RealMoney Silver - Media Stocks Revive on Blu-ray's Victory

Media Stocks Revive on Blu-ray's Victory
By Steve Birenberg
RealMoney Contributor
2/20/2008 10:50 AM EST

Media stocks have been performing quite well lately after a very bad stretch from mid-2007 through early 2008. On Friday, all the major entertainment conglomerates that produce content, and the satellite and cable companies that distribute it, were up on a day that had modestly negative market breadth.

A few things have been happening recently that may be responsible for pumping life back into the sector. First, earnings season so far has been pretty good. Several important media companies are still to report, but Disney (DIS) and News Corp. (NWS.a) both easily exceeded analyst estimates in the fourth quarter and indicated that they are seeing little impact from the economy. News Corp. raised guidance, and estimates at Disney went up.

Comcast (CMCSA) helped last week when it turned sentiment more positive by initiating a dividend, announcing a larger share buyback and letting investors know that free cash flow and shareholder value will drive the company's strategic decision-making. Even Time Warner (TWX) reported OK numbers with no disappointments. The company's initial restructuring actions were also positive.

A second factor that could have helped the stocks a bit was the writer's strike. I've been on record on many occasions stating that I did not believe the strike was a material event from a financial or investment perspective. However, as the strike lingered, there was a growing possibility that it was going to last long enough to do some damage to the 2009 movie slate, the 2008-09 TV season and TV advertising sales, and the DVD sales that go with the possibly lost content. Settlement of the strike last week may have lifted the storm watch that was in effect and helped the stocks.

A final event that may have helped, and the focus of the rest of this column, is the rapid and overwhelming victory for Blu-ray in the DVD format war. Just a month ago, Warner Brothers announced that it was going to adopt Blu-ray. Other studios and retailers quickly followed. Netflix (NFLX) went Blu-ray, then last week Wal-Mart (WMT) and Target (TGT) joined the Blu-ray camp.

Over the weekend, rumors that appeared well sourced indicated that Toshiba, the creator and supporter of the competing HD DVD technology, will be dropping HD DVD completely. Toshiba investors were happy, as the stock was bid up 5% in Japan despite the massive write-offs that are coming. Once Toshiba makes it official, the only two remaining studios supporting HD DVD, Paramount and Universal, will be free to switch to Blu-ray without penalty.

So the battle is over, but the question remains whether next-generation DVDs and DVD players can help the media industry. Data on DVD sales are difficult to come by. A Wall Street Journal article published yesterday said that DVDs are a $16 billion business. A Reuters article used a $24 billion figure. Regardless, the number is big. Time Warner reports quarterly DVD sales.

For all of 2007, the company sold 464.5 million units, which produced revenue of $4.6 billion, representing 10% of total company sales, 39% of the company's filmed entertainment segment sales and 21% of the combined revenue of the filmed entertainment and network segments.

I believe these data indicate that DVD sales matter and that Blu-ray could provide a material boost to the entertainment conglomerates. Let's assume that DVD sales are $20 billion. At Time Warner, each DVD sold generated about $10 in revenue. Right now, the number of Blu-ray DVD players in households is small, no more than a few million. However, with HDTV sales remaining robust, it seems only a matter of time until tens of millions of households have Blu-ray players. It is not out of the question that 10 years from now, 100 million or more households around the world will have Blu-ray players.

The only risk to Blu-ray penetration comes from HD digital downloads. I believe there will be a lot more heat than light about HD digital downloads, which are constrained from mass adoption by an Internet bottleneck. Furthermore, the primary benefit of the Blu-ray disk, beyond the great picture, is that massive capacity. This should allow DVD manufacturers to offer plenty of extra content that will give the DVD an edge over digital downloads.

Content creators can benefit in two ways from Blu-ray. First, Blu-ray DVDs are priced at a premium. If Time Warner merely exhibits substitution of one Blu-ray DVD sold for one regular DVD sold, the company could pick up tens of millions in extremely high-margin revenue. There is not a lot of argument about this concept, although it is possible that Blu-ray pricing collapses more quickly than is generally assumed. But this would probably take place only if Blu-ray DVD player sales massively accelerate such that the uptick in units sold offsets the reduced pricing.

A second way for the content creators to benefit is if current home libraries of DVDs are upgraded to Blu-ray. One great benefit of creating content is that technological change in the delivery system allows you to resell your library again and again. I've read some debate about whether there will be a library upgrade cycle with Blu-ray. In general, the conventional wisdom is that only a consumer's very favorite titles are likely to be upgraded. This still represents tens of millions to hundreds of millions of potential Blu-ray disks.

For example, if 20 million U.S. households eventually buy five Blu-ray disks to replace their favorite DVDs, you are looking at 100 million units. Disney seems best positioned to benefit from a library replacement cycle, as its evergreen animated titles already have proven their worth again and again, as households have upgraded technology.

The idea that Blu-ray can be a meaningful positive for content companies is real. The major movie and TV producers are Disney, News Corp., Time Warner, Sony (SNE) , Viacom (VIA) and CBS (CBS) . Lions Gate (LGF) also has a big DVD business.

Each of these companies now have a potentially new growth driver. I suspect the demand curve will be hockey stick, and we are just getting started. I also believe there's a consequential risk that the length and ultimate level of demand could be held back by the threat of digital downloads.

However, I have little doubt that starting next year at this time, analysts will be all over Disney, Time Warner and all the other studios with questions about Blu-ray DVD sales. If the answer is something like, "We are seeing a meaningful uptick in demand," you can add a growth driver to these stocks. The market began to pay for it last week.