Paramount Stock: What The Recent Media Downgrades Are Missing

It’s time for my quarterly “defense of Paramount” (NASDAQ:PARA) (PARAP) article. Trading below $20, despite no corresponding reduction in profit, the forward P/E is now a ludicrous 8. I have been a regular buyer – with some selling at the triple-digit peak – for almost two years now. As it remains mired in the teens and suffers increasing downgrades from industry analysts, I have doubled up again on my position. Including both classes of its common shares (NASDAQ:PARAA) Paramount now represents over 20% of my total holdings. I have put a lot of eggs in this basket.

I am comfortable doing so. In my opinion, those assessing linear bundle media stocks are overestimating the future expenses of these companies, specifically in the non-content expense category. While that argument applies to a lot of different companies, only Paramount has the sensible sports investments to pair it with, so that is where I am putting my money.

I will be focusing on Paramount for this article, but I hope investors in other tickers will also find it useful as many of the same principles applied here can be applied to analyzing the effect of cord-cutting on other companies, as well. Specifically, the expense reduction argument I’m going to make applies to all.

Ongoing Downgrades

The latest to hit Paramount with a downgrade was Wells Fargo (WFC). In doing so, they became the latest in a long line of analysts who have put bearish rankings on Paramount stock due to the decline of the linear bundle – which I agree is in real danger of not just shrinking, but positively collapsing – and a perceived inability to hold its own in the more cutthroat competitive world of streaming.

I have explained elsewhere why I think Paramount can not only survive, but positively thrive in a streaming environment. I won’t rehash all that here, but some of you I hope might find those previous articles useful if you haven’t read them already, in particular the differentials between Paramount and a competitor like Disney (DIS) or Warner Bros. Discovery (WBD) in the world of sports TV contracts. Frankly, it is those companies, not Paramount, that should be worried if the music in the linear bundle really is about to stop.

Both Sides Of The Profit Equation

The purpose of this article is not to repeat myself. Rather, I want to tackle one particular aspect of the bearish thesis that I have not previously addressed, and which seems to me not entirely correct. The bearish argument, in a nutshell, is that there is an impending contraction in revenues approaching owing to the linear bundle’s collapse, and this will translate into lower profit. Seems reasonable, no? But profit, of course, has two components.

To assess what Paramount’s purported linear-free future would look like, I want to examine both revenues and costs a little more closely. In a nutshell, my thesis is that, at least for Paramount, a collapse of the linear bundle will bring about a reduction in revenue – or at least theoretically could – but if it does so it will also bring about a corresponding reduction in expenses, leaving the overall profit picture not overly affected.

A Clean Look At The Right Data

We already have two of Paramount’s 2022 quarters in the bank, and the third-quarter report is due out soon. However, for this article I’m actually going to use the 2021 annual report numbers. The reason for this is that 2021 still saw the vast majority of movie theaters in the US shut down, and Paramount largely held its theatrical fire waiting for people to return in 2022.

Smart move, as we now know; Top Gun alone is approaching $1.5 billion in box office revenue, and during the summer lull in moviegoing that stretched largely from early August to mid-October, it actually returned to the top spot on the box office – five months after its initial release. More recently, Paramount’s horror picture Smile lead the box office two weeks in a row, and the lower budgets of horror almost guarantee that it will be substantially profitable.

Still, we want to talk about the linear bundle, and its effect on Paramount. A theater-free yearly report allows us to focus in on the present question more precisely.

So what, exactly, does a linear-free Paramount look like?

Constructing An Alternate Reality

Paramount is rather unique among major US content companies in that its revenues remain not just majority-US, but overwhelming domestic. Of the $28.6 billion in revenue Paramount reported in 2021, no less than $23.3 billion was domestic. Of that amount, just under half, $11.4 billion approximately, was generated by advertising while the other $12 billion came from subscription fees – called affiliate fees in the Pay-TV context – and licensing deals.

We can almost put these two revenue sources in the same bucket, because any content licensed is not available on the company’s own service to attract subscribers and subscription revenue. However, licensing also refers to the sales of consumer products and trademarks on children’s toys, etc. So not all of this revenue would be cannibalized even if Paramount chose to put every last piece of content on its own services.

The collapse of the linear bundle means that all Pay-TV advertising spending in our assumed alternate reality would suddenly need a new home. For now, I’m going to assume that advertising revenue will neither increase nor decrease as a result of the streaming transition. If the streaming services have to replace all non-international, non-advertising revenue, Paramount’s domestic streaming will need to generate some $11.9 billion per annum.

Doing The Math

International and Licensing

One small fly in the ointment of making meaningful calculations is that while Paramount disclosed the breakdown of revenues by segment and geography, it did not do so for “segment and geography.” This means that we have trouble knowing at any given time exactly how much of a segment’s revenue is attributable to the US and how much is international.

Given the much higher share of US revenue, it seems plausible that at least some of the licensing revenue that is being classified as domestic – because the company that is licensing is based in the US – is actually international because they’re licensing global rights which are then streamed around the world. This means Paramount is in a better position than we will calculate because its US streaming operation will need less revenue generation to match current profit levels.

On the other hand, at least some of the advertising revenue is presumably international as well. And we’ve already given the company full credit for that in our linear-free alternate reality. For now, I will assume that domestic streaming has to fully replicate the entire non-advertising domestic revenue pie, and that international licensing and international advertising perfectly cancel out. If anything I expect that is conservative in Paramount’s case.

Revenue Replacement Target: $11.9 billion

Showtime

Paramount+ and Showtime remain – for now – two separate streaming services. So the first step is to calculate how much Showtime brings to the table. That’s a little difficult since Showtime currently has revenue on the linear side of the revenue pie as well as the streaming side. Depending on whether someone is subscribing linearly, directly, or in a bundle with Paramount+, Showtime can sell for anywhere from $5 to $11 per month. So we don’t have an accurate revenue count and we don’t have a consistent price.

Showtime is generally seen as the #2 DTC service, behind HBO but ahead of Starz and Epix. I’m going to look to third-party data and pencil it in for the same amount of revenue as Starz. Currently, Starz is reporting 21.4 million domestic subscribers. At a DTC price of $9 per month, that is good for over $2.3 billion.

I consider this, if anything, an underestimate. Showtime is generally considered more prestigious – if only slightly – and frankly both Starz and Showtime will probably do better in a post-linear world than in the current one. OTT subscribers already make up almost 60% of Starz’s subscriber base despite two-thirds of US households still being Pay-TV subscribers.

If Starz’s 12.4 million subscribers over the one-third of the population that is currently non-linear is an accurate reflection, then some 37 million subscribers would generate over $3.3 billion of revenue.

However, I will use the lower number for now.

Revenue Target Remaining: $9.6 billion

Product Licensing

Even if you think all licensing revenue will collapse into Paramount+, which I don’t, there is still the revenue from the consumer products sales and trademark licensing. In 2021, there were $6 billion of retail sales of Paramount licensed products. Generally, the king of product licensing, Disney has reported that about 10% of those retail sales become license fees for the licensor. That means about $600 million of revenue for Paramount that we can deduct from the streaming target.

That number is probably low, however, because it excludes any non-product sales of licensed content. Disney, for example, also makes a lot of rides and experiences for its products that don’t necessarily fall into the “toy” category and which Disney therefore puts in its “Parks” category instead of its Products category. Since Paramount doesn’t have parks of its own, any similar experiences sold with its copyrights would just show up as more licensing revenue. But to be conservative, I will assume this category is $0, crazy as that sounds to me.

Remaining Revenue Target: $9 billion

Paramount+ Premium

Meanwhile, what can Paramount+ reasonably put forward? Paramount+ has two tiers, Essentials and Premium, which sell for $5 and $10. Premium is generally ad-free, and we already credited Paramount for all its advertising revenue, so we need to be a little careful here. As I’ve explained before, however, Premium is not really entirely ad-free. Some of it is live viewing, like say for example NFL games? Those remain ad-interrupted, and the streaming transition means that those ads are probably going to become significantly better targeted. Which means that it is at least conceivable that a Premium subscriber could still generate something close to the advertising revenue of an ad-supported linear subscriber now, if targeting got good enough.

To avoid double counting ad revenue while still accounting for this phenomenon, I am going to create a blended rate of Premium and Essential that assumes that only sports viewers are Premium subscribers. That assumption doesn’t need to actually be true; what we’re really assuming is that the Essentials tier generates the same ad-revenue as the ad-free premium charged on Premium tier for those who don’t watch sports. That means we can essentially treat all non-sports viewing subscribers as indifferent between the two tiers. Since we already counted the ad-revenue, we’ll count those non-sports viewers as Essentials.

As I noted in my previous article, there are a minimum of 40 million NFL viewers who are likely subscribers to Paramount+ during the NFL season. Really it’s probably more than that because some fans will not be able to watch a given weeks game for one reason or another; that 40 million per week is more like 50 million households watching 80% of the games each. But for now, we will call it 40 million. Paramount+ also broadcasts March Madness (17 million viewers for last year’s championship) in March and once every four years it broadcasts a Super Bowl and gets an extra month of 100 million subscribers. There’s also soccer and, starting next year, the Big Ten.

Altogether, I will assume that Paramount+ has an average of 40 million sports viewers for half the year. A yearly average of 20 million subscribers paying Premium rates of $10 per month and yet still watching advertising. That brings Paramount $2.4 billion in non-advertising revenue.

Remaining Revenue Target: $6.6 billion

The Missing Piece

At first glance, that would seem to leave Paramount Global in a hard place if linear collapses. In order to generate the remaining $6.6 billion per year it would need 110 million Essentials subscribers on top of the 20 million Premium subscribers, for a total household penetration of 150 million households when we consider that the Premium tier is actually a double-count for half a year. There aren’t even that many households in the US.

But I am not worried about my investment, because there is one final offset, a very substantial one. Excess linear SG&A. These are linear-focused general administrative expenses that I believe will fall off if the bundle truly collapses and they’re no longer needed.

Most analyses don’t seem to be accounting for this. Estimates are basically just plugging in linear-level SG&A expenses into a legacy media company’s streaming future. But I’m not convinced that’s right. In fact, I would argue that the number is as much as $4 billion per year too large.

Streaming Is Slimmer Than Linear

Before everyone jumps all over me, no, I’m not necessarily predicting that Paramount’s SG&A expense category is going to take a sudden and drastic plunge to the tune of $4 billion. However, there is a notable disparity between the non-content expenses of traditional linear companies like Paramount and Disney and more streaming-focused companies like Netflix (NFLX) and the YouTube division of Google (GOOG) (GOOGL).

Let’s just compare Paramount to the king of streaming – which is still Netflix by the way despite the recent doom and gloom. Here I will use 2022 numbers since theaters shouldn’t affect this at all. In the first six months of 2022, Netflix reported three non-content expense categories, General & Administrative, Technology & Development, and Marketing. They summed to $3.312 billion.

Paramount unfortunately doesn’t use the same categories. A lot of the marketing and technology side gets bundled in with content expenses. But fortunately, Paramount does kindly provide a breakdown of its Operating Expenses into Content Costs and ‘Distribution & Other’ so we will use the ‘Other’ category as a stand-in for Netflix’s more granular approach. This came to $1.96 billion, along with the General & Admin category’s $3.39 billion. Another $190 million in non-content depreciation & amortization should probably be thrown in, too, but we won’t.

Even the first two sums means that Paramount spent roughly $2 billion more in six months on non-content expenses to generate the same levels of revenue that Netflix did. I do not believe this comes down to simple managerial incompetence – other linear TV players like AMC Networks (AMCX) and Disney generate similar disparities.

Rather, I suspect this is a symptom of participating in the linear pay-TV monopoly bundle, which companies consider to be a worthwhile expense because of the benefits the bundle brings them.

Specifically, I think it’s about advertising. This article is long enough already, but I’ve explained elsewhere why the pay-TV bundle is attracting considerably more ad share – and streaming considerably less – than it should be even under current viewership statistics. There are reasons that is so, but apparently the cost of tapping into that gold mine for linear companies is a higher SG&A spend.

But presumably, those extra expenses will last only as long as the bundle lasts. If therefore, Paramount bears are going to use the collapse of the linear bundle as a justification for being skeptical of the stock, they need to adjust their non-content cost projections accordingly.

Remaining Revenue Target: $2.6 billion

Paramount+ Essentials

At only $2.6 billion, Paramount’s Essentials pot size needed looks far more reasonable. That’s about another 40 million subscribers, at a time when CBS regularly tops the channel ranking of a pay-TV bundle with 80 million households in it. A 50% penetration of the remaining linear households post-bundle seems to me, if anything, conservative.

Thesis Summary

For any company that still has one foot in the door of the linear bundle even as it dips a toe – or maybe by now a few toes – of the other foot into streaming, projections about future profitability seem to me to contain somewhat excessive projections of non-content spending. There are absolutely reasons to be skeptical of certain companies’ ability to navigate the transition from linear to streaming, but they mostly concern overpriced sports contracts. That is a major worry for Disney, Warner Bros. Discovery and perhaps even Comcast’s (CMCSA) NBCUniversal.

But I suspect that most scripted-focused providers who don’t have sports contracts – like A&E Networks, AMC Networks, Hallmark’s Crown Media and Discovery before its ill-advised merger with AT&T’s (T) WarnerMedia – will actually do relatively well.

Paramount has sports contracts but generally only well-priced ones, meaning its profit profile looks a lot more like the sports-free producers than its sports-focused industry peers. For these companies, a probable decline in revenue will almost certainly be matched by a corresponding decline in non-content expenses.

Investment Recommendations

I remain a Strong Buy on Paramount. I rank Comcast and Disney as weak Holds, and Warner Bros. Discovery is getting perilously close to a Sell rating. But until it actually re-ups with the NBA and loses its escape hatch, I’ll put a weak Hold there too.