Net Neutrality or Level Playing Field

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It was announced on December 15, 2016 that the current Chairman of the Federal Communications Commission (FCC), Thomas Wheeler, would be stepping down as of January 20, 2017. He has been the lead arbitrator and backer of a concept called “Net Neutrality.” “Net Neutrality” is a worthy concept in theory, but the loss of its most powerful supporter and bureaucrat will significantly change the landscape of internet access and concentration issues in more traditional media outlets. What is “Net Neutrality,” what are the concentration issues, and how does that effect our long duration common stock investment in traditional media shares?

“Net neutrality” is the principle that internet service providers and governments regulating the internet should treat all data the same, not discriminating or charging differentially by user, content, website, platform, application, type of attached equipment, or mode of communication.

At its best, the hope surrounding “Net Neutrality” was that there would be no discrimination on the internet for the benefit of the average citizen using it. In practice, it has worked exactly the opposite. Two companies (YouTube and Netflix) are reported to use 54% of the downloading spectrum available in the U.S. The lack of discrimination has forced the FCC to beg existing owners of the high-definition (HD) spectrum to sell it to the companies providing access so that the other 46% of downloaders can get what they want.1

Ironically, the owners of the HD spectrum are the network-affiliated TV station owners whose business is being threatened by the new entertainment distribution methodologies. Simultaneous to giving their distribution competitors unlimited market share and favorable pricing, the FCC has limited the ownership of local affiliates nationwide to 39% ownership. This has dually hindered them from having the critical mass to keep advertisers happy and fight on a level playing field.

Viewed in a Tom Wheeler FCC way, these companies are worth more dead than alive. Their spectrum satisfies a vision of the future favored by the Democratic majority on the FCC. Republicans argue that “Net Neutrality” ignores the free market and allows intellectual elites to set prices rather than letting the open market do its job. The victory of Donald Trump and the Republican Congress in the election effectively showed Thomas Wheeler the door. Where do we go from here?

First, it is likely the new FCC will have both a Republican majority and Chairman, which should result in “Net Neutrality” being challenged. If the largest users of download space aren’t forced to pay up for pigging the spectrum and pipes, small citizens will have to pay an artificially high rate for their downloads. The status quo existed so that Netflix and YouTube users could get a bargain. We own Comcast (CMCSK), who should have every right to charge their largest users to pay more as they crowd out the other internet downloaders. They also own NBC, whose affiliates are negatively impacted by the current rules. Comcast executives are probably celebrating Wheeler’s resignation.

Second, we believe the new majority at the FCC will look at 40-year old concentration rules and throw them out. Why is Netflix allowed in every home and our company TEGNA (TGNA), an owner of 46 network affiliates, is limited to 39% of the markets for local news and programming? If the concentration rules are eliminated, there could be numerous merger and acquisition transactions in the TV industry as the main players do a land grab. Think of how much more attractive Tegna would be if it could offer nationwide coverage to national advertisers or how coveted it might be by someone who is. Thanks to Tom Wheeler’s FCC, local affiliate owners trade at depressed price-to-earnings ratios and have sizable upside potential.

Compared to many other themes currently compelling investors in the post-election environment, the changes at the FCC require nothing more than naming a new member/Chairman and facing minimal Congressional resistance. Tax cuts and infrastructure spending would require legislative attention and action. In most cases, this means long delays and meaningful opposition. In comparison, this makes us think the media companies may have been given an early Christmas present on December 15th. Stay tuned to see who the Trump team names to lead the FCC.

Warm Regards,
William Smead

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The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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