To The Moon

Summary

• The launch of Venu Sports was likely influenced by the recent clash between Charter Communications and Disney, highlighting the need for a backup distribution system in case of contract disputes.
• The cost of partners to help defray the cost of the service was the exclusion of non-sports channels; secondary for Disney and Warner, but a very serious problem for Fox.
• Fox News and the NFL contract each represent the entirety of Fox's profit, Fox needs both to go right to make any money. They're increasingly at odds with one another.
• It may become impossible going forward to protect both, since distribution for the NFL requires sacrificing News and vice versa.
• The end result of the various legal disputes pertaining to Venu may not be an injunction, but matching flexibility for most linear operators, turning a limited News exclusion into a flood.

Klaus Vedfelt

Oh Spulu, we hardly knew ‘ye. With the official confirmation that the new sports streaming joint venture between Fox Corporation (NASDAQ:FOX) and its partners Disney (DIS) and Warner Bros. (WBD) will, in fact, be called Venu Sports, the surprisingly endearing moniker coined by (I think she was first) Julie Alexander of Puck must now officially be retired.

Venu Sports is one of those things that is intricate to the point of tediousness to the broad-based investor, but actually fascinating to someone like me who has made a career of the economics of media. I could write multiple articles, a whole book even, just on Venu Sports and its implications for the future of media, both what it does and the broader forces it portends.

But I want to focus right now on Fox, and what sets Fox apart from its Venu partners, and why investors should care. For Fox, Venu is both indispensably necessary to their survival… and potentially existentially threatening, all at the same time.

To fully explore this will mean going somewhat in-depth on not just the numbers, although we will get to those, but also the operational interactions between these companies in the context of the broader industry and how those operations shape their relationship. There will be an element of the birds-eye to this article, perhaps even a touch of the abstract, but I believe this is an important point that is not being fully explored, and I hope investors find it useful.

Three Unusual Partners

For Disney, Venu is small potatoes, at most one prong of a multipronged attack plan for the streaming transition; and perhaps not even a whole prong. For Warner, Venu may be a stillborn idea, if their apparently pending loss of the NBA makes them too small-time to be worth incorporating into the new big kid on the sports streaming block. Fox, I believe, is probably behind the scenes, the driving force of Venu, the one who needs it most and might arguably put it at the center of its strategy in a few years.

Prior Work

I’ve been skeptical of Fox for a while now, to be sure. My prior article’s advice to avoid Fox stock has, perhaps, not entirely held up. The stock is up 14.6% while the S&P is up 9.5% over the same period. In my defense, the five-month-old article’s advice was good for the first three months; Fox was actually down to $25 in early March. Most of the run-up has been this month, with Fox rising from $28 to almost $32 in May alone. The question is whether that run is justified.

It’s also worth noting that since my Fox article (hold rating) three years ago, Fox is down 21.4% while the S&P is up 33.8%. While a buy in early May certainly would have paid handsomely, I generally don’t recommend investors try to time the market that precisely.

Total Addressable Market Size

Those trying to figure out why Fox, Disney and Warner are doing this (and just as importantly, why they are doing it at this moment in particular) will find, I think, that this service is meant to simultaneously serve two very different purposes.

The first is, of course, to sell some pay-TV subscriptions to those who currently don’t have them or will soon drop them for being too expensive. It has become rather commonplace in the media industry to belittle the new service as a mere shadow, of little substance to any real sports fan. This is the “nothing-burger” interpretation of recent news, that it doesn’t mean anything because no one will actually buy it.

As I’ve already covered in my original ‘Spulu’ article last quarter, there are, in fact, a considerable number of sports fans who will find this service useful. I refer you to that article for all the details but basically, the service has real appeal to sports fans who are interested in other sports besides just football, and who draw most of their scripted entertainment from outside the bundle, from services such as Netflix (NFLX) and Prime Video.

That part of the Venn diagram is relatively small, but I postulated a few million people could fall into it. Fox CEO Lachlan Murdoch says he sees Venu getting as high as 5 million subs, which I would say is on the high end of reasonable, exactly what you’d expect of a cheerleading CEO.

Fox's Debts Come Due

There is, however, also another purpose to this service, I suspect.

For a long time, those bullish on Fox, including management, have actually held up its lack of a scripted studio as a positive. No studio, they pointed out, means no streaming service. That means that Fox has been able to sidestep the incredibly expensive streaming wars of the past several years that have led to myriad content write-downs across a variety of companies.

There is no doubt that the absence of those expenses has, in the short-term, been a good thing. It has helped to preserve net income at Fox at a time when Warner, Disney and Paramount have all dipped into negative territory at least temporarily, Warner almost continuously so.

However, from the beginning, I’ve been somewhat more skeptical of this approach. Not building a streaming service, and letting others deliver your content, sounds cheaper and much more profitable. Until and unless the linear bundle becomes no longer fit for purpose, at which time you have no streaming service to deliver your content.

The Match That Lit The Fire

It seems to me almost impossible to ignore the impetus that the launch of this new service was given by the recent clash of the titans in the TV industry, the blackout between Charter Communications (CHTR) and Disney. For the first time in close to two decades a TV distributor at least arguably won a showdown with a major producer, and the reason why it won is not hard to see; Charter openly threatened to simply walk away from the TV business entirely if its terms weren’t met, declaring that fees had gotten so high and consumer interest sufficiently low that it had reached a “point of indifference” as to whether it continued to offer TV service or not.

The mere fact such a statement was made was newsworthy enough, but even worse was that many industry analysts seemed to agree that Charter might very well mean what it said, calling the showdown “more tempest than teapot.” The largest cable provider in the country, providing 15 million subscribers to all the major media companies - that’s basically “keep the lights on” level - was suddenly saying, well, it might just turn its linear service off completely. And without much warning.

I think some analysts when looking at the industry today underestimate just how transformational that fight was, even though Disney arguably ended up walking away relatively undamaged, or at least far less so than it could have been. For years, the whole bullish thesis behind the transition of the more bundle-dependent operators - that’s basically these three Venu companies at this point - has been that whatever happened with the bundle would happen slowly, giving them plenty of time to adapt, and therefore they might as well milk the linear feeds for all the free cash flow they could before transitioning to whatever came next.

Charter suddenly announcing that it might pull the plug on the pay-TV bundle overnight required re-evaluation of the thesis.

Haves And Have-Nots

Paramount (PARA) and Comcast (CMCSA) probably weren’t panicking much. They already have fully-powered streaming services which broadcast almost all their content, including live streams of their flagship broadcast channels. If suddenly there was no more pay-TV, Peacock and Paramount+ would suddenly have a lot more subscribers, and Comcast and Paramount probably wouldn’t be affected too much. (They would be affected.)

Fox, Disney, and Warner, however, are in a completely different boat. There are no live streams of TNT, ABC or Fox broadcast network on any SVOD service. If pay-TV suddenly stops broadcasting one of them because of a contract dispute - or stops broadcasting all of them because the linear bundle collapses rapidly, even near-instantaneously, instead of gradually - they simply did not have a backup plan to monetize their billions of dollars a year in sports fees, which they owe to the leagues regardless of how many people do - or don’t - receive their broadcasts.

Like I said, not having a streaming service sounds great, until you realize you don’t have a streaming service. They have a dependency on the linear system to stay afloat, and Charter has now proven there are ways of exploiting that weakness. The Venu Three, I believe, realized they needed a backup plan in case someone held them hostage like that again.

Standing Up A New Service

The problem is, as I noted several years ago, that the technology to stream live events to millions of devices simultaneously isn’t something you just build overnight. What’s more, Fox’s needs are far more acute than Disney and Warner. Warner’s biggest sports property up until this month was the NBA, which averages about 5 million viewers on a Conference Finals game, the biggest game Warner broadcasts. A typical NBA national game is more like 1.6 million.

ESPN is more heavyweight; the College Football Playoff Final can get up to 25 million viewers; and Monday Night Football can get close to 20 million if it’s a good schedule. ESPN has only one first round NFL playoff game, not much more viewership than that.

Fox’s biggest property, however, putting aside the Super Bowl itself, is multiple NFL late-round playoff games including, often, a Conference Final. Those can get viewership of over 50 million simultaneous streams or more. What’s more, Fox doesn’t have the luxury of spending the whole year planning how to do 20 million+ for a single night event, and then have another whole year again to recuperate the infrastructure. As one of the NFL’s mainline Sunday afternoon partners, it needs to be able to deliver 20 million+ streams every weekend for five months of the year. 20 million is standard load for the NFL.

The Dynamics Of The Deal

Well, spilt milk, and all that. The key now is to get a service up and running as quickly as possible that is fit for Fox’s needs. Hence, Venu Sports, which to many non-insiders probably looks like it kind of came out of nowhere.

Obviously, the tech needs to be tested so the Venu Three can be certain it works if called upon, and to test it in the field they need some considerable number of customers, at least enough to stress test the system. Insurance or not, they wouldn’t be launching this if they didn’t think somebody would buy it, indeed they must be counting on enough somebodies to become regular users that they can find and work out the insects, which you just know any new service will have.

What’s more, such tech is not cheap, and Fox lost a lot of scale when it sold out of scripted operations. Running such an operation itself for such a small content pie as it has would be somewhat draining in and of itself. So, of course, reach out to a couple of other sports-heavy, bundle-dependent operators and see if you can’t all help one another.

And a deal was struck. But for Fox, it came at a severe risk.

Non-Sports Sold Separately

These are three very different companies, with different interests, content strategies, and even political leanings. Getting them all on the same page must have been very difficult. Basically, the only thing they all have in common is that they all want a way to broadcast sports that doesn’t depend on the linear bundle, just in case. So the deal they’ve struck includes only sports channels in their new mini-bundle.

Well, again, for Warner and Disney that’s not so bad; they have on-demand streaming services already which can similarly sell the non-sports content direct-to-consumer.

Fox, however, is in a whole different boat. Fox has agreed to exclude not some sideshow channels, but Fox News. Which is not only the crown jewel of the Fox family but is, I think, responsible for virtually all the profit the company generates.

Cable Networks Profit Sources

While Fox broadcast net and Fox Sports 1 and 2 cable channels do generate significant revenue, they incur significant costs to do so, with the NFL and the Big Ten in particular costing a very pretty penny. Major League Baseball isn’t cheap, either, not when they’ve sold you the World Series rights in your contract.

Media analyst Patrick Crakes estimated that the value of FS1 was $1.2 billion. That’s the total Enterprise Value, not the annual profit. At an EV/EBIT multiple of 10, that means $120 million of the annual operating profit of Fox’s cable networks can be ascribed to its biggest cable sports channel. But cable networks generated almost $2.5 billion of EBITDA last fiscal year. How?

Well, the Big Ten Network probably helped a little, but mostly, Fox News.

Subscription And Advertising Revenue

Fox, like all media companies, does not break out its cable division by individual channel. We have no Fox News line item in the earnings. But certain details have leaked out over time in media reports. In the absence of other information, I’m going to use those.

Fox’s cable operations have a relatively clear hierarchy. Basically, Fox News generates twice the per-subscriber fees of Fox Sports 1, which generates twice the fees of Big Ten Network, which generates twice the fees of each of the other channels. Fox News had a $2.20 fee as of last year, but reports were that it was going to use the latest round of renewals to boost the fee to $3 per month.

Depending on how successful it was, assuming 72 million pay-TV subscribers, Fox News is generating somewhere between $1.87 and $2.55 billion in annual subscription fees right now.

Advertising revenue is harder still. According to S&P, Fox News ad revenue peaked in 2019 at almost $1.2 billion. But it fell back to $1 billion in 2020 as advertiser boycotts began, first with Laura Ingraham and then spreading to Hannity and Carlson. More recent reports about News ad sales are all over the map and frankly, I don’t find any of them more reliable than the next.

Since then, we’ve had four years of inflation, as well as more outrage and boycotts. I will assume it is still at $1 billion.

Profit Margins

What is most important about Fox News is that even its critics agree that Fox News doesn’t need a single ad dollar to be profitable. Media Matters, one of the harshest critics of Fox News, says that it has a 35% profit margin before it sells a single ad. That would put Fox News profit at $654 million to $893 million before a single ad, plus another $1 billion on top. $1.65 to $1.9 billion in profit from a single channel.

In fiscal year 2023, Fox Corporation’s total profit before taxes came to $1.7 billion. It’s literally Fox News’s house, the rest of them are just living in it.

Ripple Effect Across Linear

This makes it far more dangerous for Fox to agree to sell a bundle that excludes Fox News than it is for Disney to sell one without Disney Channel and FX, or Warner for Cartoon Network and CNN. In the first place, there’s the danger that the new bundle proves more popular than expected despite not having Fox News - or perhaps even because it doesn’t have Fox News - and people will swap out traditional pay-TV for the new News-free bundle.

But the second danger is, I think, the far more acute one. Barely had Venu been announced than the DOJ announced it would be launching an investigation. FuboTV couldn’t even wait that long; they filed a lawsuit of their own long before the DOJ was ready to announce any findings.

These lawsuits have been criticized for seeking to use antitrust law to block the launch of a competing service, when the whole point is to promote competition. As one put it, “antitrust law protects competition, not competitors.” Fubo, a streaming sports service, can’t use antitrust law to keep another streaming sports service out of the market, so goes the argument.

Legal Rights And Remedies

Such arguments miss the point, in my view, and the real danger. As the article notes, the courts are highly unlikely to block a new competitor from entering the market.

Far, far more likely, however, is that the court could order that because Venu is entering the market as a sports-only service, the Venu Three must also offer other linear providers the option to take only the sports channels from those three companies as well. In other words, instead of being confined to Venu, the News-free option could spread like wildfire across the whole linear bundle.

Indeed, it may do that anyway. As I’ve explained before, pay-TV contracts with large distributors like Charter, DISH (SATS) and DIRECTV (T) almost always include a Most-Favored-Nation clause that requires that concessions offered to smaller operators also be offered to larger ones. The minute Venu goes live, the Big Four - including Comcast - at least will probably have a contractual right, even if not a legal remedy, to the same terms. Those four providers represent almost 70% of the pay-TV universe.

Revenue Orthogonality Approaching 100%

Like most cable operations, Fox News’s costs don’t really scale with revenue - lost money basically comes straight out of the bottom line, almost one-to-one. By our calculations, Fox News is generating a profit margin of almost 50% - and that profit accounts for all the profit of the parent company. Assume about half the country likes Fox News and the other half hates it - if the wrong half suddenly doesn’t have to pay anymore, that could be all or most of Fox’s profit.

Venu won’t even launch for a few more months, and there’s still a lot we don’t know. I do believe, however, that the odds that none of the lawsuit, DOJ investigation, and MFN clause rights will buffet Fox News are low.

Investment Summary

Fox is in an unenviable position - it needs to both monetize the NFL effectively and keep News mandatory on all cable packages. Failure to do either one can represent a hit roughly equal to the entire profit stream of the company. Because I believe it is rapidly becoming very difficult to do both successfully, I am still Avoiding Fox.