged the exclusive live rights to 42 Premier League matches for the 2016/17 to 2018/19 seasons, for an increased cost of £320 million a season.
BT has clearly shaken up the market with its investment in content rights. However, the jury is out on just how successful this will be given the huge investment being made.
Perhaps a more compelling move on a financial basis is recently announced transformational takeover of EE, which gives BT a mobile capability in the UK which it lost after spinning off O2 in 2001. The two companies agreed definitive terms at the start of February, with BT looking to buy the business for £12.5 billion. In what looks like a compelling deal, given the minor overlap between services, the acquisition gives BT 31 million customers, 24.5 million being mobile customers, and an additional 834,000 broadband customers.
Not only does BT get those customers at a stroke but synergies of around £360 million are expected in the fourth year following completion, which BT calculates is worth a net present value of £3 billion after integration costs. There are obviously huge cross selling synergies as well, with BT planning to sell its broadband, fixed line services and pay-TV services to EE customers. These revenue synergies are estimated to be worth another £1.6 billion on a net present value basis, with the whole deal expected to be accretive to earnings in the second year following the acquisition.
However, there is one big threat to the EE acquisition not going ahead, with it being subject to approval from the UK Competition and Markets Authority, the review expected to complete before the end of March 2016. Of course the deal has its critics, not least from major competitors such as Vodafone, whose CEO Vittorio Colao said if the deal goes ahead it would create “The new, old BT”, referring to the company’s previous monopoly dominance of the UK fixed line market. Perhaps one likely outcome will be that the deal will go through but that BT is forced to sell or spin off its Openreach business, which enables other telecoms companies to access its network. This should open up competition in this area of the market given that most of the UK’s mobile and broadband operators, including the likes of Vodafone, and TalkTalk, are Openreach customers.
What’s it worth?
With new life having been breathed into the company BT shares have performed well over recent years, currently trading up by 549% from their 2009 nadir. The shares currently trade on a multiple of 14.2 times consensus forecasts for the financial year to March 2016. They also offer a reasonable yield. In Q3 results released in January BT reconfirmed that it intends to grow its dividend per share by between 10% – 15% in both the current and 2016 financial years, regardless of whether the EE deal is completed. On balance, we believe that these figures look reasonable value for a company which has clear growth plans. And should the investment in sport and the EE deal pay off, then there is the potential for significant upside.