Marketing drives BSkyB's revenues

Similar to its first fiscal quarter, British Sky Broadcasting reported great revenue results for the first half, but at the expense of higher costs. We will be maintaining our 587p fair value estimate. Total revenue increased 10% versus our expectation of 6% for the full year. The firm is doing a great job selling additional services, which has significantly increased its average revenue per user (ARPU), with 18% of its subscribers now taking pay television, broadband, and telephony services. In addition, 40% of new customers have signed up for more expensive high-definition packages, leading to an annualised ARPU of £492, an 11% improvement from a year ago.

However, the successful sales have been driven by higher costs. Marketing costs jumped 22% year-over-year, and programming costs increased 9% as the firm added additional sports rights. While sports programming is one of the company's keys to success, the higher costs fit our concern that competition for licensing is increasing and BSkyB will have to pay up in order to maintain its stranglehold on sporting rights.

We continue to be impressed with the success the firm has had in attracting new subscribers and selling premium packages in the midst of the worst recession in the UK in decades. BSkyB also announced that high-definition converter boxes will be the standard going forward and it will eat the additional cost. While we think this will allow the firm to continue to ramp up sales, we are concerned about the costs and the firm's ability to recoup them in the future through higher pricing.

Fair value estimate: 587p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow

Thesis
(Last updated 22/10/2009)

BSkyB has performed admirably in the face of a weak British economy, as the firm has continued to grow its subscriber base recently. We believe this performance demonstrates the high value consumers place on its services despite the large amount of free content available in the country.

BSkyB has done a great job of aggregating some of the best content available and then marketing its services. More than a decade ago, the firm began to enter exclusive deals to carry major sporting events in the UK. While it resells much of its sports content on to other television carriers, it maintains exclusivity on enough that hard core fans must come to it for full viewing. In addition, it acquires rights to many first-run movies and US-produced series, which are becoming increasingly popular in the UK. While BSkyB's main competitor, Virgin Media, has posted pretty stagnant video subscriber numbers for years, BSkyB continues to grow nicely. In addition, it is selling additional services, such as high-definition television, DVRs, second set-top boxes and video on demand services. All of these increase ARPU without much additional cost.

In addition to television, the firm is now offering broadband and phone services. While these businesses are growing rapidly, they are a distant third to Virgin and BT Group, the incumbent telephone operator, in size. These businesses are also currently losing money. BSkyB clearly doesn't have the scale in broadband and telephony that it has in pay television services, which we believe detracts from its competitive position. Despite the losses in these areas, the firm continues to generate substantial cash flow, which we expect will increase as the new businesses gain some scale going forward.

While we expect the firm to successfully continue to grow, we are concerned about regulatory action and increased competition. Ofcom, the telecom regulator, has stated it thinks the prices at which BSkyB resells content should be lower and regulated. If it succeeds in its desire, BSkyB's profitability will be in jeopardy. On the competition side, Setanta Sports--an Ireland-based media company that owned rights to show a third of UK football matches--recently went bankrupt, putting this content up for grabs. Disney's ESPN was the highest bidder for Setanta's rights, and we believe this move provides a solid toehold into European sports that will make ESPN a more potent bidder for future sports offerings. In addition, we think Virgin Media, BT, and other Internet access providers like France Telecom, Telefonica, and Vodafone increasingly recognise the importance of controlling content. Several of these firms have significantly deeper pockets than BSkyB. At the least, we expect this competition will increase the amount BSkyB has to pay for content in the future.

Valuation
We are maintaining our fair value estimate for BSkyB at 587p. We continue to expect only about 6% revenue growth in fiscal 2010, with only a modest rebound thereafter, allowing revenue to grow about 6.5% annually over the next five years. Growth will be driven from a combination of new subscribers, particularly for high-speed Internet access and phone services, and price increases. We expect continued cost-cutting and increasing scale in the Internet access and phone businesses will enable margins to improve. We estimate the operating margin, before depreciation and amortisation, will increase from 21% in fiscal 2009 to around 26% in fiscal 2014.

Risk
The biggest risk facing BSkyB is whether it can sustain its hold on the best television content in the UK. Although it historically has done an impressive job in this respect, we are concerned that increased competition makes it unlikely the firm will be able to continue to dominate content in the same manner it has in the past. Other risks include the amount the firm might pay in order to maintain its control of content and the success of its new broadband and telephony businesses. The new businesses are much more competitive than pay television, and BSkyB still has a long way to go to turn the businesses into profitable ventures. Ofcom has also stated that it should regulate the prices it charges other pay television operators for its content. If this ruling is enacted, it would likely have a material negative effect on BSkyB's revenue.

Management & Stewardship
Rupert Murdoch and his family control BSkyB. The family owns about 40% of the stock and Rupert was CEO until 2003 and chairman until 2007. His son James took over the two positions when Rupert stepped down. When James took over the CEO role, there was a lot of concern in the market that he had limited experience and the company would suffer as a result. He surprised the market by competing well and further growing the business. When he took over the chairman's role, he turned over the CEO position to Jeremy Darroch, who had been the firm's CFO. Prior to joining BSkyB in 2004, Darroch spent many years in the finance departments of retailer Dixons and Proctor & Gamble. We like the mixture of fixed and variable pay the firm's executives receive and think the amount is reasonable considering the size of the firm. However, we would like to see more independent directors. Only seven of its 14 directors are independent in our opinion. Between the lack of independent directors and the control of the Murdoch family, minority shareholders have little influence on the direction of the company.

Overview
Growth: We expect revenues at BSkyB to increase because of the rapid growth in its broadband and telephony businesses. The firm should also continue to grow its pay television customer base. However, we expect the current recession to slow growth during fiscal 2010 to 6%.

Profitability: BSkyB is solidly profitability despite losing money in broadband and telephony. The firm has been paying higher amounts to win sports content, but the pay television business remains very profitable, generating returns on capital well above its cost of capital.

Financial Health: The firm has negative equity and £1.8 billion of net debt, but we think it is generating plenty of cash to handle its debt load.

Profile: BSkyB is the only satellite television operator and largest pay television provider in the UK with 9.4 million subscribers. It has the best content, particularly with sporting events, which allows it to charge a premium price. These include the majority of games in English and European football, as well as rugby and cricket matches. The firm also offers broadband and telephony services, where it has 2.2 million and 1.9 million subscribers, respectively.

Strategy: BSkyB's strategy is to dominate the UK pay television market and to add ancillary services. The firm has more than twice as many pay television subscribers as its nearest competitor and is using its dominant position in content to not only take customers from its competitors, but also to convince people that haven't seen a need for pay television service to sign up. One way it is doing this is by adding bundles of broadband and telephony to its TV service.

Bulls Say
1. BSkyB has more than twice as many pay television subscribers as Virgin Media, the cable operator in the UK.

2. The firm has the best content, especially for sporting events in the UK, including football, rugby, and cricket.

3. BSkyB added additional games from the Scottish Premier League starting this year and will add more from the English Premier League starting next year.

4. The firm is adding new broadband subscribers faster than any other operator in the UK.

Bears Say
1. Competition for television content is increasing. At a minimum this will increase the costs BSkyB has to pay for content and potentially could cause it to lose its lock on major sporting events.

2. Ofcom is cracking down more from a regulatory perspective. It has ruled BSkyB must reduce its ITV stake to below 7.5% and is trying to regulate the prices at which BSkyB resells its content to other operators.

3. The firm is losing money in its broadband and telephony businesses. These businesses are also much more competitive than the pay television market.

4. The Murdoch family controls BSkyB, and their objectives may not be in alignment with minority shareholders.