For the media world August 4 felt like a remake of The Day the Earth Stood Still. It began serenely enough, with a quarterly earnings conference call by Robert Iger, chairman and CEO of Walt Disney Co., the planets foremost entertainment conglomerate. From his Burbank, California, headquarters, a relaxed Iger announced record-high earnings and dividends above consensus estimates.
But then he lowered long-term guidance, noting that viewership was down at Disney sports juggernaut ESPN. Acknowledging the rapidly changing media landscape, Iger conceded that younger audiences were increasingly turning to video streaming.
The market freaked. If even ESPN, the most profitable channel on television, was losing viewers, what hope did traditional media companies have against cord-cutting upstarts, led by Netflix? In the five trading days that followed, more than $50 billion of market cap was swept away from older U.S. media companies, and there is no recovery in sight. Along with declines in Disneys stock, the share prices of AMC Networks, CBS Corp., Comcast Corp., Discovery Communications, Time Warner Inc., Twenty-First Century Fox and Viacom plummeted. By September 19 shares of these leading media companies were down 11 to 23 percent from their August 4 levels.
Investors got paranoid about the potential for accelerating changes around cord cutting and advertiser behavior, says Brad Barrett, Los Angelesbased media analyst for Capital Group, which runs several funds invested in both traditional media and cordless newcomers. In a business like media, with large fixed costs, changes in future revenue expectations can have a big impact on future profit expectations.
Investors have good reason for paranoia. Netflix offering on-demand films and TV shows at a fraction of pay-TV prices has become the media worlds great disruptive force. Skeptics think Netflix is overly dependent on subscription fees and vulnerable to cordless rivals it helped spawn. But over the past five years, the Los Gatos, Californiabased company has transformed itself from a struggling DVD rental business into the premier video streamer, with 66 million subscribers worldwide, 45 million of them in the U.S. Many of those viewers have turned their backs on cable and satellite companies that force them to accept bundles of hundreds of unwanted channels for access to a few favorite programs heavily interrupted by commercials. And the price for these privileges now averages more than $80 a month about ten times the lowest subscription fee for Netflix. The traditional pay-TV system is pricing itself into oblivion, says Craig Moffett, a New Yorkbased senior analyst and partner at MoffettNathanson, a leading media research firm.
Linear TV, with real-time programming, hemorrhaged 600,000 subscribers in the second quarter of this year alone. With the loss of these viewers, advertisers are turning increasingly to online players like Facebook and YouTube. The two legs of the traditional media stool are subscriptions and commercials, and they are getting wobbly, says Richard Greenfield, a media analyst at global brokerage BTIG in New York.
Nobody disputes that linear television will survive and reap profits, albeit at a slower pace. Most consumers still depend on their cable or phone companies for access to high-speed Internet. And many of them sign up for packages of phone, Internet and cable TV that are cheaper than buying these services separately.
But its hard to overestimate the impact of Netflix and other online companies in reshaping U.S. media, an industry with a whopping $150 billion in annual revenue. Cord cutting has exposed deep fault lines in traditional media. What we are seeing is a bifurcation between the losers whose content is no longer viewed as interesting versus those who still offer top-shelf content, says Lawrence Kemp, New Yorkbased portfolio manager of BlackRocks Capital Appreciation Fund, whose $3.4 billion in assets includes stakes in Facebook, Google and Netflix. Behemoths like Disney and Comcast with film studios, theme parks and resorts as well as television operations are profiting from their diversified revenue streams. Others, like Viacom, are struggling to revitalize business models too closely tied to linear television.
Netflix has been a driving force in M&A activity, splitting content providers mainly, studio-based media conglomerates and distributors (broadcast, cable and satellite companies) into separate camps that battle each other over slower profit growth in linear television. Both camps are looking to mergers to increase their negotiating powers against each other and cordless rivals.
But Netflix, with support from consumer advocates and regulators, has successfully lobbied against mergers it views as threatening to its broadband access. Comcasts failed bid for Time Warner Cable (TWC) earlier this year was a direct result of Netflix lobbying. (Time Warner spun out its TWC cable operations as a separate company in 2009.)
Hoping to slow down Netflix, traditional media companies are making their own attempts at video streaming with mixed results. The biggest such initiative is Hulu. But this joint venture of Comcast, Disney and Fox has been dogged by internal disputes over brand placement and content that have slowed its decision making and growth. This is an industry with big personalities and competing interests that can make it difficult for large studios to work together, notes Nidhi Gupta, Boston-based manager of the $865 million Fidelity Select Multimedia Portfolio, whose largest holdings include Comcast, Disney and Time Warner. Although the $8 monthly subscription fee for Hulu is virtually the same as for Netflix, it has drawn complaints because, unlike Netflix, Hulu interrupts its programs with ads. In response, Hulu in September began to offer a commercial-free monthly subscription for $12.
Although Netflix is the cordless leader, questions are rising about its business model, which single-mindedly focuses on fees from subscribers, whose numbers are rapidly growing around the world. This one-track strategy makes Netflix vulnerable to rivals. Amazon Prime has become the second-largest streamer by offering its videos free to customers who sign up for unlimited delivery of other Amazon.com goods and services for a $99 annual fee. Promoting itself as commercial-free entertainment, Netflix has ceded ad revenue to Facebook and YouTube, both of which are becoming video-streaming competitors. And lurking on the horizon as a video streamer and an advertising platform is Apple.
This variety of pressures on Netflix have given investors pause. Though at first the company seemed immune to the Disney-induced summer sell-off, Netflix shares dropped 15 percent from August 4 to September 19.
Although the impact of video streaming on linear television has been dramatic, big media companies had plenty of time to prepare for the onslaught, yet failed to do so. The worlds of music, publishing and retailing had already been devastated by Internet upstarts. Audio streaming now accounts for 350 percent more music sales than compact discs. E-book sales trail hardcovers by only 20 percent, while print advertising for newspapers and magazines is at all-time lows. And Amazon, with a $252 billion market cap as of September 19, has soared past mighty Wal-Mart Stores $203 billion valuation.
But media giants were convinced they would be the exceptions in the new digital age. In a memorable December 2010 interview with the New York Times, Time Warner CEO Jeffrey Bewkes scoffed at Netflix: Its a little bit like, is the Albanian army going to take over the world? I dont think so. Over the past 18 months, as the Netflix blitzkrieg has spread unchecked around the globe, media companies have become surprisingly silent with the press, preferring to confine their comments to quarterly earnings calls and the occasional forum with analysts.
How did Netflix manage to stay under the radar of the media establishment for so long? For one thing, it was long identified as a video-rental company, and it stumbled, sometimes spectacularly, during its transition to on-demand digital streaming. Media companies initially viewed Netflix not as a threat but as an added source of income and gladly sold it rights to video-stream their reruns. Without question, the media companies were outfoxed, says BlackRocks Kemp.
Netflix was co-founded in 1997 as a video-rental company by Reed Hastings and Marc Randolph, two Silicon Valley software entrepreneurs. In 1991, Hastings, a former Marine and Peace Corps math teacher, started a computer debugging company called Pure Software, which Randolph later joined. Following the 1997 sale of Pure Software for $700 million, Hastings invested $2.5 million as start-up cash in Netflix.
Randolph, who was briefly CEO of Netflix, left the company in 2004, two years after it went public. He has criticized his former partner for taking too much credit for the companys early business model. Randolph takes special exception to Hastings account of how Netflix first differentiated itself from brick-and-mortar rivals. According to Hastings, he came up with the notion of flat-fee, unlimited rentals of videos distributed by mail after being forced to pay a $40 fine on an overdue rental of Apollo 13. Regardless of whether that was the eureka moment, it did not lead to immediate liftoff. In fact, after running up continuous losses, Netflix offered to sell itself to Blockbuster in 2000 for only $50 million but was refused.
The turning point for Netflix was its 2002 IPO and subsequent share sales that year, which raised $95 million. A year later Netflix posted its first profit. Success came quickly after that. By 2007 the company had become one of the largest users of the U.S. Postal Service, delivering a cumulative 1 billion DVDs to customers who were allowed to keep the discs at no extra charge until they were ready to order the next batch. That same year Netflix launched its video-on-demand service on the Internet.
But the company blundered. On September 17, 2011, Hastings announced that Netflix would split its DVD rental and streaming services, charging clients a 60 percent premium to receive both. It was a public relations and stock market disaster. In three weeks close to 1 million of the companys 25 million customers canceled their subscriptions and the share price plummeted almost 25 percent.
Netflix reversed course less than a month later: DVD mailings and streaming services would operate under the same Netflix name and on a single website. But the price increase remained in place. It took 15 more months for Netflix stock to recover to its precrisis level.
No wonder Netflix inspired little fear as recently as four years ago. Even after becoming the top cordless company, it convinced traditional media businesses that they could extend the life and profitability of older programs like Family Guy and SpongeBob SquarePants by letting Netflix stream them. That allowed all the media companies to rationalize the selling of content to Netflix, says analyst Moffett. Little by little, Netflix addicted everyone in the industry to revenues from digital licensing.
Now its too late for any traditional media company, including giants like Disney and Comcast, to refuse to deal with Netflix. With advertising revenue down for linear television, Netflix checks have become important contributors to profits and dividends. Sure, you could decide not to sell to Netflix, says BTIGs Greenfield. But what if your peers continue to do it? You end up losing revenue and consumer behavior continues to shift to streaming anyway.
Netflix has gone on to become a content aggregator in its own right. No longer satisfied with simply buying material from other studios, it is increasingly producing its own TV series and films. In 2015, Netflix earned 34 Emmy nominations for hit shows like Washington thriller House of Cards, prison drama Orange Is the New Black and comedy series Unbreakable Kimmy Schmidt. This years likely breakout series will be Narcos, about the rise and fall of drug kingpin Pablo Escobar, shot on location in Colombia.
Some media companies are already wincing at the prospect that Netflix will continue to bulk up through a combination of original programming and acquired content. Netflix is the most powerful content aggregator in the world today, and theres nobody thats even close, said Charles Ergen, chairman and CEO of DISH Network Corp., during the Englewood, Coloradobased pay-TV providers most recent quarterly earnings conference call, in August.
In 2015, Netflix will spend $450 million on original programming, up from $243 million last year. That still amounts to only about 10 percent of what Netflix is spending on content. But the company wants eventually to raise that figure to 50 percent.
Not only does original programming earn a higher investment return than reruns, it also tends to be more popular with subscribers. It helps grow the brand, and more importantly, it drives viewing hours, said Ted Sarandos, Netflix chief content officer, during the second-quarter earnings call, in July.
Netflix has grabbed 36 percent of the total video-streaming market, well ahead of Amazon Prime (13 percent) and Hulu Plus (6.5 percent). Netflix still lags far behind linear television viewership in the U.S., with only 6 percent of total viewing time. But the speed of the companys growth impresses investors and strikes fear into the established media. According to MoffettNathanson, the video streamer has doubled its share of TV viewing hours over the past two years and by 2019 could reach 22 percent. That figure doesnt include people watching on smartphones, tablets or computer screens, who arent tracked by Nielsen Holdings and other audience-monitoring agencies.
Rising investor expectations have pushed Netflix into that financial gravity-defying category that includes Amazon, Uber Technologies and other disruptive Internet companies. Netflix net income last year was $267 million, certainly an impressive 138 percent jump from $112 million in profits in 2013. But that total looks paltry compared with 2014 net earnings for Disney ($7.5 billion), Time Warner ($3.8 billion) and Fox ($3.7 billion).
Even so, Netflixs market cap has doubled since the beginning of this year, reaching $43.7 billion by September 19. Thats well behind Disney ($173.6 billion) and Comcast ($143.1 billion) but within striking distance of Fox ($53.1 billion) and Time Warner ($56.8 billion). The rise of Netflix has widened the gap between these strong media companies and weaker businesses whose valuations are melting.
Disney unquestionably remains the strongest media player. Before the August sell-off investors viewed the Mouse House as an unparalleled success story in the entertainment world. It still is an earnings-beating machine with a diversified business profile that is the envy of the industry. While its competitors all depend on television for at least two thirds of their revenue, less than half of Disneys sales are from TV, with the rest coming from its studios, parks, resorts and consumer licensing divisions. (Only Comcast has managed to mirror the Disney model with its Universal studios and theme parks, and NBC broadcasting to go along with its powerful cable networks.)
Disneys Christmas-season release of the new Star Wars movie will almost certainly be the biggest film event of the year perhaps even of the decade. Cordless rivals are determined to maintain good relations with Disney as long as they can. When you say Disney movies, mothers know what that means, kids know what that means, Netflix chief content officer Sarandos noted at a May media conference run by MoffettNathanson. Thats a partner we want to have around the world.
Revenue in Disneys current fiscal third quarter was $13.1 billion, a 5 percent increase over the same period the year before. Net income rose 11 percent to $2.48 billion. For the 17th straight quarter, Disney beat the Wall Street consensus for its profit outlook.
Before the summer sell-off it seemed inconceivable that Disney would be lumped with weaker companies battered by lower subscription and ad revenues. Disneys media business was somewhat protected from these trends because of its sports exposure through ESPN, says Fidelitys Gupta. With 90 million subscribers, ESPN is the single most profitable channel on television. But then Iger announced during the last earnings conference that ESPN had suffered some modest subscription losses. It seemed to confirm a Nielsen estimate in July that ESPN had lost 3.2 million subscribers over the previous 12 months.
That was the catalyst that headed investors to the exit, says David Bank, a New Yorkbased media analyst for RBC Capital Markets. It accelerated a portfolio management shift out of media investments. Market pessimism hit hardest at weaker media companies. The business models that are really struggling in terms of valuations are those with poor ratings and low engagement of viewers, says BlackRocks Kemp.
By those criteria, once-high-flying Viacom is among the most vulnerable media companies. Viacom built a strong following of younger viewers through its bundle of cable networks, which include Comedy Central, MTV, Nickelodeon and Spike. But its core demographic of children and teenagers is precisely the group that is shifting the fastest away from linear television to cordless viewing.
Recent hit programs such as MTVs Scream and Spikes Lip Sync Battle failed to stem a 17 percent year-over-year ratings decline at Viacom during the quarter that ended June 30. Net earnings were $591 million, a 3 percent drop. The departure of Jon Stewart from The Daily Show could not have come at a worse moment.
Of even greater concern is the slowing growth of Viacoms affiliate fees the money paid by cable, satellite and telecommunication companies to content providers to air their programming. A few distributors havent renewed their contracts with Viacom, and there are fears that the trend may snowball.
During his August 6 quarterly earnings conference call, Viacom CEO Philippe Dauman sought a silver lining. There is no question that our industry is in the midst of significant change, he said. Change can create uncertainty and concern, but with change also comes opportunity, and Viacom is seizing every opportunity.
Among the opportunities Dauman outlined: international operations. He singled out Viacoms growth in Great Britain. We have also undergone major expansion in Latin America, Asia and Africa, building our brands in countries with enormous headroom for growth in their own media markets, Dauman said.
The problem is that Netflix is expanding abroad as well. Most of the world is going through the same dynamics we see here, says analyst Moffett. Over the past four years, Netflix has opened operations in more than 50 countries. Around the world everybody wants on-demand Internet TV, said Netflix CEO Hastings during the companys most recent quarterly earnings call.
Abroad, as in the U.S., Netflix has been better than other video streamers at carving out market share. A case in point is Japan, where Hulu began operations before anybody else. But Hulu initially priced itself too high, charging subscribers about $20 a month. It also failed to provide any local content. That opened the door to Netflix, which is making Japan its top priority abroad this year.
Our pricing will be more aggressive than [Hulus] was, Hastings said. We will have local content. We may even have some local originals. To ease its penetration of the Japanese market, Netflix has persuaded Panasonic Corp., Sony Corp. and Toshiba Corp. to integrate the video streamer into their devices. In fact, if you go buy a television in Japan today, it is going to have a red Netflix button on it, even though we havent yet launched, Hastings said.
Traditional media companies are discovering that the market indulges Netflix even more abroad than at home. By MoffettNathansons estimates, investors value Netflixs international operations at more than $15 billion, despite the fact that the video streamer offers no guidance on when it will begin to make a profit outside the U.S.
Investors are holding Fox to a much tougher standard. We will continue to focus on selective deep growth in markets that really matter, said CEO James Murdoch during his August 5 earnings call, singling out India. Fox is especially strong in the fast-growing Indian market, where it owns Star India, the countrys leading media and entertainment network. Analysts cite increased investments abroad and foreign currency losses the same headwinds facing Netflix as sufficient reasons to lower valuations for Fox.
The pressures brought on by Netflix and other video streamers are driving the traditional media industry toward consolidation. The prospect of lower subscription and advertising income, plus higher fees to content providers, is increasing M&A activity among broadcast, cable and satellite companies. Distributors are bulking up to gain more negotiating clout with content providers and aggregators, says Fidelitys Gupta. This is typical of a maturing industry that has reached limits of pricing power because neither subscriptions nor ad revenues are growing.
Last year affiliate fees overtook advertising revenue for the first time. While subscriptions and ad revenue are on a downward course, affiliate fees are still rising by 5 to 10 percent every year. Unlike advertising, affiliate fees arent cyclical; they are contractually owed for years.
Thats a growing problem for the distributors. Consumers are rebelling against $80-plus monthly subscription bills from their cable and satellite companies, which in turn spend $40-plus a month in affiliate fees. Those 50 percent margins are rapidly evaporating because affiliate fees are rising at double the rate of subscription fees.
Slowing down affiliate fee growth is reason enough for distributors to consolidate and increase their clout in the next round of negotiations with content providers. But there again Netflix is wielding its influence.
The most dramatic activity thus far has been the failed attempt by Comcast to buy TWC, Time Warners former cable operation, followed by what looks to be the successful $67.1 billion acquisition of TWC and Bright House Networks by Charter Communications. Netflix played a crucial role in preventing the Comcast deal and has thrown its support behind Charters bid.
The Comcast deal was announced in early 2014 but fell apart this past April, when the Federal Communications Commission threatened to reject it on the grounds that it would reduce competition and hurt consumers. Only a few days before Comcast surrendered, Netflix CEO Hastings told analysts during an earnings conference call that the video streamers main goal at this point is to get the government to block the ComcastTime Warner Cable merger.
Netflix made some compelling arguments that gathered support among new Internet players and regulators. The Comcast-TWC deal would have created a combined company controlling 57 percent of high-speed Internet access subscriptions in the U.S. Even before the attempted merger, Netflix asserted it was being strong-armed into paying higher Internet access fees by Comcast, which allegedly reduced the bandwidth for Netflix programs and sparked widespread complaints by subscribers about the quality of their video streaming.
By contrast, Netflix has swung behind Charter because it does not charge Internet access fees. Netflix is standing in for the interests of any high-capacity online application, says Susan Crawford, a Harvard Law School professor who follows Internet issues. Anyone looking to invest in or run a new use of the Internet that requires a lot of bandwidth has to be worried about a future in which a very few gatekeepers control most of the eyeballs.
Consolidation among distributors is leading to M&A activity by content providers and aggregators, as well. If there is greater scale on the distribution side of the table, then there is a perceived need for more leverage on the content side, says RBC analyst Bank.
Last year, about the same time Comcast made its pitch for TWC, Fox launched an unsuccessful, $80 billion bid for former parent company Time Warner. Had the deal gone through, it would have created a $150 billion conglomerate combining the two largest Hollywood movie and TV studios. Another attempt at the merger is possible in the months ahead.
Some investors and analysts are skeptical that M&A will restore high-growth prospects to the traditional media industry. Mergers may create cost savings opportunities, analyst Moffett says. But size alone isnt going to change the trajectory of the business. Increasingly, Netflix and other cordless companies are bypassing content aggregators and distributors, going directly to the studios to buy content and then selling it to consumers.
The era when television was king of advertising is over. An extraordinary migration of ads is under way from print and broadcast media to online formats like Facebook and YouTube. Advertisers and their clients can now accurately track who is conducting searches and what transactions are being made. If you look at the market cap of the search engines and social media companies, it reflects growing ad revenues, BlackRocks Kemp says. Clearly, thats where the money is going. In fact, Amazon, Facebook and Google have emerged largely unscathed from the market hits taken by media companies since August.
The shift online is especially apparent among the tech-savvy 18- to 34-year-old demographic encompassing Millennials. For this group, paying hefty fees for a broadcast with 22 minutes of programming and 8 minutes of commercial interruption seems a ludicrous way to seek entertainment. According to the U.S. Bureau of Labor Statistics, Americans average 168 minutes a day watching TV and 198 minutes a day using apps, with Millennials by far the heaviest app devotees.
When we work with brands whose goal is to reach younger audiences, our first instinct is to move dollars away from linear television and toward digital, says Ian Schafer, chairman of Deep Focus, a New York ad agency. Because the older Millennials have children, they are smack in the middle of what has long been the most valuable demographic for advertisers.
Traditional media companies are trying to stanch the advertising hemorrhage by partnering with hip new-media companies that have a reputation for drawing Millennials. In August, Comcasts NBCUniversal announced $200 million investments each in Vox Media and BuzzFeed. Both online companies have discovered ways to get viewers to dip in and out of their content sports, video games, news and share it with friends. Thats something that linear broadcasters and even other digital companies have just not figured out, Schafer says. They are still hooked on trying to get people to spend more time on their programs or websites.
But for the foreseeable future, such initiatives will not be nearly as lucrative as TV commercials for traditional media companies. Despite the fall in television advertising revenue and the proliferation of online ads, the prices for commercials on TV arent going down. Thats because linear television still reaches the biggest audiences. Sports and other live events draw tens of millions of simultaneous viewers, and only broadcasters and cable companies have the money to sign up these events. No digital platform can outbid ESPN, Schafer says.
Thus far, Netflix has remained aloof to advertising and chosen to depend entirely on fees from new subscribers. It has stood aside as advertisers have turned to a growing list of digital platforms, including Facebook, Snapchat, Yahoo, YouNow and YouTube.
Among video streamers Amazon has a huge leg up in advertising. It streams videos for free if customers pay $99 annually to become Amazon Prime members, which also entitles them to free delivery of products purchased on Amazons website. Amazon is a place where people will not only consume video content but buy goods and services, says Schafer.
Apple may also emerge as a formidable force in advertising. Apple TV, an entertainment device that allows viewers to access online content through a television, was launched in 2007 but has been nowhere as successful as the iPhone and iPad. On September 9, CEO Tim Cook unveiled another major initiative for Apple TV: the ability to stream content from broadcast networks by offering viewers dozens of channel apps to choose from. We believe the future of television is apps, Cook told the audience at the launch of new Apple products. Starting in October users will be able to watch Apple TVstreamed programs on other Apple devices: iPhones, iPads and Mac computers. Advertisers could plumb an almost unrivaled wealth of viewer data from Apple.
But for the next few years, Netflix appears less vulnerable to these advertising developments than traditional media companies are. One of the few things that can be said with some certainty is that consumers are going to be watching much more of their programming in an on-demand environment, with lower ad loads than we see now, says Capital Groups Barrett.
Netflixs strategy to profit from these trends by adding ever more subscribers seems simpler and easier to achieve than the paths being charted by traditional media companies whose business model remains largely tied to linear television. The more subscriptions Netflix gains, the more it can spend on content, says BTIG analyst Greenfield. Providing enough desirable content to consumers thats what drives the hamster wheel.
Looking beyond the 18-to-34 demographic, Netflix is reaching out to even younger Millennials, who spend more time on smartphones and tablets than on TV screens. In August the company announced a programming push aimed at teenagers and tweens by licensing two films based on popular YouTube personalities Smosh: The Movie and Bad Night. It began September with the launch of Puffin Rock, an action and suspense series aimed at the preschool crowd.
They are selling content at a low price with a quality that gets better each year and not even worrying about advertising revenues, says BlackRocks Kemp. That is why they are so hard to displace.
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