DTC Video vs Cable TV Economics
I've been looking at media companies but the more I look, the more I get nervous the long-term economics of DTC video aren't going to be close to linear. This article explores why.
The current media landscape is fascinating to me; multi-billion-dollar companies battling it out for a slice of the DTC video market is as exciting as it gets for finance nerds. I haven’t found much value though; the reason is I (currently) have a pretty negative view on the long-term economics of streaming. When I think through possible end-game scenarios, I come to a similar conclusion pretty much every time; the cable bundle was the perfect distribution tool for legacy networks, and the advantages lost by going direct to consumer are significant and almost impossible to replace.
The Cable Bundle
We all know the cable bundle; you’d pay ~$100 a month to your cable company for a bunch of channels, you’d watch the same 5 or 10, and leave the others unused. Every year the cable company would jack up the price, you’d complain, blame the cable company, and then sign on for another year.
Cablecos don’t make much money from this arrangement, with networks keeping most of the profits. There are a few reasons for this; media consolidation moved some leverage to the networks in the 90s and early 2000s, with acquisitions like Disney/ABC, Viacom/CBS, and NBC/Universal. This allowed networks to negotiate deals on more channels at once. But the biggest reason imo is the rise of the internet. The internet ended the bundles’ dominance, but it also allowed networks to milk every last available dollar.
Over the past couple of decades broadband has morphed into the main driver of Ebitda for cablecos; high barriers to entry, low-cost provider, high margins, and a growing need for data… a gold mine. Video was still an important piece of the puzzle though; customers used the product daily, and not carrying key channels had a significant impact on customer satisfaction (raising the risk of churn). Cablecos wouldn’t just lose a video sub if a customer churned, they might lose a high margin broadband sub as well.
Networks realized this and began to push price. Comcast’s programming cost per subscriber has increased at a ~9% CAGR since 2010.
So, networks kept the profits, customers were locked into contracts (churning wasn’t easy), and, until recently, linear tv was an essential part of the average American’s tv experience. The kicker? Networks didn’t have to manage the customer relationship and dissatisfied customers directed their anger towards cablecos… no wonder they were slow to embrace streaming.
DTC/Streaming
Netflix, in early 2010s, created a new type of tv habit; binge watching. Consumers always liked the idea of binge watching, but before the internet it was difficult to do. People would watch Star Wars or Lord of the Rings trilogies at Christmas, but content was purchased individually; you had to weigh up the cost of the content with the benefit you’d get as a viewer. Netflix created a way around this. You could pay a monthly fee and have access to hundreds of titles on demand. This meant you could try a tv show for no incremental cost; if you didn’t like it, no problem, just pick another show and go again. If you found something you liked, you had 5 seasons to “binge”. All this cost ~$10 a month (the price of a box set DVD).
At first this wasn’t a bad thing for networks, Netflix would pay good money to license the content. It was seen as an add-on to a cable tv subscription; you still needed cable for appointment tv, live sports, and news. They’d just provided a better way to binge watch legacy tv series and created a new way for networks to monetize IP.
This has obviously changed over the last 5 years; DTC is now the future, pretty much all scripted tv is on streaming services, with sports and news starting to get some traction (e.g., EPL Peacock, NFL on Amazon Prime). Legacy networks have launched competing streaming services and are trying to balance profitability from linear tv with streaming growth. Consolidation is likely coming, but even if you can predict the winners, I struggle to see economics anywhere near the levels of legacy tv.
Some key changes with the DTC model that have a negative impact vs linear:
Owning the relationship
Having a direct relationship with the customer is usually seen as a benefit; keep more of the profits and control the customer relationship. But, as explained above, the cable tv relationship was a best of both worlds for networks; keep the profits and don’t deal with customer resentment towards price hikes. Now, when Disney raises the price of Disney+, the consumer is fully aware who raised the price. They also need to maintain a website/app and create a user experience that satisfies the consumer.
No more hiding behind cable
A recent settlement between Comcast and Altitude TV, a Denver based RSN, provides some insight into why DTC might not be comparable to cable tv. Altitude TV filed an anti-trust case in 2019, claiming Comcast had demanded significant fee reductions and were forcing them onto a separate premium tier (similar to an add-on like HBO). They settled in March of this year, but the agreement does not involve Comcast carrying the channels. An interesting quote from Altitude President back in 2019:
Translation - the deals we signed are based on cable subsidizing us; the math doesn’t work if we go it alone. This comment has proven prophetic, with the recent bankruptcy filing from Bally Sports, who tried their hand at DTC (they never really stood a chance with their debt load). RSNs are an extreme example but the point stands, cable has been subsidizing video (through broadband), and the distribution model of linear tv was great for networks.
Live tv confusion
Streaming live sports has become incredibly confusing as the industry attempts to transition to a hybrid distribution model. ESPN+ costs ~$10 a month (ARPU is more like $5 with Disney bundle), but you get limited access to certain marquee events like the NFL’s MNF (8 games) or the NBA. This is because MVPDs pay carriage fees (~$10 per month per sub for ESPN) for exclusive rights to certain content.
ESPN cable, using $10 a month and ~60mm subs, generates ~$7bln in revenue. ESPN+ is currently ~$1.6bln… The true pain for legacy media will be negotiating full access to must watch content.
Churn
The DTC model currently makes it incredibly easy to cancel your subscription. House of the Dragon premieres, you sign up for the 10-week season, the season finishes, do you cancel? A significant portion of these sign-ups effectively need to be reacquired with new content, a legacy series they want to watch (e.g., The Wire), or comfort tv (e.g., Friends). It’s possible, but it’s significantly more difficult than just collecting your monthly fee from a cable operator. It shows up in the numbers; SVOD churn is ~6% and has been rising. It’s hard to find a perfect comp for a linear tv, but Dish’s churn was 1.5-1.75% in 2014/15 (start of linear tv decline).
This puts pressure on streamers to consistently release must watch content. Netflix has taken a machine gun approach, greenlighting a huge amount of content, with a few hits making up for the many misses. Legacy networks have historical IP they can utilize, but it’s starting to feel like some are leaning too much on a high value franchises. Disney, with both Star Wars and Marvel has got to a point of what feels like content overload; I’m a Star Wars fan but I haven’t kept up with all the new series (admittedly an anecdote). WBD 0.00%↑ is best placed here, they have some unused world class IP like Harry Potter and Lord of the Rings (movies) available to drive traffic to HBO Max (or theatres).
I see these differences as significant headwinds. Netflix avoids a lot of these issues (outside of churn) as they don’t have to balance legacy cable tv agreements, but they’re still relatively inexperienced in producing content, have a weak IP library, and are new to the advertising world (their valuation is also at a significant premium to legacy media players; ~20x EV/Ebitda).
Potential Upside
There are definitely benefits to the DTC model, but I don’t see how they make up for the lost benefits of the cable bundle.
Scale
Like pretty much any internet-based product, where the incremental cost of a new subscriber is 0, scale is key. Now video is available to anyone with an internet connection, the world is wide open for networks to distribute content themselves. Historically, U.S. networks would license content to international tv providers and their content would air under a different brand. A good example of this is Sky (owned by CMCSA), they air HBO content under the Sky Atlantic brand to U.K. customers. This type of relationship is now unnecessary (HBO looked at trying to get out of it), and networks can either use this leverage to drive better licensing deals with foreign networks, or launch their streaming services and compete.
The problem I have with the scale argument is Netflix already has scale... They were the first mover, have ~230mm subs worldwide, and despite the claim there’s plenty more runway (~800mm worldwide pay tv customers), they’ve already tapped most high value customers (U.S./Western Europe), with competition now aggressively attacking this cohort (their churn is up significantly over the couple of years). They make ~$32bln in revenue with a goal of ~20% operating margins (free cash flow is just above breakeven when you include the ~$17bln of actual content spend).
The real question is what are the margins when streaming reaches maturity (post consolidation etc.)? I don’t know the answer to that question, but they need to be pretty good with NFLX 0.00%↑ at ~$150bln EV and ~20x EV/Ebitda.
Advertising
The best argument I can make for long-term streaming economics is consolidation occurs over the next few years and we move towards an oligopoly. Content spend normalizes as consumers have their 4 or so streaming services that give them news, sports, and scripted/unscripted tv. Advertising returns to ~15-20 mins an hour, with targeted ads increasing efficiency. I would also expect the cost delta between the ad-free and ad-based tiers to increase; selling ads is too profitable long-term to be such a small piece of the DTC model.
OTT CPMs are ~50% higher than cable tv; ads can be curated for each viewer based on their digital profile, increasing their efficiency. Streamers are also a safe place for advertisers to place campaigns. Other growing ad options like YouTube, Twitter, TikTok etc., run a higher risk of being placed with questionable content. As linear tv declines, streamers appear well placed to take a significant portion of this share at higher CPMs.
This is a possible scenario, but I’m not sure consolidation and a more efficient product for advertisers will be enough. The amount of other content options (a lot of them free) have grown dramatically over the last decade, with huge growth in gaming and the rise of “content creators”. Esports audiences are growing rapidly and content creators like Mr. Beast have shown you can create a billion-dollar business on YouTube. This is real competition and shows up in Nielsen’s streaming data, with more time spent on YouTube than Netflix.
End Game
I don’t believe legacy media economics are a great guide for the future of streaming. More competition, easy to churn and no cable subsidization; the big winner looks to be the consumer. At some point streamers are going to have to increase ad loads and/or increase prices to make the economics work. The problem is a positive customer experience is essential due to the ease at which you can cancel or opt for another entertainment option. This wasn’t the case in 2010.
Valuations are definitely cheap for legacy media players, but a lot of their Ebitda is made up of legacy cable fees. Streaming profits will definitely improve as focus shifts from sub growth, but I don’t think it will be easy to keep churn down while providing less content at a higher price point. Thanks for reading and let me know what you think.