Investing in the Midst of Disruption: The Internet’s Effect on Media and Retail
Research Associates Dan Kohnen and Kavi Shelar contributed to this piece.
The internet has created enormous amounts of societal benefits by helping us stay connected with our friends and family, making information available at our fingertips, and transacting goods and services with a few clicks. Although the internet has existed since the late 1990s, the rate of innovation has accelerated sharply in recent times with the proliferation of mobile devices. For the first time, we have a computer that fits in our pocket, is always internet connected, and is becoming very affordable. The combination of mobile penetration, increases in broadband speeds, and the abundance of data is now contributing to a shift into cloud computing as well as advances in artificial intelligence and machine learning.
In our opinion, we are still in the very early innings of this revolution that will further transform people’s lives and businesses in ways we haven’t thought of. In the words of Eric Schmidt, chairman of Alphabet, “The Internet is the first thing that humanity has built that humanity doesn’t understand, the largest experiment in anarchy that we have ever had.” Technological shifts are often accompanied by increased uncertainty, but they also tend to present interesting investment opportunities. The goal of this piece is to articulate how we are positioned to take advantage of the long and short opportunities presented to us as a result of the profound disruptive forces impacting the media and retail industries.
Search and Discovery
Digital advertising is more effective than traditional forms because of its ability to target audiences based on intent, demographics, and location. These attributes, combined with an increasing amount of time spent online, has resulted in digital now representing a third of the overall ad spending in the developed world, and it continues to take higher incremental share. This trend has impacted all forms of traditional advertising, including TV in recent times, triggered by demographic shifts and the emergence of alternate viewing options.
No other company benefits from the growth in digital advertising as much as Alphabet (GOOG), in which we invested early last year. Search and discovery will continue to remain an important use case for the ever-expanding internet. Alphabet’s search and YouTube properties are well-positioned to continue benefiting from this tailwind. Over 60% of the total spend on digital advertising is going to two companies, Alphabet and Facebook, with Alphabet receiving close to half of the total digital spend (see chart below). Furthermore, Alphabet’s Android operating system has a dominant market position and its increasing penetration should result in higher monetization of the mobile ecosystem. Thus, even in a mobile-dominated world, we believe Alphabet will continue to play a key role in search and discovery.
The Internet’s Last Mile
Another area that is poised to grow at a sustainable pace due to the increasing use of mobile devices and digital video is the broadband industry. Cable’s fiber-coaxial networks can handle large increases in bandwidth demand with low incremental investments. This ability to be scalable gives cable companies a distinct competitive advantage relative to the copper-based networks of telecom companies. Our cable holdings, Comcast Corp. (CMCSA), Charter Communications (CHTR), and Liberty Global (LBTYA), benefit from sustainable pricing power due to their competitive positioning, ample room for market penetration, and high incremental margins.
The market also seems to be overestimating the impact of cord cutting on video revenues. The cable companies have used their video service as a loss leader to sell high-margin broadband and telephony services. As a result, video represents a small portion of the overall free cash flow. Furthermore, the bundling of multiple services offers an avenue for cable to take market share away from the satellite companies. Unlike cable, satellite cannot bundle broadband alongside their video service under a common platform, thus placing them at a competitive disadvantage. Another advantage of cable’s bundled offerings is that its price point may render any possible savings from cutting the cord immaterial for a consumer subscribing to multiple services. A great example of this is Comcast, a company at the forefront of innovation with its TV Everywhere video platform. The company has lost fewer video subscribers relative to the industry and in recent quarters has actually been growing subscribers. Comcast’s recent deal with Netflix to make the latter’s service a part of its platform will further enhance its attractiveness in the market place and reduce consumers’ tendency to cut the cord.
Unique and Differentiated Content is Still King
Compared to cable companies, the impact of digital video disruption is likely to be more pronounced for the media content companies. The historical live TV distribution model, predicated upon the bundling of content and its monetization via a dual revenue stream of affiliate fees and advertising, will be increasingly challenged in a world with abundant ‘on demand’ options available via a better user interface. Although we do not expect the video bundle to break anytime soon, media companies that own undifferentiated or lower-quality content are increasingly at risk with the proliferation of lower-cost streaming bundles and stand-alone services.
Both of our holdings in this area, Twenty-First Century Fox (FOX) and The Walt Disney Company (DIS), are less exposed to this risk, having built their businesses around premier franchises, live sports, and broadcast networks, all of which give them the flexibility to transition online if the landscape were to change more rapidly. In addition, both of these companies have diversified their businesses over time into areas that are likely to benefit from growth in digital video or are relatively immune from that trend. Disney owns a movie studio with strong franchises, as well as a growing theme parks and consumer products business, which accounts for over half of its revenues. In the case of Fox, a substantial portion of its revenues comes from its studio business and from the media properties it owns and distributes in the faster-growing overseas markets.
Local television companies are also resilient to streaming competition because the content produced is local and difficult for newer entrants to produce and distribute at scale. One of our holdings in this area, Tegna (TGNA), is particularly attractive because of its scale of viewership (over 30% of households) and exposure to economically strong U.S. regions. Tegna also owns Cars.com, a premier internet auto property poised to grow rapidly by penetrating the online used car marketplace.
Retail: Location, Location, Location?
The internet’s advent is fundamentally changing the retail business by removing the physical constraints of global distribution and product selection. Perhaps no other company has taken advantage of this shift as much as Amazon, a company we don’t own but monitor closely for its implications across the entire retail space. Amazon gained a sustainable competitive advantage by building a highly sophisticated logistics network, nurturing strong customer loyalty, creating an open platform of third-party sellers, and — most importantly — taking a longer-term business perspective. As a result, the company is capturing approximately 25% and 50% of incremental U.S. retail and e-commerce sales, respectively, and the trend is accelerating.
Big box, physical retailers that sell undifferentiated products face structural problems. This reality forms the core of our short theses on Wal-Mart Stores (WMT) and Best Buy (BBY). To compete, both of these companies have no choice but to simultaneously invest in the e-commerce and physical retail channels, putting themselves at a meaningful cost disadvantage relative to Amazon. Even in the case of fashion retail, an area not long ago thought to be immune from online competition, Amazon has started to make meaningful inroads into expanding its assortment. As people get more comfortable buying clothing online, Amazon is capturing a very high incremental portion of fashion retail sales. It is not easy for retailers who have optimized their business using a physical storefront to pivot into a different channel and execute at scale, which is why we’ve been short Gap and Macy’s in the past. We’ve since covered those positions as our expectations of weakening fundamentals have played out.
As it is often said, investing is as much about what you don’t own as it is about what you do own. This phrase is even more pertinent in the media and retail industries where the future is likely to be very different from the present. This is why we have avoided investing in companies whose valuations look cheap but there is a high likelihood of a material business impairment in the future, as well as those that are priced for perfection, leaving less margin for error. It is the ability to forecast the future cash flows with reasonable certainty, a differentiated view relative to the market, and our valuation discipline that gives us conviction in the companies we have chosen to invest in. We also monitor these companies regularly to ensure that our analysis and intrinsic value estimates stay accurate over time.
As of July 31, 2016, Diamond Hill owned shares of GOOG, CMCSA, CHTR, LBTYA, FOX, DIS, and TGNA.
As of July 31, 2016, Diamond Hill held short positions in WMT and BBY.
Originally published on August 17, 2016
The views expressed are those of the research analyst as of August 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.