Original Content Powers AMC

The most widely distributed channel, AMC, reaches more than 90 million households in the United States. The shift to original scripted content was spurred by the success of its shows such as Mad Men and The Walking Dead. With a reach of 85 million households, WE tv traditionally targeted a female audience, with its recent success based on unscripted series. IFC reaches 73 million households and mainly shows independent films and alternative comedy series. The shift away from showing lower-rated movies to original scripted and unscripted shows has attracted a larger audience for AMC's networks. We expect this to give management leverage to increase affiliate fees as the current carriage agreements continue to expire. However, AMC faces stiff competition for fees from entertainment networks that are owned by larger media peers.

Creating a new basic cable network with carriage, high-quality content, and attractive affiliate fees requires not only a large up-front monetary investment but also deep industry relationships. Most pay-television distributors worldwide believe their channel offerings are deep enough and see no need to expand. A new channel could overcome this reluctance by paying for carriage, but the risk inherent in this tactic precludes small firms from employing it. These hurdles led AMC to purchase the international cable channel business Chellomedia for just over $1 billion in January 2014. The acquisition provides the firm with a larger presence outside the U.S. and a platform for its hit programs. As result, the AMC channel is now available in 120 countries. This also better positions AMC to benefit from increased pay-TV penetration internationally, as 20% of revenue now comes from abroad versus 8% before.

We Expect Value of Video Content to Increase We assign AMC Networks a narrow economic moat rating. The media company operates five domestic cable channels and a portfolio of international channels that reach 390 million subscribers in 130 countries. Its primary channel, AMC, regularly ranks in the top 10 cable networks in the U.S., but none of the other channels are in the top 25. The company has expanded its exposure to international markets via the Chellomedia acquisition. Our guiding premise in media is that the value of video content continues to increase even as the distribution markets mutate. Despite the changes in consumption patterns, pay-TV penetration remains well above 80% of households in the U.S. Even without a pay-TV subscription, most cord-cutters still consume video content. While over-the-top offerings such as Netflix NFLX and Amazon Prime AMZN have begun to create their own content, both services require deep libraries to gain and retain subscribers. Given the ongoing demand for content, we believe content creation for cable networks is not a zero-sum game as quality content will always find an outlet.

The company's largest network, AMC, reaches over 95 million households subscribing to basic cable in the U.S. The next largest channel, WE tv, is in over 85 million homes while the recently acquired BBC America is in 78 million. The two smaller channels, IFC and SundanceTV, are in 73 million and 56 million households, respectively. A new entrant would encounter two major hurdles to launching a new cable channel with widespread distribution in the U.S. or abroad. First, the cost to create new quality content is very high--especially the higher-quality scripted content on AMC such as The Walking Dead, Mad Men, and Better Call Saul. Second, gaining distribution without paying for carriage in many markets for a new company may be nearly impossible, as cable operators have no need for new channels, which only add potential costs down the road. While the company lacks the established global network that took competitors such as Discovery DISCA and Fox FOX years to build out, the acquisition of Chellomedia helps to kick-start the process for AMC by providing platforms to distribute the programming from AMC and the other channels.

Over the past 10 years, AMC has positioned itself as one of the prestige platforms for scripted television with its Emmy wins for outstanding drama series. We believe AMC will continue to prosper as an outlet of choice for creators of original scripted programming. Beyond prestige programming, AMC has proved its ability to deliver a large audience for its shows, given the success of The Walking Dead. With over 20 million total viewers, the show provides advertisers the ability to target a mass audience that is usually only generated by the top broadcast network shows or the NFL on Sunday night.

AMC has lowered its exposure to advertising, with 38% of revenue derived from advertising versus 68% at Scripps SNI, 56% at CBS CBS, 50% at Discovery, 35% at Viacom VIAB, and under 20% at Time Warner TWX. We continue to believe that in the long run, the U.S. television ad market will grow slowly, if at all, as advertisers continue to spread their ad budgets across a growing number of advertising platforms including streaming video and social media. Networks will increase advertising revenue at the expense of competitors, not by maintaining share of a rapidly expanding pie. Also, a larger percentage of the spending will occur in the scatter market, making real-time ratings even more important. Internationally, we expect a similar diversification of ad spending, albeit offset by increased penetration for pay TV. As penetration increases and crosses certain thresholds such as 50% of households, we expect increased advertiser interest in those markets. While advertising only generates 11% of international revenue, we expect the combination of increased penetration and better content from AMC to help international advertising revenue grow much faster than U.S. revenue.

Like Scripps, AMC entered the international market relatively late compared with its peers, particularly Discovery, which spent decades building out its international networks. International revenue only accounts for 20% of total revenue for AMC versus 47% at Discovery, 45% at Fox, and 31% at Time Warner. However, unlike Scripps at 3%, AMC has already made a transformative acquisition with the acquisition of Chellomedia. Beyond adding distribution, we believe that AMC's high-quality scripted content can easily move across borders, as seen by the success of Breaking Bad, HBO's Game of Thrones, and Netflix's House of Cards outside the U.S.

Economic Slowdown, Lower Viewership Are Risks Because the company's cable network business depends on advertising for about 38% of its revenue, AMC could be vulnerable to a general slowdown in the economy or weak programming that reduces its viewership. Competition from larger general entertainment networks like TNT, TBS, or FX, which also generate original content, could cause AMC's viewership to decline. AMC's success remains contingent on its ability to source and cultivate strong original content as well as monetize the programs internationally. The increased interest in original scripted content from traditional cable networks, premium cable networks, and streaming-video-on-demand players such as Netflix could cause the cost of acquisition for original programming to rise dramatically, negatively affecting margins. AMC's overseas expansion exposes the company to country-specific regulatory risks as well as potential foreign exchange headwinds.

AMC Networks was spun off from Cablevision, so it has a relatively limited history as a distinct entity. It has a stretched balance sheet relative to its direct peers but is in decent financial shape. Since the firm currently does not pay a dividend, we expect a combination of reinvesting in the business and a steady paydown of debt over the next few years.