Sky TV changes gear as foes turn friends

Thursday 28th March 2002

Will Shoeshine's colleagues in the financial media ever get their heads around the pay TV business model?

For years no financial result announcement has passed by without somebody somewhere wondering out loud why Sky's share price keeps rising when the company keeps reporting losses.

For the December first half this function was served by Warren Head's normally sensible The Headliner newsheet.

Under the headline "Why should Sky Network TV be viewed as a growth stock?" its reporter wrote:

"It never ceases to amaze veteran stockbrokers and investors that Sky, a company that has consistently reported significant losses every year of its existence (actually, no, it posted modest bottom-line profits in 1998 and 1999) and thus has no earnings per share or dividend history is regarded as a growth stock."

"Today," the article goes on, "Sky surprises and pleases the market when its losses are less than expected."

Shoeshine is reminded of the far off days when Rupert Murdoch was setting up BSkyB in Britain.

Murdoch gobsmacked the market by announcing blithely that he expected to lose £100 million a year for 10 years to get the pay TV operator going.

In the event he was only half right. It took about five years, and £500 million, before BSkyB started producing profits at the bottom line. Murdoch has now made all his money back and plenty more.

According to Tom Mockridge, the chief executive of Sky's 66% shareholder Independent Newspapers, Sky will break even in two years' time.

But Mockridge knows the actual date depends on a stack of variables, some under the company's control and others not. His comment should be seen as setting a goal, not making a prediction.

The market's rating of Sky as a growth stock comes about, without wanting to sound facetious, because Sky keeps growing, on all the indicators that matter, and will continue to do so for some years yet.

Subscriber numbers on the day before the half-year announcement were 476,210, including the subs taken over from TelstraSaturn, giving Sky 34.3% market penetration by its own assessment.

Revenue was up $22.3 million to a record $166.8 million.

Earnings before interest, tax, depreciation and amortisation for the half year were $52.1 million, up 43% on the same period a year before. Customer "churn" was at record low levels.

Does this sound like a company that is stagnating or shrinking?

While long-term growth-oriented investors can afford to ignore the bottom line and simply watch the shares climb, Sky's major shareholders can't.

INL's shareholding, and Telecom's 12%, are both backed with debt. Both are long-term, strategic shareholders but they will want Sky to furnish them with some dividend income with which to service their interest bills sooner rather than later.

Some commentators have speculated Mockridge was sent over here by Murdoch's News Corp specifically to prod Sky into running its show to achieve early profitability.

Certainly the way Sky operates has shifted but the reason is a combination of a new CEO and a changing strategic environment.

Sky's former chief operating officer, John Fellet, took over as CEO from Nate Smith in November 2000 and brought with him a different approach to the growth/profitability equation.

Under Smith's reign Sky's market penetration was far from unassailable and it faced potential competition first from Telecom's First Media broadband plan and then from TelstraSaturn.

Even TVNZ had its eye on pay TV, eventually announcing and then dumping a joint venture with TelstraSaturn.

Smith's strategy was to run Sky flat out for subscriber growth to push up the barriers to market entry.

The company spent hard on advertising and marketing, for instance, and offered heavy discounts on installation costs.

The expenditure had the desired effect of piling on the subscribers but the cost was to push back bottom-line profitability.

A secondary but important effect of running the model in full growth mode was to bump up capital expenditure and depreciation costs.

For each new subscriber Sky has to buy a dish and decoder. In the last annual report Sky estimated the total direct cost of installing equipment for a direct satellite broadcast customer at $815 and it depreciates this over five years.

Last year the total depreciation bill hit $95 million.

Hence investors' enthusiasm for losses. The bigger a loss Sky reported, the quicker it was pulling away from potential competition and safeguarding its monopoly.

But eventually, when Sky reaches market saturation point and stops taking on net new subscribers each year, that bill will start shrinking, in effect falling straight through to the bottom line.

By the time Fellet climbed into the driving seat the need to run the model in hell-or-bust mode had receded and he changed gear.

By then Sky had 397,000 subscribers, a lead would-be competitors regarded as unassailable.

Fellet throttled back on marketing and discounts. He is still, of course, looking for subscriber growth but thinks Mockridge's goal of profitability in two years is achievable, all other things being equal.

The rerating of the share price, from around $3 to $4.60 over the last four months, reflects the market's recognition that while Sky still faces risks those risks have diminished.

Perhaps Fellet could reallocate some of his marketing budget to media education.

Shoeshine owns Sky shares

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