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Morningstar | Still a Future Despite Market Betting on Sky Falling

Shares in Sky Network Television continue to languish and are now trading at a whopping 50% discount to our NZD 2.50 (AUD 2.40) fair value estimate. Some may urge a reduction in our intrinsic assessment to "follow" the stock price, such an action would be devoid of any rational reasoning.

First, the outlook for near-term earnings is little changed. We continue to expect Sky to hit our fiscal 2019 EBITDA forecast of NZD 234 million, in line with management's NZD 230 to 235 million guidance. That already implies a 20% year-on-year decline for the second half, after suffering a 16% fall in the first half, and shows we are making no heroic recovery assumptions.

Second, we also remain comfortable with our dividend forecasts, expecting NZD 0.055 final DPS for fiscal 2019 and an interim DPS of the same amount for fiscal 2020. At current prices, this aggregate dividend forecast of NZD 0.11 for the next 12 months equates to a juicy yield of 9%. The balance sheet can certainly support the forecast 60% payout, given comfortable net debt/EBITDA of 0.8 especially as the no-moat-rated group is still forecast to generate around NZD 70 million in free cash flow a year.

The issue then becomes the longer-term outlook, in the face of relentless structural pressures on Sky's traditional pay-TV subscribers which have fallen to a forecast 628,000 in fiscal 2019 from 851,000 in fiscal 2015. This has seen Sky's EBITDA fall from a peak of NZD 380 million in fiscal 2015 to a forecast NZD 234 million in fiscal 2019.

We believe the earnings decline will continue until fiscal 2021 (forecast EBITDA of NZD 195 million) before stabilising, with mere low-single-digit growth thereafter. Judging by the low 6 times price/earnings multiple the stock is trading at, the market is clearly more pessimistic on the earnings stabilisation front. Such a dire view is not yet warranted, and we believe new management should be given time to execute on bringing Sky to the new era of home entertainment.

In the course of this execution, a change of strategy and modus operandi is possible under the new CEO Martin Stewart, who began his duties on Feb. 21, 2019. The slate is certainly clean for him, with the earlier than expected departure of the previous CEO John Fellet from the board in late March 2019, replaced by Stewart himself. Fellet has been instrumental in overseeing Sky's dominance as a monopoly traditional pay-TV company in New Zealand. But the time has come for a clean divorce from the previous management regime whose focus on protecting the legacy business may have contributed to Sky's diminishing relevance against the might of Netflix and the encroachment being made by Spark. Stewart has now been given unfettered sway to transition the group to a new-age operator, with an emphasis on building its presence beyond the set-top-box.

That emphasis could have implications for Sky's earnings trajectory. Greater near-term investment in new streaming products (programming, marketing, customer segmentation) could push the time horizon for earnings stabilisation, in the interest of stemming overall subscriber losses. At this stage, however, we stick with our current forecasts, with EBITDA settling at just below NZD 200 million in fiscal 2021 and total subscribers stabilising at 757,000 (around 600,000 in pay TV customers, rest in streaming customers). We also expect average revenue per user, or ARPU, from traditional pay-TV subscribers to settle at around NZD 76.00, down from current NZD 84.23, and overall blended ARPU at around NZD around 70, down from current NZD 75.82.

The critical assumption underlying all this is that Sky retains its rights to key content, particularly the SANZAAR rugby rights which expire post 2020. Negotiations are likely to have begun already and this is the first litmus test for the new management, as Sky attempts to restore its positioning in the New Zealand home entertainment delivery space.