Towards the end of 2019, BBC director-general Tony Hall told an audience at the Royal Television Society convention in Cambridge:

“Our industry is about to enter the second wave of disruption. The first was about the rise of Netflix, Amazon and Spotify: market shapers that fundamentally changed audience behaviour, often at the cost of huge losses or massive cross-subsidy.

“The second wave will see a range of new entrants entering an already crowded market. We saw it last week as Apple announced their new subscription service. Disney, Hulu and others are to follow.”

His point is simple and incontrovertible – too many companies spending too much money vying for too few eyeballs. In the stocks game, this means three things for certain: there will be winners, there will be losers, and until the dust settles, there will surely be casualties.

NETFLIX ON THE DEFENCE

Netflix has the advantage of being the incumbent lord of the Kingdom. If Netflix was sovereign territory, it would be ahead of Russia as the world’s ninth-largest country with 158 million citizens, all of whom have $11.99 to spend every month on an engaging means of sitting around doing nothing.

But as powerful adversaries quickly amass over the horizon, Netflix is finding its supremacy challenged on several fronts. 

While revenue is high, investors are wary that Netflix’s perennially discussed challenges are beginning to manifest themselves. The threat of competition is drawing ever closer, and the consensus view is that the company’s constant borrowing to sustain its current level of original content is unsustainable.

A TREACHEROUS LANDSCAPE

Netflix’s subscriber count translates into roughly 53% market penetration, far ahead of its next closest competitor, Amazon Prime at 30%.

Statista projections forecast that Netflix will be the market leader over the next five years, peaking at 219 million subscribers worldwide by 2024.

Amazon Prime is expected to drop away in total market share, down to 25% by 2024, but will remain the second-largest player.

Disney+ is projected to capture 82 million subscribers, which puts it at about 8% market penetration, although its growth rate so far has been staggering, confounding all expectations so far.

Meanwhile, Apple TV is not expected to rival the other services (or even try) and is expected to achieve approximately 1% market penetration.

THE RULE OF THREE

There is a saying: In a long-distance race wins not the one who runs faster but the one who runs out first. But sayings alone can’t contend with economics, and if history is our best guide, then the work of Jag Sheth and Raj Sisodia suggest that the one who runs out first will not, in fact, emerge victoriously.

In 2002, the Ivey Business Journal confirmed a theory, originally offered in 1976, that in any mature category, markets evolve in a highly predictable fashion.

Sheth and Sisodia conclude that in competitive categories, there can only ever be room for three major active players to serve the general market at any one time, who will between dominate up to ninety percent of the market. The rest operate in what the paper benignly calls, “the ditch”.

Examples cited of proof of the rule of three include Nike, Adidas, Reebok, and McDonald’s, Burger King, Wendy’s.

The No. 1 company is usually the least innovative, though it may have the largest R&D budget. Such companies tend to adopt a “fast follower” strategic posture when it comes to innovation.

The No. 3 company is usually the most innovative. However, its innovations are usually “stolen” by the No. 1 company unless it can protect them. The extent to which the third-ranked player is comfortable or precarious depends on how far away that player is from the “ditch”.

In the long run, a new No. 3 full-line player always emerges. In the global soft drink market today, the emergence of Cadbury-Schweppes has resulted in the creation of a viable new No. 3 player, with approximately 17 per cent share.

As the earliest of the three emerging players in the streaming category, Netflix is also the most prone to playing the “innovator” in the rule of the three – early out of the races, but susceptible to having its best ideas and practices ripped off and then improved upon by major conglomerates with much deeper pockets and the stomach for a war.

The Rule of Three would suggest, then, that Disney and Amazon are in a prime position to supplant Netflix on the seat of the streaming throne. Compared to the original innovator, its two main rivals have bottomless resources which will allow them to pick apart everything Netflix has done right, and figure out how to do it in a way that will capture maximum market share.

If the rule of three is even scarcely correct, then the stories of giant slaying and power-hungry villains with designs for the throne will play out off-screen as well as on it.

It’s hard not to be amazed by Netflix’s story and its transformation from a DVD-by-mail rental company to a $146bn production studio and the world’s most popular streaming service. 

It’s currently a profitable business – $1.9 billion in pre-tax profits after Q3 in 2019, although debt currently stands at over $12 billion. That gives them an operating cash flow of $1.4 billion, which they burn through easily each year.

Although profitable, Netflix is going to have to dig much deeper into already stretched pockets to compete with multimedia conglomerates that have seemingly endless resources and massive libraries of original content, built over decades, spanning TV classics and modern-day hit series.

The stark realities facing the company had investors spooked at the end of 2019 as NFLX stocks plummeted 30% between July and October.

But the alarm soon faded as the company’s consistent underlying strength gradually pulled investors back onside.

Piper Jaffey released a widely reported piece of research showing not only that 75% of Netflix subscribers do not intend to purchase a rival streaming service, but that the vast majority of those who do intend to purchase an alternative intend to do so as an additional subscription. This suggests that there is room in many of our lives for more than one Netflix. And that’s good for Netflix.

The problem is, of course, that answers to questions in a survey aren’t able to reflect a reality that didn’t exist when the survey was taken. Ask that same sample those same questions in a year, and you may just remind them that, oh yeah, they really need to cancel that Netflix subscription.

The strength of Disney+ lies in its army of powerhouse productions brands like Disney, 20th Century Fox, Pixar, the Marvel superhero movies, as well as household broadcasters like National Geographic, ESPN and ABC.

One would think each of those colossal names alone could stake a claim for their own monthly fee, so to house them all under a single catalogue will send shivers down the Netflix spine.

It’s a startling list of blockbuster studios that have spent a combined number of centuries and many billions amassing legions of loyal fans to their world-famous productions. Star Wars, Toy Story, Fight Club, Batman, Mary Poppins, Simpsons. If there’s something you’re craving to watch again, there’s a good chance it’s on Disney+.

Morgan Stanley predicted that Disney+ would gain 15 million subscribers in its first year. It achieved that number in 15 days. At the time, it was adding new subscribers at a rate of one million per day.  

To be fair to Morgan Stanley’s timidly faint-hearted prediction, even Disney confessed that demand for its new service “exceeded even our highest expectations”.

In addition to its hugely popular archival content, Disney+ also boasts the promise of exclusive new content, which should at the very least rival whatever’s on offer from Netflix given their comparative budgets. It also yields the unique advantage of being able to pull its shows and movies from rival services, demonstrated by its steely-eyed move to forego $150 million in annual income by ending the studio’s output deal with Netflix.

APPLE

Apple has been teasing the idea of its own original content streaming service for years. 

Using the same go-to-market strategy as it did for its hugely successful music service, Apple Music, the company will seek to tap into its huge existing customer base of more than 1 billion active Apple devices across the world.

Apple TV is being offered free for a year with all purchases of new devices. The company’s plan is simply to have a high enough conversion rate from its staggering number of device owners to mark itself down as a serious as a streaming service in its own right.

Apple TV+ is also part of a company strategy that aims to diversify revenues away from reliance on device sales. As customers wait for versions longer than they used to upgrade their iPhone devices, the Silicon Valley giant is eager to start its push into high-margin digital services that will offer the diversification it needs.

Its success in the service category, which also includes Apple Music and Apple Credit Card, will have a large impact on its share price, with revenue from service up 17% in 2018, to $46.3 billion. That growth figure will be key to investors looking to see if the company can improve its margins.

It’s curious then, that the company which is frequently cited as having the highest cash reserves in the world ($102 billion just sitting there), that Apple has budgeted the paltry sum of $6 billion to compete with giants like Netflix and Disney.

It could, in theory, easily budget two or three times that amount for the first year of the Apple TV without second thought or worry. But perhaps the prudent investor will laud the company’s unwillingness to simply throw money at something without first testing the waters and finding a viable path to success.

The first year of Apple TV will stream just 10 shows, with the likes of Jennifer Anniston, Reese Witherspoon and Oprah Winfrey the star-cast of a first-year launch that has an oddly 90s, wholesome quality about it, especially for a company that has staked its whole brand image on being innovative.

Until it begins feeding new shows into its offering after the first year, Apple will try to target existing customers and anyone who buys new hardware, most of whom are certain to take advantage of the free year they’ll be entitled to. 

Apple’s goal with the service in the short-run is not to compete based on becoming the number one streaming platform and beat the likes of Disney and Netflix. Rather, the strategy is to become a secondary service offered to existing Apple customers, and once that side of the business is profitable in its own right, maybe reconsider ambitions as relates to its rivals.

THE COST OF CONTENT

When Disney unveiled its pricing for Disney+ in August 2019, the company’s share price dropped swiftly by 1.4%, while Netflix shares dropped by more than 3.5%.

The surprisingly low subscription cost of $6.99 had investors recoiling from the brewing storm of price wars and stratospheric production costs. The conclusion was that the cost of defeat in the streaming wars could be dwarfed only by the cost of victory. 

Netflix’s chief content officer said the cost was 30% higher than a year ago – and that only looks set to escalate as Disney throws down $1bn in 2020, in addition to the eye-watering $500bn it has spent already in preparing for its service launch. Meanwhile, Amazon has budgeted $7 billion and Apply TV+ will scrounge off of a measly $6bn.

Netflix is investing more than any of its competitors in content, but it has had to raise funds through debt, issuing a series of junk bonds to prop up its $15bn a year production costs. And that was before the competition even really got going. Just as the pricing of its service is being challenged by the likes of Disney ($6.99 vs $11.99), the pressure to splash on production will send costs through the roof.

The other side of the original-content coin is seeing streaming services begin to arm themselves with libraries of proven shows. HBO paid $1bn for the Big Bang Theory, one day after Netflix bought exclusive rights to Seinfeld from Sony for $500m. 

Earlier in the year, Netflix had lost its two most popular shows, The Office (to NBC for $500m) and Friends (bought back by WarnerMedia for $25m) and so decided to act.

Take the cost of Seinfeld in context and it feels a snip. That’s $500m for a 9-season TV show that still commands a cult-like following, compared, for example, to the approximately $175m paid out in production costs for a 3-season-run of Stranger Things, the Netflix original horror series. The show was successful and springboarded Netflix’s reputation not only as a streaming service but as a high-level production company in its own right. 

However, other equally expensive productions have and will continue to turn out duds. Shows like Fuller House, Real Bob, Iron Fist and at least a dozen other original Netflix series have proven that the value of old, tested and proven content like Seinfeld is not just about attracting and retaining viewers, it’s also about not being completely reliant on in-house productions that may frequently flop, despite the urgency with which original content is now being produced.

The opportunities to acquire the rights for old goldies will grow slimmer when the streaming wars escalate, as new entrants such as Disney take their content off rival streaming sites when old contracts expire over the next several years.

 The fierce competition is seeing both the demand and price for old shows skyrocket, while at the same time putting pressure on the companies to produce their own big-name titles. It’s a tightrope that requires a super-human level of comfort with budgeting and planning. A new streaming service here, a merger there, and if you’re not Disney, you could suddenly find yourself without your top-performing shows. Netflix’s chief content officer said the cost of programming was 30% higher in 2019 than the previous year, and it’s partly a result of this external pressure.

DEFINING MOMENTS

Price squeezing and burgeoning cost of production will see average revenue per user decline heavily from 2021 to 2023. Meanwhile, Statista figures revel revenue growth projects are likely to plummet from 15% in 2018 to less than 1% by 2023, as the market rapidly saturates.

Also, growth is set to come to a near standstill in the years ahead as saturation and competition see most companies discover their peak growth rates in the next couple of years, and then stagnate, inch forwards, or begin their inevitable decline.

Netflix had already seen growth slow before the likes of Disney and Apple launched off the board. Earlier this year, it reported the first-ever fall in US customers, but with around 60% of Netflix growth coming from international markets, this was translated more as market saturation than any problem endemic to Netflix.

When crunch time comes, it will seem to have been inevitable. Faced with more content available each day than can be uploaded onto a person’s brain in a lifetime, consumers will eventually be faced with a choice.

As Disney+, Amazon, Apple TV and Netflix expand their regions of service, and potentially huge subscriber base, the real flags investors will be looking for will be whether one streaming service will continue to grow subscribers while another experiences a decline in the same period. When that time comes it will show investors that consumers are finally beginning to speak on who has won the streaming wars.


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