In the UK, Leading Pay-TV Provider, Sky, Starts to Feel the Icy Grip of OTT

You would never believe it from looking at the company’s financial statements, but Sky is will eventually be forced to close its satellite-based distribution network


With over 10.4 million subscribers in the UK and an almost unbroken record of growth in practically every financial metric, Sky has developed a well-earned reputation for exemplary financial management.

But the company's tried-and-tested business model is now being placed under pressure and the next 10 years will be very different to the last 10:

  • With a penetration of about 40% of UK homes, Sky's core business is approaching saturation: the number of Sky Pay-TV subscribers has grown by just around 1% annually over the 2 years to June 2013 (compared to 4% in 2010 and 3% in 2011). In spite of a sustained level of marketing representing around 20% of total operating costs, and continuing investments in programming (about 40% of operating costs), Sky is clearly finding it harder and harder to persuade new homes to take out a Sky Pay-TV subscription;
     
  • Sky is deriving most of its revenue growth not from expanding its core Pay-TV business, but by upselling existing customers with Sky Broadband (a service that the company can only provide by reselling BT's xDSL broadband service which BT sells to Sky on a wholesale basis);
     
  • Because Sky's total subscriber numbers are no longer growing strongly this process clearly cannot go on forever: While Sky does have some broadband-only subscribers we see this user segment as not being easily scalable, as doing so would take Sky into a head-on competitive battle with pure-play broadband ISPs of which there are a large number in the UK and many of which have a more advanced network infrastructure than Sky. Therefore, we assume that Sky's broadband business is mainly an upsell opportunity and because of this we estimate that in about 3 years, Sky will find that sales of Sky Broadband start slowing down, at which point, the company's opportunities for continued organic growth will be severely diminished.
     
  • The arrival of new competitors in the form of Google (Chromecast and Android TV), Apple TV, Amazon (Amazon Instant Video and Fire TV), Netflix and others, including the BBC with its iPlayer service, will increasingly chip away at Sky's subscriber base and make it even harder for the company to expand market share. We see three specific corrosive mechanisms:
    • As these players offer very price-competitive deals, then the homes that have resisted Sky's marketing advances to date might be more interested in an internet-based Pay-TV deal with a player like Amazon or Netflix, rather than paying 5 or 10x as much for a Sky package.
       
    • As the scale of the internet TV platforms increases, then these platforms will become an increasing force when it comes to negotiating license rights for internet-based distribution and this will apply for TV programming and movies. We foresee a future market environment where a company like Netflix will be able to bid on a level playing-field basis with Sky. At this point, Sky's primary source of competitive advantage (the amount it can afford to pay to acquire exclusive broadcast rights) will begin to be directly challenged by these upstate TV platforms.
       
    • Another part of Sky's strategy has been to invest in its own content production (e.g. Sky News). But even here we are beginning to see worrying signs that the internet players are copying this proven strategy: Netflix and Amazon are already well advanced in developing their own content production businesses.

All in all, we see Sky falling into a negative growth situation within 5 years, the reasons for which will be structural and will have nothing to do with how well Sky's management team are executing the company’s core business.

A clear downwards trend began to take hold starting mid-2012:

We note that Netflix launched in the UK in January 2012 and announced 1 million subscribers in August 2012. Research published by UK audience monitoring service, BARB, in March 2014 indicated that Netflix's UK subscriber base had increased to about 2.8 million while Amazon Prime Instant Video had attracted about 1.2 million subscribers. As of 30 June 2013 Sky has 10.4 million UK households has a Sky Pay-TV subscription.

We further note that the BBC's 'catch-up' TV OTT TV service, iPlayer has also been making steady progress:

Another interesting trend is to look at how Sky's advertising revenue has been changing over the last few years. While accounting for just 6% of total revenues, ad revenue tracks directly with total viewing hours.

While the total amount of viewing time (average viewing time per subscriber x net number of subscribers) is strongly correlated with ad revenue, other factors also affect ad revenue. For instance, the prevailing conditions in the UK ad market (which, for example, gave the whole market a boost during the London 2012 Olympics) and also the effectiveness of Sky's ad sales team and the quality of the inventory, including targeting and reporting options etc.

Nevertheless, we feel that the following chart is highly revealing:

This shows that the total number of viewer minutes for all of Sky's DTH programming has been falling for the last two years - which would be something that we would expect if our thesis is correct: which is that the arrival of OTT players which are offering rival programming at lower prices, will at some point start impacting on the amount of time Sky's subscribers are viewing their TV service.

We got the viewing data used to create the above chart from BARB who report on all TV viewership for all TV broadcasters and channels in the UK. We then checked the resulting downwards trend in viewing time with Sky's reported advertising revenues which, as we would expect, also showed a similar fall (ad revenue is in proportion to total viewing time).

As expected, the two curves (above) followed a similar trend - the reason why the red line has not fallen as much as the blue line is partly a testament to the skill of Sky's ad sales team and partly due to Olympics in 2012 which would have boosted overall UK ad revenues.

While it is too soon to conclude that a trend is taking hold, we will be very interested to repeat this calculation when data for the present financial year is released.

We think that we are now beginning to see the first worrying sings that OTT-TV is having an adverse impact on Sky's core Pay-TV business. As the OTT-TV market develops further these effects will become more pronounced.

The main reason for Sky's growing problem is that OTT-TV is having the effect of commoditising television distribution.

It is easy to see this if we ask a theoretical question: imagine that a new company wanted to raise USD 10 billion to build a new satellite-based TV distribution network, similar to the one that is operated by Sky in the UK.

It is clear to us that this would be futile: with high-speed broadband already in over 80% of UK households, and with a stated Government intention to raise broadband speeds to an average of 10Mbit/s, there would be no basis for building a satellite distribution network, such as the one Sky has. In comparison with what is already possible with the UK's fixed and mobile broadband infrastructures, Sky's satellite network uses yesterday's technology to solve a problem that no longer exists.

The bottom line is that whatever Sky's satellite network was once worth, it is worth a lot less today.

At this stage we project that Sky might one day close its satellite-based TV service altogether and instead sell NOW TV (a Sky OTT service) packaged with Sky broadband - which would be provided with network assets that Sky would either have to build or acquire. This model would imply a smaller sized company than exists today.