HBO (Home Box Office) is a premium pay-TV service owned by Time Warner (NYSE:TWX) and primarily offers recently released movies and original TV programming. HBO’s U.S. operations account for more than 20% of Time Warner’s value as per our estimates, making it a business worth close to $15 billion. The primary reason behind this steep valuation is the high monthly subscription fee that HBO charges in the U.S. This figure has increased from about $6 per subscriber per month in 2008 to an estimated $7.60 per subscriber per month in 2012. The increase has been more or less consistent, as is the case with most cable networks. Sustained demand for programming, multi-year contracts with pay-TV service providers and rising programming costs are some of the reasons driving growth in HBO’s subscription fee. We expect the same factors to continue to drive growth in the future. However, the rising pressure from pay-TV companies, competition from alternative video service providers and a slowdown in subscriber growth will moderate the subscription fee increase. We expect the figure to reach close to $9.40 by the end of our forecast period.
Other than the subscription business in the U.S., HBO also earns money via its subscription business in international markets, licensing content to cable networks and selling its original programming via DVDs and Blu-Rays.
Continued Demand For HBO’s Original Programming
The majority of HBO’s programming includes recently released, uncut and uncensored movies. The company typically acquires exclusive rights to these recently released movies, creating a unique appeal among movie and video entertainment enthusiasts. In addition to movies, HBO also shows several original dramatic and comedy series, many of which have won awards and are critically acclaimed. These include True Blood, Boardwalk Empire, Game of Thrones and Curb Your Enthusiasm. Apart from this, HBO also shows mini-series, boxing matches and sports news programs, family programming and documentaries – catering to a wide range of viewers.
HBO generates strong demand due to a significant investment in content. This is the reason why the network has been able to grow its subscriber base to over 40 million despite charging the highest subscription fee in the industry. Continued investment in programming will ensure that the growth in subscription fee continues.
What Historical Growth Suggests?
We estimate that HBO’s monthly subscription fee grew from close to $6 in 2008 to $7.60 in 2012. This amounts to an average annual increase of close to 40 cents, which is similar to what ESPN has witnessed. A parallel can be drawn between ESPN and HBO in the sense that both are market leaders in their respective fields. They focus on quality and original programming that no one else in the market currently offers. As a result, they have carved out a loyal customer base for themselves and have been able to sustain substantial growth in subscription fee without risking subscriber loss. In terms of percentage, HBO’s subscription fee has increased at an average annual rate of close to 5.5% for the last few years but the annual growth rate has dropped slightly.
Although the multi-year programming contracts with pay-TV service providers will ensure that HBO’s subscription fee will continue to increase, we expect a slightly lower growth rate of close to 3-3.5% in the future, implying an annual increase of 25-30 cents per subscriber per month. We believe that there are certain factors at play that will reduce HBO’s ability to grow its fee at historical rates. These include stagnating subscriber growth, pressure from pay-TV companies in response to rising programming costs and growing competition from alternative pay-TV service providers such as Netflix (NASDAQ:NFLX).
Competition, Slowdown In Subscriber Growth & Pressure From Pay-TV Companies
HBO will face some competition from online video service providers such as Netflix, Amazon (NASDAQ:AMZN) and others. Currently, Netflix focuses on relatively older movies and past seasons of TV shows already aired on television. However, the company is making efforts to bring original content to its subscribers and trying to strike some more exclusive deals such as the one with Disney (NYSE:DIS). As the amount of original and new content on Netflix increases, the service will directly compete with HBO. In such a scenario, the subscribers may opt to drop HBO and subscribe to Netflix instead if they see the value in its content. HBO and Netflix will find themselves in a bidding war, trying to acquire exclusive rights for the same content. Other big names might join in, creating a plethora of options for customers. In 2011, Netflix outbid HBO to acquire rights for House of Cards. As competition in this space increases, HBO’s ability to increase its subscription fee will reduce.
In addition, HBO’s subscriber base growth also seems to be stagnating. For the last 5 years, the subscriber base has stayed within the range of 39.5-41 million. There is no clear trend as well. While the number of subscribers grew between 2007 and 2009, there was a decline in 2010, followed by a slight increase in subsequent years. We believe that as the U.S. economic growth and the housing market picks up, more subscribers may join in but the growth will remain slow. As a result, HBO may not have the same kind of leverage it used to and may moderate its subscription pricing growth in the near future.
Pressure from pay-TV service providers is also increasing as they battle rising programming costs that are slowly squeezing their margins. Pay-TV companies such as Time Warner Cable, DirecTV, Dish Network and others are increasingly taking a strong stance against the media companies’ demand for carriage fee increases. As a result, we have seen multiple disputes in recent years leading to brief channel blackouts. Some companies are also contemplating dropping ESPN from their low-tier programming packages in order to contain costs. We believe that HBO will face some pressure from these pay-TV service providers and may not be able to enjoy the same growth in subscription fee as it has in the past.
The Significance For Time Warner
HBO U.S. accounts for close to 20% of Time Warner’s value based on our current forecasts. There is not a lot of upside/downside potential for the stock due to stable growth in HBO’s subscription fee and a low likelihood of a significant deviation from the current projected path. Even if the subscription fee remains stagnant and doesn’t grow at all, the downside will be limited to 5%. On the other hand, if HBO’s fee in the U.S. continues to grow at the historical annual rate of close to 40 cents per subscriber per month, the upside will be limited to about 5%. HBO is a significant business for Time Warner, but the company also has several other successful networks in the U.S. and international markets.
Our current price estimate for Time Warner stands at $62, implying a premium of about 15% to the market price.