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Friday, January 10, 2014 - 14:30
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Friday, January 10, 2014 - 14:30

Warning: This Old-Line Tech Sector Is About To Crumble

Friday, January 10, 2014 2:30 PM

It's never fun to start the new year with word that Congress is looking to attack your business model.

For operators in the cable TV industry, the possibility of onerous legislation is just one of the headaches for industry executives. Rapid technological changes and growing consumer dissatisfaction also promise to bring plenty of misery to this remarkably profitable industry. Investors should consider repositioning their portfolios now to avoid the fallout to come.

Attacked from all sides
As a recent article in The Wall Street Journal notes, three different prices of legislation are being pursued in the halls of Congress.

They would:
• force cable companies to keep their Internet lines fully available to rivals that aim to stream video and other TV content

• break up the all-or-nothing packaging choices that currently force consumers to pay upwards of $100 dollars per month, even if they watch just a few channels. (SNL Kagan estimates that consumers watch fewer than 10% of the channels they receive)

• force cable companies to negotiate more favorable deals with broadcast networks

It may be a while before any of these legislative moves are approved, but it's clear that the cable industry, which used to have Washington in its pocket, is now in retreat. Consumers are fed up, and lawmakers sense an opening.

Will It Matter?
By the time any of these legislative moves are approved, the entertainment world will have already changed. As we saw at this month's International Consumer Electronics Show (CES) in Las Vegas, hardware makers are rolling out a range of new devices that usher in a new era of video watching that doesn't require a cable box.

For the cable companies, the dual pressures of legislation and technological change represent a huge threat. Companies like Time Warner Cable (NYSE: TWC) already rate poorly in terms of consumer satisfaction, and what has been a trickle of cord-cutting could soon swell into a flood of customer cancellations.

Perhaps the greatest threat to this industry is the fact that it is no longer a capital-intensive business. Citigroup analyst Lucio Aldworth noted: "Video entry used to require possession of scarce assets: 60 years ago, it required TV station broadcast spectrum; 40 years ago, (it) required heavy capital investment and cable franchise agreements; 25 years ago, (it) required orbital slots and DBS/DTH geosynchronous satellites.

"Today, video entry requires....a Web server."

Aldworth looked at a variety of factors to determine which countries are most likely to migrate to OTT video (which stands for over-the top, bypassing a traditional cable box). His conclusion: "Three countries face the greatest threat from over-the-top video services: (the) Netherlands, Sweden and the U.S. These three countries have high pay-TV penetration rates, higher Internet penetration rates, high broadband speeds, no data caps and ample free-to-air TV stations."

The changing industry trends not only pressure the cable companies, but also the broadcast networks that greatly benefit from the current cable box packages. "As Web TV grows, cable network ad revenues come under pressure. And if households view Web-based services as a substitute for linear TV -- resulting in cord-cutting -- cable network ad revenues and affiliate fees disappear," Aldworth predicts.

He cites Viacom (NYSE: VIA), Discovery Communications (Nasdaq: DISCA) and Scripps Networks Interactive (NYSE: SNI) as being especially vulnerable, as they derive more than half of their revenues from cable TV advertising.

The Change Has Already Begun
Aldworth thinks that Americans already view roughly 16% of video entertainment online, a figure that's sure to rise in coming years. Of course much of that online video consumption is offered by Netflix (Nasdaq: NFLX) and Google (Nasdaq: GOOG), through its YouTube service. In Asia, the major video streaming provider, PPStream, was acquired by Baidu.com (Nasdaq: BIDU) in May.

Considering Netflix and Google are hardly well-kept secrets, with market values of $20 billion and $382 billion, respectively, let's focus on other firms that want to make a big push in the OTT market.

1. Sony (NYSE: SNE)​
As announced at the just-completed Consumer Electronics Show, this Japanese entertainment giant plans to test video delivery service in coming quarters. Recall, that Intel (Nasdaq: INTC) made a similar announcement roughly a year ago, and eventually found that lining up content deals was too hard, eventually selling its technology to Verizon (NYSE: VZ).

It would be unwise to assume a similar fate for Sony's efforts. Shares of Sony have weakened over the past six months as the company is still feeling the negative effects of its low-margin hardware business, but it's clear that this company is finally getting serious about regaining relevance as a leading-edge software and entertainment provider, as evidenced at CES and by other announcements. This is one of the clear underdog stocks in the global technology/media landscape.​

2. IAC/Interactive (Nasdaq: IACI)​
Although IAC is involved in a number of Web-based businesses (such as About.com, Match.com and Ask.com), I'm most intrigued by its stake in Aereo, which was recently boosted through a round of capital-raising. If consumers do cut the cord, they still need to find a way to watch local over-the-air networks, and many would prefer to watch such content on their own time, with a DVR-like device. That's precisely what Aereo offers, and if the company can continue to fend off legal challenges from the cable companies, then this service could become a blockbuster.​

3. Brightcove (Nasdaq: BCOV)​
This company provides video delivery systems for content producers, along with tools to insert ads within that content. Shares have come under sharp pressure in recent sessions as management reined in growth expectations.

Still, on an annual basis, revenues have been rising at a solid clip, from $64 million in 2011 to a projected $140 million in 2015, according to Morgan Stanley. Rising sales are expected to finally push this company into sustained positive free cash flow. Brightcove generated negative EBITDA (earnings before interest, taxes, depreciation and amortization) in 2010 through 2012, though that figure should approach $10 million by 2014 and $15 million by 2015.

Lastly, there is another company aiming to break the cable stranglehold. Privately held ChannelMaster offers a DVR-like device that records over-the-air shows. CNET has given the product strong reviews, both last month and more recently at CES. "This is a fantastic solution for people like my mother-in-law, who don't have cable but can watch live broadcasts just fine," noted a CNET reviewer.

Risks to Consider: As an upside risk, the major cable companies can aggressively cut fees to discourage customers from cancelling their service, but that would negatively impact margins and cash flow.

Action to Take --> The "cut the cord" theme has been around long enough for many to conclude that it's an overblown threat. Indeed, only a small fraction of U.S. consumers have made the move -- but it appears as if an inflection point is at hand, thanks to a combination of legislative and technological changes. It's a good time to reassess your portfolio to make sure you don't have too much exposure to yesterday's entertainment industry.

P.S. If "cutting the cord" has you excited, wait until you see what StreetAuthority's Andy Obermueller has been working on. The Chief Investment Strategist behind the premium Game-Changing Stocks advisory, Andy has identified five trends with the potential to revolutionize the way we live our lives -- and make early investors a killing. These developments include robots that perform surgery with microscopic precision... machines that can "replicate" objects seemingly out of thin air... and a pair of technologies that will change the face of transportation forever. To learn more about these innovative technologies -- and the companies behind them -- follow this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.