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Pick Stock How Media Companies Make Money
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Companies in the media sector offer ample opportunity for great long- term investment gains, but successful investing in media stocks takes more than picking the next hit TV show, predicting the next blockbuster movie, or finding a new best-selling book. Of the two dozen media companies that "we follow, all but one have some economic moat associated with their business, and five have wide economic moats. The key is identifying those companies that will continue to grow consistently and churn out lots of cash for years to come. Many companies in this sector benefit from competitive advantages, such as economies of scale and monopolies, which make it easier to sustain excess profits for long periods of time.

Overall, the media sector has been rewarding over the past decade. Ac­cording to Morningstar's historical performance data, the annualized total return of the media sector was just above 16 percent between 1993 and 2OO2, whereas the S&P 500 returned a little more than 9 percent per year during the same period. The strong showing in the media sector can be traced to a number of factors, but "we'd argue that the two most important factors are appealing economics and significant competitive advantages. Differentiated and focused products give media firms competitive advantages within unique geographic areas (newspapers and radio stations) or niche categories (techni­cal books). Dominating one of these areas normally translates into strong and sustainable free cash flow for these firms.

Media is a broad term, so it helps to divide the sector into three different groups: publishing, broadcast and cable television, and entertainment production. After we review the general economics of the media sector, we'll dig into the specific characteristics of each of these three areas.

How Media Companies Make Money

Media companies generate cash by producing or delivering a message to the public. The message, or content, can take several shapes, including video, audio, or print. The method of delivery is even more varied. Television, movies, radio, the Internet, books, magazines, and newspapers are the most popular means of distributing content, but there is no real limit on how a message can be delivered.

User Fees

Business models in the media sector can vary significantly depending on a firm's primary source of revenue. We're all familiar with one-time fees that "we must dole out to see the current hit movie, read the best-selling novel, or buy the hot new CD. Film studios such as Disney and Paramount , publishers such as Simon 8f Schuster, and music labels such as Warner Bros, are highly dependent on these one-time fees.

Companies that rely on one-time user fees sometimes suffer volatile cash flows because they're heavily affected by the success of numerous individual products, such as newly released films or novels. While having a string of hits can result in a bonanza for the firm, the converse is also true: Several flops in a row can lead to disaster. This uncertainty can make it difficult to forecast future cash flows.

Because the success of this type of business model relies so much on big hits, the big-name stars tend to reap most of the profits, which makes for nar­row profit margins for the company. For example, a top box office draw such as Tom Cruise commands $25 million for each film plus a cut of the box office receipts, and studios are willing to pay this staggering amount because Cruise is an actor "who attracts both interest and dollars. The situation is sim­ilar in the music and book publishing businesses, where successful bands and authors often gain a big slice of the profit pie.

Subscriptions

Subscription-based businesses (such as cable and magazine publishing) are generally more attractive than one-time user fee businesses because subscription revenue tends to be predictable, which makes forecasting and planning easier and reduces the risk of the business. There is another advantage to subscriptions: Subscribers pay upfront for services that are delivered at a later date. Although firms can't recognize this cash as revenue right away, they can use it to fund operations, thus decreasing their reliance on outside sources of capital.

Because of the ongoing customer relationship and the cash received up- front, subscription-based business models usually are less sensitive to economic downturns. Moreover, there aren't many other businesses in which you can get paid upfront before you have to spend the money to create a product.

Many subscription-based companies have heavy fixed costs, giving them significant operating leverage. Thus, swings in revenue have a large impact on earnings and cash flow. Magazines and newspapers are good examples. The most important variable cost for these businesses is paper; other than this expense, almost all other costs are fixed, regardless of the number of magazines or newspapers that are sold. Thus, as these companies gain market share, profit margins should Increase dramatically.

The exception is in companies that need to make large, ongoing capital expenditures to stay in business, such as those found in the cable and satellite- television industries. For these companies, system upgrades often eat up the vast majority of operating cash flow, with little cash left over. In theory, once these upgrades are complete, these businesses should throw offloads of cash. The problem is that the upgrade cycles seem to be never ending.

Advertising Revenue

Companies with advertising-based models can enjoy decent profit margins, which are often enhanced by high operating leverage. The reason for the high operating leverage is that most of the cost in an advertising-based model is fixed. The cost of generating programming for a television or radio station or hiring a news staff for a newspaper or magazine publisher doesn't go up with more subscribers. However, advertising revenue streams can be somewhat volatile—advertising is one of the first costs that company executives cut "when the economy turns south, which is why advertising revenue growth tends to move with the business cycle. Media firms that rely on advertising are fairly sensitive to the state of the overall economy.

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