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Media M&A is about to heat up

In early 2000, an Internet giant called AOL bought a content giant called Time Warner. The delivery of movies and TV programming through the Internet was supposed to be just around the corner. A few months later, the stock market peaked. A few years later, AOL took a goodwill write-off of $99 BILLION.

How could movies via the Internet fail?


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Though AOL was the undisputed leader in Internet access, it was DIAL-UP access. My kids don't even know what that is. Watching a movie on that bandwidth was just not going to happen. In addition, only half the country had Internet access and broadband was in its infancy. The looming recession, bursting of the stock-market bubble and culture clash between the two companies made what sounded like a great idea, in hindsight, one of the WORST mergers in stock-market history.

By the year 2000, only 7 percent of the global population had Internet, with roughly 400 million users. Today, roughly 45 percent of the global population, or 3.3 billion people, have Internet access. And, many of them have it in the palm of their hand — on their iPhone or other smart-phone device.

That's led to a massive shift in the viewing habits of consumers: In 2013, for the first time ever, consumers spent more time with digital media than TV. Video exceeds half of global consumer Internet traffic and traffic from wireless devices exceeds traffic from wired devices. Advertising dollars also moved onto the Internet. We view this as the core revenue growth driver for the next several years for most Internet companies as advertising dollars shift to mobile online devices.

The question becomes: How do you most effectively get these dollars? You have to have content the consumers want to watch. You may not know who PewDiePie is, but if you have teenage boys like I do, they will. He earns over $10 million per year and has 35 million followers who watch him … play video games. I don't get it, even though I like playing video games. But as I am told regularly, "Dad you are so old."

So was AOL wrong? No. Just too early. The distributors of the content have already started to bulk up to get more viewers and drive down the cost of the content they are distributing. Over the past year, we have seen an unprecedented roll-up in the content-distribution space: AT&T buying DirecTV, Chartered buying Time Warner Cable & Brighthouse, and Altice buying Cablevision, to name a few blockbusters.

The TV broadcast stations are also bulking up, with Media General recently offering to buy Meredith and Nexstar offering to buy Media General. The broadcast stations also view size as a way to improve their negotiating leverage with the major networks.


So what is happening with the content producers? Since the failed attempt mid-last year by Fox to buy Time Warner, not much. The content producers have the advantage in that they actually make the stuff that we all want to watch. Having said that, as more over-the-top services are launched with skinny bundles, the bigger you are, the better. If you only have a handful of hit shows, you may be excluded from a slimmed down package of channels for $40-50 a month but if you have a lot of shows, then your odds are much better of being included.

We believe many of the smaller content players are likely to be acquired over the next 12 months to 24 months. The interesting thing is that the buyers for media companies are broadening from just other large media companies to Internet providers and telecom-service providers. Verizon, after increasing their subscriber heft by buying out their joint venture with Vodaphone, just beefed up their content by buying AOL, which owns the Huffington Post among other sites.

It would not surprise us to see Softbank, Googlel, Netflix, Verizon and AT&T to be acquirers or take significant stakes in media companies in the future.

As for possible takeover targets, I view any company with a market cap under $50 billion as a potential target. EVERY SINGLE ONE.

The interest isn't just U.S.-based. In 2007, China box-office revenues were close to $1 billion; by 2014, they were $5 billion; and by 2017, they will be nearly $10 billion — or almost the size of the U.S. market. However, to get access to the Chinese market, only a certain number of films are let in each year through a quota system. To become one of the chosen few, a working relationship with a Chinese firm/the government is the preferred path. Last month, Warner Brothers announced a joint venture with China Media Capital which also did a joint venture with DreamWorks in 2012.

The big Chinese Internet firms — Alibaba, Tencent and Baidu — are also investing heavily in content to drive users to their sites. Last week, Alibaba made a $4.6 billion offer to acquire the 82 percent of video-streaming site Youku that it did not already own.

Softbank and Sony in Japan are two other foreign players that are likely to be involved in any future media consolidation. Softbank already has a big distribution network through their ownership of telecom assets including Sprint in the U.S. and also has investments in Internet assets such as Yahoo Japan and Alibaba. Sony is trying to more effectively monetize their content through online distribution which so far has not been very successful.

Unfortunately, on a fundamental basis, as ratings continue to decline as more users spend time with social media applications like Facebook, Instagram, Vine, SnapChat and Twitter, there is less time being spent watching professionally produced content on traditional TV. As a result, earnings for the media companies in general are under pressure. Even the mighty Disney saw subscribers decline at ESPN for the first time ever. Live sports was supposed to be immune to the pressures of over-the-top service and cord-cutting. As a result, investing in many media companies has not been good in 2015, with most still down 15-35 percent from their 52-week highs as can be seen in the table below.

Company
Mkt.
Cap $B
Stk Price
10/18/2015
Return
YTD
% from
52W High
Disney 183 $108.24 15% -11%
Time Warner 59 $72.02 -16% -21%
21st Century
Fox
59 $29.48 -23% -25%
CBS 21 $43.18 -22% -32%
Viacom 20 $49.75 -34% -36%
Discovery
Comm.
18 $28.49 -17% -24%
Liberty Media 13 $38.80 10% -4%
Scripps
Networks
7 $56.08 -25% -32%
Lions Gate 6 $41 28% -1%
AMC Networks 5 $73.95 16% -15%
Starz 4 $38.98 31% -16%
Dreamworks 2 $21.15 -5% -29%
         
S&P 500   2,033 -1% -5%
Source: Bloomberg

The upcoming earnings season is also likely to have its share of disappointments, which investors should be appropriately wary of. Our view is that a basket of the smaller high quality media companies, over the longer term, is likely to generate solid profits as M&A activity heats up over the course of this next year.

We believe the recent acquisition of AOL and Youku is just the tip of a very large wave of consolidation that is coming between content providers and content distributors. The merger between AOL and Time Warner in 2000 may not have succeeded, but it looks like it is time to fire up the DeLorean and go "Back to the Future."

Commentary by Dan Niles, founding partner of AlphaOne Capital Partners and senior portfolio manager of the AlphaOne Satori Fund. Previously, he was a managing director at Neuberger Berman, a subsidiary of Lehman Brothers.

Disclosure: AlphaOne and Dan Niles have an investment position (either long and short or through options or other derivatives) in the following names that were mention in the article: FOXA, FB, DIS, VIAB, DISCA, SNI, LGF, STRZA and DWA.

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