Originally published by Cuffelinks
We have seen this before – companies spending big, not to advance their competitive position, just to hold their current spot. Newspapers around the world tried the strategy but many ultimately failed. In Australia, the car industry, clothing and footwear manufacturers and video stores all tried to save themselves by spending more money. They collapsed, unable to stop a king tide from drowning them in losses. And while we have yet to see the final death throes, fossil fuel retailers may have already been handed their death warrant by advancing renewable technology and battery storage.
Struggling in a corporate death spiral
Throwing good money after bad seems like the only strategy when an industry is in a ‘death spiral’ but history proves it’s often a waste of shareholders’ and lenders’ money. Of course, the alternative of accepting inevitability in a particular industry requires companies to abandon everything, including their revenue, while terminating the vast majority of their employees.
Checkmate.
While disruption is just another buzzword for ‘change’, there is no escaping the profound impact it has on old technology, incumbent businesses and legacy revenue models. And often, the disrupters are no better off.
When a technology advances, bringing down prices, it opens new markets. Increasing customer utilisation reduces the price even further, opening up still newer markets, increasing demand, reducing the price further and so on … until of course another newer technology replaces it. Businesses caught up in the cycle must run faster just to stay in the same competitive position.
Where does it leave television?
In the television entertainment industry, video streaming technology has fragmented audiences and squeezed margins by driving down consumer prices and driving up content production costs.
Scale and globalisation are important and the largest companies in the communications industry are colliding or competing. The growth of Netflix (NASDAQ:NFLX) is the best evidence of a changing dynamic in content creation and distribution.
This year, Netflix, Amazon (NASDAQ:AMZN), NBC Universal, Warner Media and CBS (NYSE:CBS) will collectively spend US$7 billion more than last year on content. The ‘food fight’ or ‘hail Mary passes’ in terms of creating unique scripted content is exploding with the new businesses disrupting the traditional studios by going directly to talent and bidding against each other. Viewers are demanding shorter product lifecycles and cheaper prices.
And while industry chiefs addicted to legacy affiliate fee [1] revenue suggest that content owners prefer to be aggregated in a bundle of channels and, as a result, to receive affiliate fees, they ignore the fact that viewers are ditching traditional cable and satellite packages at the new record rate of over one million per quarter.
Perhaps cable operators aren’t listening to consumers who are voting with their wallets. Just as we have already seen in the music industry, consumers don’t want to pay for an entire album – they just want to buy the songs they like. A ‘pick-and-pay’ or ‘skinny bundle’ model in television offerings, where consumers only pay for the channels they want, seems logical but the consequences for legacy revenue streams are terminal.
Recently, cable industry veteran and Liberty Media (NASDAQ:FWONA) Chairman John Malone warned his industry brethren that they must morph from being bundled retailers of video services to bundled providers of interactive Over-The-Top (OTT) TV services [2] as well as devices that will inevitably be connected to the internet of things.
Most content owners do not want to launch a direct channel and be forced to win viewers one-at-a-time through an OTT TV service, and there are alternatives. They include nano piracy networks, the private networks where applications are used to stream live or recorded content to the public or a defined group of viewers. Remember what Napster did to the music industry?. Content producers may need to reconsider their current distribution models anyway. Indeed, the Diffusion Group estimates that every major TV network will offer an OTT service in just three years.
New competition with different models
The financial implications of the shift are not confined to the traditional content producers and aggregators. Netflix holds hundreds of millions of direct consumer relationships and their credit card details, but emerging competition from Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB) Watch, YouTube TV and Disney (NYSE:DIS) is forcing Netflix to lower prices while spending more seeking new revenue streams overseas. In its most recent quarter, Netflix reported record negative free-cash-flow.
For example, Apple wants to develop a direct-to-consumer entertainment service beyond music. Like Netflix and Amazon, Apple has an estimated 700 million direct consumer credit card relationships. It would be relatively easy for Apple to offer a service, whether subscription based or free and supported by advertising. It is reported that Apple is having conversations with the content industry and wants to drive its ecosystem into the living room through video.
According to Variety Magazine, rising competition has meant higher salaries for actors, directors and production staff, which has increased the cost of producing a high-end drama for either cable or streaming from between US$3 million per hour in 2013 to as much as US$7 million today.
Meanwhile, younger, mobile-savvy consumers are leading the exodus from cable TV subscriptions. According to Deloitte, Gen Z, Millennials, Gen X, Baby Boomers and mature-aged consumers are all reducing their subscriptions to Pay TV. In the case of Millennials, those reporting a household subscription to Pay TV in the US has fallen from almost 75% in 2013 to approximately 50% in 2017.
Higher costs and lower subscribers (cable TV subscribers are being lost at the rate of 11,000 per day) mean business survival demands existing subscribers pay more. This can only accelerate the exodus to cheaper and more convenient alternatives, checkmating traditional operators who cannot remain in business without raising prices.
Impact on investment markets
The S&P500 Media & Entertainment index recently slid 15% from its all-time highs. Investors who are aware of the common traits seen in industry death spirals are better positioned to avoid falling for a potential value trap. Like many history-changing technologies before – think motor vehicle manufacturing or air travel – it is often the consumer that wins, not shareholders. In fact, in some industries today such as TV, the best opportunities might come from short selling.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.
[1] Mainstream television content development is funded by affiliate fees, which are the ‘share’ of the subscription fees paid to cable or satellite operators that are ‘rebated’ or distributed back to the content producer/owner/distributor on a per subscriber basis. By way of example, ESPN – as content owner – can negotiate high affiliate fees because, at least for now, a cable or satellite operator would appear insane offering a television bundle without ESPN included.
[2] Over-The-Top (OTT) refers to content providers that distribute streaming media as a standalone product directly to viewers over the internet, bypassing other broadcast platforms that traditionally act as a controller or distributor of such content.