Sky is falling

Sunday 1st July 2001

Sky founder Craig Heatley and Roger Armstrong agree on one thing: Sky's just not as sexy as it used to be

Heatley, Farmer and Gibbs - they're smart, and they've been selling. But Murdoch knows about TV, and he's been buying. Who's right? Is Sky a superstar of the future that will reap huge benefits from being the digital gatekeeper to the home? Or is the pay-TV operator likely to continue to struggle to turn a profit, hampered by the low New Zealand peso and the eventual arrival of meaningful competition, as former Sky investors Craig Heatley, Trevor Farmer and Alan Gibbs seem to be thinking?

Personally, I stand closer to Heatley and company than media mogul Rupert Murdoch - and I'm not just talking about personal worth. Sky's current financial performance is so poor that its share price can only be justified if the company has fantastic growth this coming decade. In the long run, though, the competitive environment and technological advantages Sky currently enjoys may dissipate.

If history is a teacher, Heatley and I must be reading the same textbook. Sky, financially speaking, has continually disappointed the market since listing.

Supporters of Sky point to the company's medium-term opportunities, which are good, admittedly. Sky is clearly going to be in an enviable position for a while - an effective monopoly in the pay-TV area, with the content Kiwis want (rugby, rugby, rugby and some dirty movies), interactive capabilities (email over TV and the ability to buy products by clicking a button) and an established subscriber base.

When Sky listed, the sponsoring brokers predicted that it would make a profit of $56 million in the year to December 2000 and $81 million in the year to December 2001. In contrast, Sky is likely to make a loss in the $45 million to $50 million range for its June 2001 year. Sure, the currency has gone against the company big-time, but that doesn't explain the difference between expectations at listing and the outcome. When it listed, analysts thought Sky would be able to grow fast and "leverage" its existing cost base, thus achieving a dramatic rise in operating margins. The theory was that after a certain number of subscribers, additional ones would bring in big profit.

In hindsight, this assumption was flawed. Sky has had to invest strongly in programming to keep subscriber growth going. Until Sky improved its programming content, with the acquisition of cricket, soccer and more movies, it had a very lean subscriber growth period, adding only 44,000 subscribers between December 1997 and December 1999 (an annualised growth rate of about 7%).

But here's a remarkable thing: the investment community just love this turkey. Take its losses. The story put about by Sky and swallowed whole by many investment professionals is that the losses are caused by the channel subsidising the rollout of its digital platform. This is debatable. Consider this: when you sign up for the digital service, the box and installation costs Sky, in round figures, $750. You pay $199 (incl GST) - a "subsidy" of around $570. The profit-and-loss effect? Sky books the $177 (ex GST) to revenue but capitalises every bit of the cost to the balance sheet. End result? In 2001 Sky will get about $20 million in profit from "subsidising" the installation of digital boxes.

Biggest worry

That's a tidy profit, but not enough to offset some worries for Sky. Take the benefits gained by upgrading customers from the old top-of-the-line UHF service to digital. The old package cost about $50 a month. The new digital package, with two movie and two sport channels, costs $62 a month. Sky gets about an extra $128 (ex GST) a year out of these clients - not great when you remember the box will be due for replacement after five or six years, that Sky should be looking for a 15-20% pre-tax return on its investment, and that the digital service costs around $20 million a year to transmit (around $80 a subscriber at current levels). And the customers demand expensive extra programmes each year. Since almost all its programming comes from overseas, this is where the effect of the New Zealand peso kicks in.

To make the game plan work, Sky is going to have to extract reasonably large amounts of revenue out of its customers by selling interactive services. Currently this means pay-per-view movies, which to date have been reasonably successful (particularly the adult movies offered through the Playboy and Spice channels), but Sky has big plans to offer more interactive products. Email (no attachments) via TV is set to arrive within the next month or two. This is unlikely to be a big revenue earner but should drive subscriptions. Children's games, interactive gambling (bet on a rugby test as you watch) and home shopping (order your pizza for half-time) should all be with us within the year. Judging by UK standards, Sky will be looking to extract 6-8% of any transaction originated through the TV.

Interactive TV could be bigger than Texas. It will almost certainly be bigger than e-tailing; unlike your computer, your TV is likely to be in the main living area, probably always on, unlikely to crash due to the latest Sino-US hack attack, or time out due to a slow phone line. But, and here's the important bit, interactive TV will have to be bigger than Texas for Sky to dig itself out of the $40-$50 million profit hole it has found itself in.

At the nub of Sky's profit problem is the fact New Zealand consumers are getting a fantastic deal under the company's current pricing structure. The majority of Sky's costs are programming, and the majority of programming costs are in US dollars. Since the dollar tumbled from over 60 cents to 40 cents, Sky has only implemented inflation-like price increases. It has hugely increased the quality of programming (cricket, soccer, movies and so on) and given us crystal-clear reception via satellite.

I would suspect that the quality of service New Zealanders get, relative to the US dollar price we pay, is very good, internationally speaking. Unfortunately, we are a poor country and might not pay more if asked. Neither might enough of us adopt Sky to justify its current share price. It certainly wouldn't surprise me if penetration tops out at well below what analysts are forecasting, simply due to New Zealand's poverty.

Competition

Which brings us to the other big long-term issues. Most brokers' discounted cash flow valuations rely on the so-called "terminal value", calculated by extrapolating cash flow for the next 10 years, to generate the vast majority of Sky's value.

Right now Sky more or less has a monopoly. This means Sky doesn't have to fight for customers, and it doesn't have to enter a bidding war to secure good content. This will change. TelstraSaturn fired a shot over Sky's bows when it grabbed the rights for the All Blacks' end-of-season tour. And TelstraSaturn will almost certainly force Sky to pay more for rugby league rights, currently being renegotiated.

In five years' time, TelstraSaturn is likely to have extensive fibre-optic networks in Auckland, Wellington, Christchurch and Dunedin, and TV distribution to the rest of the country via satellite. In those major metropolitan markets it may well have a business relationship with 40-50% of households it passes (though it won't pass all homes) through its telephone offering. Expect a substantial effort by TelstraSaturn to secure the rights to All Black rugby - at what price to Sky if it succeeds?

Sky is well run with a fantastic current market position, but to justify a $1.4 billion market capitalisation (when currently making losses of $45 to $50 million) its future will have to unfold perfectly. Penetration must keep rising for a long time, customers must buy heaps over the TV, the New Zealand dollar must rise and the technological environment mustn't shift. You need to be a braver man than I to bet on all these coming right.

Roger Armstrong is a financial analyst. He owns no shares in Sky TV.

Roger Armstrong
rogerarmstrong@clear.net.nz

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