Starz: Original Programming Revolution at a Price

Starz has attracted the attention of investors due to its apparent cheapness against other cable networks. Any relative valuation is by its nature inexact, but the discount here is clear:

This discount is justified by a weak competitive position, something that bulls, at least in part, would not deny. Starz lacks negotiating leverage with distributors, and is in the midst of a risky transition toward original programming.

Negotiating Leverage
Starz is the third largest premium cable network with just under 22 million subscribers. HBO, which is owned by Time Warner (NYSE: TWX), has around 28 million subscribers, and Showtime, which is owned by CBS (NYSE: CBS), has around 22 million. Starz is usually priced at the same level as Showtime, and both are priced at a substantial discount, as much as 40%, to HBO. Including all the other subscription units, such as Encore, does not change this position.

The structure of this category makes it hard to compete. HBO is clearly the leader and has substantial pricing power. According to Susquehanna, 90% of households that have premium cable have HBO. For distributors, premium channels are a useful source of revenue and the premium that HBO obtains is highly attractive. For the other players, distributors can always trade them off against each other. Any threat to go elsewhere from Starz is pretty weak, as distributors can just offer Showtime instead. HBO's lead makes it difficult for anyone else to obtain pricing power in negotiations.

In these negotiations, distributors can choose either fixed rate or variable rate (also known as 'consignment') agreements with Starz. Under fixed rate deals, distributors pay an annual fixed license fee. Under variable deals, distributors pay for each customer. The upside under fixed rate deals is limited, although marketing expenses are lower as the onus is on the distributor to increase subscribers.

Most fixed rate deals are made with large cable MSOs that tend to grow slowly, if at all. Variable rate contracts are made with growing MVPDs, such as Verizon or DirecTV. These contracts align Starz with distributors and any upside from subscriber growth is shared. As 60% of subscribers are fixed rate, it seems that future growth is limited. Growth in variable deals has been strengthening year-over-year and recent renewals seem to have been more favorable, but the number of fixed rate deals remains a headwind.

So clearly the picture here is of a company facing some headwinds with little pricing power with customers. Why? Why is HBO so far ahead?

Original Programming
The big difference with HBO and Showtime is ownership and original programming. Both HBO and Showtime can use the scale of their parents to negotiate better affiliate fees. More importantly, HBO has 77 hours of original programming, Showtime has 69, but Starz has only 38.

So the key reason why Starz has no negotiating leverage is the lack of original programming. The majority of current programming is output deals with Disney and Sony. HBO and Showtime make output deals with studios too, but Starz really relies on them. Distributors view film content as replaceable, while consumers can watch the same films on DVD, and they could have already seen the films at the cinema.

Again, if a distributor loses Starz, they just put in Showtime with HBO, no big deal. Output deals do not make Starz indispensable. The value of moving to original content has been demonstrated at AMC, which previously showed old movies but transitioned with series such as Mad Men and Breaking Bad. To gain pricing power, Starz needs to undergo a similar transition.

Starz has been forced into making this move by the loss of the Disney output deal to Netflix (NASDAQ: NFLX). Netflix paid around $350 million, an increase of $100 million to what Starz is estimated to be paying annually. Content will only start coming up in 2017 for the deal, but pressure on renewals will likely increase in the run-up without any new content. There may be pressure on a renewal with Sony too, although competitors are likely to recognize how important it is to Starz and back off, though maybe not before making Starz pay. Either way, Starz will add 40 hours of original content by 2017. If the company has not transitioned by then, it will be in trouble.

Starz currently lacks negotiating leverage, both with customers and suppliers, which is why Starz will continue to trade at a discount to the sector. Inhibiting any improvement is the current structure of the industry and the company's strategy, which focuses on output deals with Disney and Sony. The company now clearly has to change this strategy.

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