If you subscribe to DISH Network (NASDAQ:DISH), odds are you have experienced blackout periods for certain channels while the satellite TV provider negotiates with companies such as CBS (NYSE:CBS) and Time Warner's (NYSE:TWX.DL) Turner Broadcasting.
DISH has made some concessions to broadcasters lately to keep its carriage fees low enough to prevent its customers from paying too much. Sooner or later, though, higher carriage fees are passed on to customers, which is quite evident in the steady rise of the average cable bill.
But 2014 was different for cable networks. Ratings declined significantly from 2013, which forced brands to reconsider their television ad spending. Indeed, ad sales growth fell well below expectations for most networks last year. Many brands are shifting ad dollars to digital as people spend less time watching cable channels, and more time watching Netflix (NASDAQ:NFLX) and other over-the-top services.
Making up for lost ad revenue
A recent report from Nielsen showed that live TV viewing declined 4% year over year in the third quarter of 2014. Meanwhile, hours spent watching online streaming video increased by 60%, to almost 11 hours per month on average. That still pales in comparison to the 147 hours per month the average American spends watching television, but it points to the main cause of the decline in viewer hours.
For the third quarter, Time Warner's domestic advertising revenue was flat, with a low-single-digit decline in entertainment channels such as TBS, TNT, and Cartoon Network offset by an increase in news networks including CNN.
CBS, meanwhile, reported a 2% increase in advertising revenue. That's a significant deceleration from the 4% ad revenue growth the company saw in the third quarter of 2013, especially considering CBS has added Thursday Night Football, for which the company was asking for $500,000 per 30-second spot.
With fewer people watching live television -- particularly outside of prime time -- brands are shifting their ad dollars toward digital outlets. Digital advertising allows companies to target their ads even better than cable channels. Cable networks targeted at niche audiences attract higher ad rates per viewer. Those ad dollars are more rapidly shifting to digitally targeted ads than the broad-reaching broadcast network and prime-time shows.
As a result of the declining ad revenue, networks are asking for more in carriage fees to make up for their own failures to attract an audience.
An unsustainable solution
Pay-TV operators aren't willing to pay as much for channels that only a few people watch. So media companies bundle their networks together to force cable providers to buy things they don't really want. For example, if DISH doesn't want to pay for Cartoon Network, it also doesn't get CNN.
All of these costs are ultimately passed to subscribers. As a result, churn is becoming a big issue for pay-TV providers as customers chase low-price promotions from other providers in the same territory. Those deals slow the pace at which people abandon cable, but both the increasing average subscription price and the low-price promotions are unsustainable.
If carriage fees continue climbing, such promotions will stop being worthwhile for competing pay-TV operators. Meanwhile, the average pay-TV rate for those no longer on the promotional contract will also climb higher, increasing churn and leading to cord-cutting. At some point, the networks will find an equilibrium where it no longer makes sense to increase carriage fees.
What happens then?
The networks are already asking for more money from Netflix and other over-the-top services to license programming. Those rates ought to continue climbing, especially as networks run out of leverage with cable providers.
Content owners have greater leverage over Netflix, since the streaming service relies on them for the bulk of its content. Additionally, Netflix leans on its content library to attract and maintain subscribers -- its only source of revenue. Finally, Netflix's no-contract monthly subscription makes it easy for subscribers to leave at any time.
Netflix will do what is necessary to maintain its content library. Raising rates has been difficult in the past, but it looks like the $1 increase instituted last year did not slow new subscriptions. Whether that price spike will provide enough additional cash flow to pay increasing content costs is yet to be seen. The company might have to issue debt or more stock to cover its content costs down the line, which would negatively impact shareholders.
With other companies relying on content owners, Time Warner and CBS will figure out how to keep growing revenue one way or another. But it's starting to become a zero-sum game for profits.
Adam Levy owns shares of Apple. The Motley Fool recommends Apple, Google (A shares), Google (C shares), and Netflix. The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.