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Sky High

By Jenny Ruth

Saturday 1st November 2003

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 Jenny Ruth
They say it takes 15 years to create an overnight sensation. Give or take a couple of years, Sky Network Television is living proof of the adage. After clocking up losses of $236.3 million in its 13-year history, seeing off all competition in the pay TV market, and infiltrating the living rooms of 39% of Kiwi homes, it's finally payback time.

This year Sky produced only its second profit in 13 years. And while the modest-seeming result of $671,000 doesn't sound like anything to get excited about, profits should grow exponentially from here. Sky looks set to spit out swollen rivers of cash in the next few years. It's little wonder Independent Newspapers (INL) wants to swallow up the 33% of the company it doesn't already own (see "INL reaching for the SKY" below).

Analysts are forecasting a net profit of between $29 million and $47 million for the current year. Rob Mercer, head of research at Forsyth Barr, reckons by June 2005 it'll be turning in a net result of $90.5 million. "This thing's got some serious growth coming," says another.

Given that we've become accustomed to hearing negative figures of that order from Sky over the years, it all takes a bit of getting used to.

Indeed, observers of Sky's fortunes could have been forgiven for wondering if the company would ever deliver. In its relentless drive to increase subscribers and roll out new digital technology, its appetite for cash, through bank debt and then in October 2001 through a $110 million capital notes issue, has been voracious. Year after year, it delivered losses, with the lonely exception of 1999's $4.5 million net profit.

But this year's result shows the hard part is over. The man who has presided over Sky's 13-year "overnight success", first as chief operating officer and then as chief executive from November 2000, is John Fellet, an affable but reserved (so much so that he wouldn't even be photographed for this story) 50-year-old from Arizona. He was working for the world's largest pay TV company, Denver-based TCI, when it and Time Warner joined with former Telecom shareholders Bell Atlantic and Ameritech to form the HBK partnership to buy 51% of Sky in 1991. He was sent to New Zealand to "do pay TV the way God meant pay TV to be" and turn Sky into a cable network - at the time, he held the record in the US for the greatest number of miles of cable laid in a year. The New Zealand assignment was "just supposed to be for 18 months", he says.

But when he got here, he soon realised laying cable in New Zealand was never going to be economically feasible, although several competitors later tried it unsuccessfully. Indeed, the company had already figured out that the most economical way to roll out pay TV in this country was via the ultra high frequency (UHF) network, which the government had begun selling off from the early 90s. Picking up a swathe of UHF through a series of government auctions through the 1990s, Sky by the mid-1990s was beaming into 250,000 New Zealand households.

Although this was impressive growth from a standing start, the problem was that Sky's UHF technology could reach only 75% of the population and could provide only five channels. So in 1998 the company decided to switch from UHF to digital - a big call that would see it clock up losses of $101 million between 1998 and 2002.

At the time, Fellet didn't see the decision to go digital as a big call, although with hindsight he says he would have waited another year before making the move. Sky, along with Rupert Murdoch's British BSkyB, was one of the first pay TV companies in the world to go digital.

In the first year, it cost $1000 per customer to install the digital product, although a year later that was down to about $800. Because few subscribers could be expected to pay such sums, Sky heavily subsidised the dish and decoder installations. The cost has now fallen to $523.

All of this capital spending and lack of profitability added up to a pretty unpalatable offering for retail investors, who were given the opportunity to buy into Sky when it listed in late 1997. "Sadly for us, Sky's never been seen as a good investment by the average mom and pop investor. Retail investors tend to ask what kind of dividend a company is paying. We have to say not only do we not pay a dividend, but we don't make any profits either,"says Fellet.

Not only that, but shareholders equity is razor thin at a mere $56.2 million equity against assets of $477.4 million. But Fellet reckons this sort of number crunching is "antiquated". He says a better measure of value is Sky's market capitalisation, which stood at $1.94 billion in late September. That's against net debt, including Sky's capital notes, of $315.6 million at June 30.

Reaping the rewards
But with the digital rollout complete, the big capital spending is over. From a peak of $153.3 million in 2001, capital expenditure was down to just $86.1 million in the latest year. And with few major new technological developments on the horizon capex is unlikely to spike again as it has in the last four years.

Sky is also in the happy position of being able to generate a steady revenue flow from UHF technology that is, in accounting terms, worthless. "We still have 117,000 UHF subscribers. They're all using decoders that have been completely written off. They don't show up on our balance sheet but we still have that many people writing a cheque every month," Fellet says. (On average, Sky's 117,000 UHF subscribers each paid $40.36 a month in 2003.)

It helps to be a monopoly in the pay TV market too. Back in 1998 when the company decided to go digital, there was plenty of competition. Television New Zealand was looking at going digital and Saturn, later TelstraSaturn, was laying cable in Wellington and later moved into Christchurch, and was talking about expanding further. And Telecom was experimenting with the now defunct First Media.

Five years on, the competition has melted away - TVNZ forced by the government to abandon its digital ambitions and the phone companies realising it's much easier to simply resell Sky than to try to provide their own content. Sky's trump card has always been that it had most of the major sports rights, and in particular its 1996 deal to buy exclusive coverage of the NPC, Super 12 and Tri-Nations rugby. Its standing as a sports broadcaster has gone all but unchallenged, although TelstraSaturn did try to take it on, paying megabucks for rugby rights when it only had about 20,000 customers. The damage to Sky was negligible, and by December 2001 Telstra had settled into a seven-year deal to resell Sky.

Fellet says Sky's decision to wholesale to the phone companies - starting with a trial deal with Telecom in 2000 - is a way of protecting its position. "We've said to Telecom, do you want to be in the pay TV business or do you just want access to pay TV? We think we know exactly what New Zealanders want in pay TV. You don't want to worry about programming."

It all adds up to a pretty indomitable position in the market. So can Sky and its shareholders just lie back and watch the profits roll? There's no sign of such complacency on Fellet's part. He describes his job as first building a castle and then constantly reinforcing its defences - primarily through the quality and targeting of its programmes. Hence the introduction a couple of years ago of female-oriented channels, E and Lifestyle, and the recent announcement of three new channels, UKTV (which will combine the best programming from the BBC, Fremantle International and Granada), The History Channel and the Disney Channel.

But in a market the size of New Zealand, it's not a simple matter of continually adding to Sky's smorgasbord of programming options. At the moment Sky offers 34 television, four radio, 12 audio and five pay-per-view channels, while in the US there are about 300 channels and in Britain 250. Fellet's problem is that he has a maximum target market of just 1.4 million households, compared with the 24 million homes BSkyB can market to, yet satellite costs are exactly the same for both companies.

That means practising what Fellet calls " programming Darwinism" - constant monitoring of viewership, and axing of channels which fail to measure up. Such was the fate of the Australian financial news channel CNBC when it failed to grab viewers' attention. "We've got this pipeline in the home and it's only so big and we want to get as many people hooked up to it as we can. We're going to have to constantly weed out the weak channels."

The strategy appears to be working - subscribers are spending progressively more on Sky services. In 2001, average monthly spend was $48.79; by 2003 it was $51.83. Fellet is confident he can continue to extract more cash from his customers by adding new services. One tool that may help him to do that is the latest digital refinement, the personal video recorder (PVR). This is a smart box that can monitor your viewing habits and, if it notices you aren't watching something you usually watch, it will automatically record it.

"I think that's a great killer application. This will be more valuable than a DVD to most customers," Fellet says, but adds that Sky hasn't figured out the best way to economically roll out the technology (which he picks is at least 12 months away for local viewers).

Churn it down
Not only is Sky becoming more expert at parting customers with their dollars, its record in retaining existing customers is outstanding. Its churn rate (the percentage of customers cancelling the service) is currently sitting at about 14.4% a year compared with around 30% in 2000 and 24-36% for other pay TV companies around the world. Fellet says while having a buoyant economy helps, the key is to try and make Sky ever more valuable to its customers.

It seems to be succeeding in that task - last year subscribers spent 35% more time watching Sky, suggesting the service is becoming an ever-more entrenched part of the average Kiwi's life. "That makes the value relationship a lot stronger. If the subscriber wants to cut spending, they're more likely to cut something else rather than Sky."

Fellet hasn't lost sight of the basics in bedding in Sky's digital service and enhancing the quality of programming - cost cutting has also played a part in the route to profitability.
Programming costs have fallen from 48% of sales in 2002 to 43% in 2003. And, although Sky pays for programmes in US dollars, this result can't be dismissed as a by-product of the high Kiwi dollar. The company has currency hedges a year out, and won't receive any direct benefit from the soaring dollar until the 2004 result.

Fellet is known as a hard bargainer on the programming market. Being the only player in what is, for the programme owners, a peripheral market, he can threaten to walk away from a deal. In fact, he has. Sky used to provide Formula One but gave it the flick when the owner wanted too much for it. "They kept expecting increases because they saw our subscribers going up."

Profitable though it finally is, there's a pervasive sense of frugality about Sky. Fellet jokes about the impact the company's head office in Auckland's Mt Wellington has on programme sellers - the main entrance is a cubby hole on the side of a huge barn-like industrial building, and the modest but adequate executive offices are slotted into a corner of the barn. "It scares them. They go to TVNZ, which is quite palatial, and Channel 3 and then they come here and say: are you sure these guys can pay for the programmes?"
Judging by the expectations of soaring profitability, there ought to be few worries about that.

INL reaching for the SKY
Sky Network Television is currently the target of a takeover offer from 67% shareholder Independent Newspapers (INL), controlled by Rupert Murdoch. Having sold its newspapers, INL is sitting on $754 million in cash, which it plans to use to take out the minorities in Sky.

INL is offering the Sky minorities $3.35 a share plus three INL shares for every 10 Sky shares. Telecom, which also owns 10% of INL, has accepted the offer for its 12% Sky stake.

Sky's independent directors have rejected the offer as too low.

Rob Mercer, head of research at Forsyth Barr, says the offer is only acceptable to those, like Telecom, that are also INL shareholders. He values INL shares at $5.10 and Sky at $5.17, and estimates the maximum value Sky shareholders can realise from the current offer is $4.90 a share. If the current offer succeeds, INL's valuation will rise to $5.18. "It goes up because they're getting Sky on the cheap," Mercer says.

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