Of Moats & Media – Part Deux: Disruption!
In our previous post on moats in the media space, Setting the Scene, we discussed the history of the US Pay-TV industry as a partnership between Media companies and Distribution companies and the value it created for investors as strong moat, high ROIC industries and for consumers by bringing them a vast selection of content with better quality than their alternatives.
We highlighted the key moat qualities that Media companies exhibited, namely scale-driven advantages like access to a portfolio of channels to the end consumer through distribution networks, the content talent seeking financing and an audience, and access to low-cost financing needed to develop a portfolio of content.
Distribution networks, initially just cable and satellite companies then later telecom companies, acquired their moats by physically building, acquiring, and owning the physical connection (copper wires, fiber, satellites, spectrum and associated electronic infrastructure) to the consumer and owning the billing and service relationship with the consumer.
The Media companies took ownership of developing the content while Distribution companies had the customers and means to deliver the product to them. In order to optimize both the service they were providing large groups of customers with disparate tastes while optimizing revenue, service, and scale effects, the content was categorized into individual linear feeds called channels that were then bundled into a handful of service tiers.
Consumers signed up and paid to get video content in this traditional video service model. In order to deliver the content, the distribution companies allocated bandwidth over their physical network as an implicit part of the offering to the end user, since consumers only valued and paid for the content they were receiving and not the underlying infrastructure it was provided by. It wasn’t really until consumer friendly web browsers and HTML began creating and making the Internet usable for non-technical people that bandwidth came to be seen as a valuable service in its own right to consumers wishing access to the explosion of information and services available on the Internet. Offering Internet service (an open slug of bandwidth essentially) became a very profitable offering for the Distributors, driving higher profits even, as we’ll come to see later, their video service margins underwent compression.
We illustrate the value delivery segmentation with the following diagram reproduced from the excellent Stratechery.com website:
The traditional Media company is at its heart an aggregation company that will also have some significant creation and production/financing aspects to it. However, it will also license/buy content from third party content creators/studios to fill its content portfolio in its role as aggregator. That portfolio of content is then categorized and used to fill the channels it is given access to by the cable companies/Distributors in exchange for an “affiliate” fee that comprises some portion of the video service fee subscribers pay the cable company.
One reflection of the powerful moats that the media/distributor complex built were regular increases in service fees and bigger video channel bundles provided to the consumer. A classic characteristic of a moat is the ability to raise prices at the rate or faster than cost increases. According to the 2013 FCC’s cable pricing report, expanded cable bundle pricing increased at nearly 3x the rate of inflation between 1995 and 2012 and rivals the bogeymen we usually describe as having runaway costs — the US healthcare system and higher education! While this is terrible company to keep from a cost perspective, its great from a consumer spend priority perspective.
The table and chart above show big increases in video service fees driven by both increasing numbers of channels bundled into the service and, until the Great Recession of 2008/09, average fee per channel also increased. This made for a fantastic business where both units and per unit prices can be increased, resulting in strong revenue growth! However, despite a tripling in channels offered to the consumer from 1999 to 2013, average channels watched has only grown 35% as average viewing time per subscriber grew a similar order of magnitude from about 4 hours to over 5 hours per day.
Source: Matthew Ball and Tal Schacher at Redef.com
This makes any argument about service cost justification based on the booming number of channels provided a red herring from the consumer’s perspective. The real service cost measure to the subscriber is the cost per min or hour of viewing, which was increasing every year. However, this wouldn’t necessarily be a negative if the value/quality of the content has also increased in lock step. There are reasons to be doubtful of that service cost increases have delivered equal or better value since subscriber penetration has been declining since 2010 in the face of alternatives (discussed below).
The perception among individual subscribers is that they’re still watching 15 or 17 or 20 channels but paying for 150 with a large multi hundred dollar monthly bill associated with it (though the subscriber is also paying for other services on a common bill, like broadband service and telephony that accumulates to a “cable bill” averaging $120-150 per month, exacerbating the perception that they are paying a substantial sum every month for their TV service). Despite the perception, the reality is that Pay-TV is still one of the most affordable forms of entertainment with an average hourly cost of of 0.25-0.30 per hour per person (assuming 2 person HH average and 5 hours of average viewing per day).
In the process of fattening the bundle of channels and charging higher fees for them, large media companies have garnered increasing revenue from network fees charged to cable companies while cable companies passed on costs to the end user. Despite the distributors’ upper hand in owning the customer, as subscriber growth matured, media companies have taken the upper hand in fee growth since that is the content that kept subscribers paying for Pay-TV service. Broadly declining margin percentage on video services among cable companies in recent years demonstrated that content has taken more of the value of each incremental video subscription dollar than distribution, demonstrating the relative moat dynamics between content and distribution. It’s become a regular occurrence for a Media network to black out its channels while negotiating contract renewals with an aggressive distributor in order to demonstrate its relative value to subscribers and strengthening its negotiation position.
In a filing with the SEC, Comcast reported that between 2004 and 2013, the cumulative change in its programming (content) costs grew 6x the rate of CPI! Also notice that the average fees charged to subscribers reported in the FCC report above grew at roughly half the rate of overall programming costs reported by Comcast. It’s not apples to apples comparison in that the cost per “unit” of content/channel is not reported. As channel bundles get bigger, the overall “units” of content sold also increases. In addition, we’re comparing industry average subscriber service pricing data to programming costs reported by a specific video service provider. A like for like analysis would be more rigorous, but inline with our overall argument above, the net per unit cost of video consumption (whether per channel or per hour) for the subscriber has effectively grown at a much faster rate than CPI rate for decades.
Source: Comcast SEC Filings
Making things worse, it is the case that many markets in the US are oligopolistic with 2-3 video service/broadband providers (cable and telco) who tend to be equally bad at customer service (cable and telco companies are listed as having among the worst customer satisfaction levels). So you end up with a scenario where the subscribers of Pay-TV are over-served by a huge number of channels at ever increasing real prices by an industry notorious for being difficult to deal with, making it ripe for the traditional Christensen definition of disruption:
“the phenomenon by which an innovation transforms an existing market or sector by introducing simplicity, convenience, accessibility, and affordability where complication and high cost are the status quo. Initially, a disruptive innovation is formed in a niche market that may appear unattractive or inconsequential to industry incumbents, but eventually the new product or idea completely redefines the industry.”
Cue the Internet…
We believe the Internet disrupts the traditional moat structure by fundamentally democratizing the content/service “channels” between content/service creators and the end customer. A broadband Internet pipe is effectively a big fat channel that the end users pay to control in the physical distribution network. They choose what comes through that channel instead of flipping content channels that have been pre-selected or curated for them.
It used to be that Distributors had to select the Media companies to share access to their limited number of channels in order to maximize revenue, retention, and profitability, resulting in the most widely watched content with the strongest audience viewership ratings/advertising interest being produced and pushed to subscribers. This meant content producers (individuals or “studios”) had to either have scale or had to sell their content to the large Media companies that owned channel access in order to get their shows to consumers. Media companies were the default curators, shapers, and financiers of content (and culture) as a result.
Having access to a large bandwidth uncontrolled and democratized “channel”, consumers can now pull the content they are interested from content producers who have developed the marketing ability to make their potential audience aware of their existence, no matter their scale. Beyond traditional TV, large media has to compete for audience attention with other types of fast proliferating content that does not even play by the traditional formats of the 30 minute sitcom, 1 hour drama, and 2 hour movie that traditional audience had been trained to accept.
Now content can be a 10 second Snapchat/Vine/Periscope/Facebook Live user generated amateur video up to a multi-day “binge” of a high-end professionally produced series on a smartphone, tablet, or TV and often two of these devices simultaneously. There is no ubiquitous standard of any kind and the potential for content format/type disruption is unprecedented. The effect of the democratization of network bandwidth, mobile devices, social media networks, and digital brands and marketing can be seen in the following charts, which demonstrate trends based on the behaviors of younger vs older cohorts.
Overall, traditional TV watching has declined by 16 hours per month or 10% over the last 6 years with the steepest drops among the age group most coveted by media companies and their advertising customers, the 18-49 year olds. The “Millenials” generation is the next biggest cohort of the US population after the “Baby Boomers”, comprising the 18-34 year old group, are watching 40% less traditional TV (where traditional media companies still have the best positioning) — an ominous sign of things to come to TV!
Source: Matthew Ball and Tal Schacher at Redef.com
That’s led to what looks like a peak in TV viewing hours per month and declining relevance (TV viewing as a % of total hours spent). The average adult in the US now spends more time on a connected device per day than with their TV, with all of the change coming from the sub-50 year old group. This makes having significant digital presence vital to long-term growth, profit, and ultimately survival!
These trends have driven the first ever decline in US Pay-TV penetration rates outside of a recession (“Peak Cable”). Subscriber declines appear to be continuing at about 2% per annum according to the most recent company reports. Given the tendency of technological change to start slow then accelerate rapidly, the acceleration in declines since 2014 is likely to continue to some much lower base threshold.
Since audience attention is at the heart of the business model for media company economics (higher audience “tent pole” content that draws in larger crowds is more valuable directly in the revenue it generates from broadcasters/syndication and from the advertising it draws as a result), hits that can bypass traditional media are a huge threat. With a lower distribution bar to get to the consumer directly over the internet, a higher threshold to surmount among all content types vying for attention, and lower cost to experiment with new types of content, the traditional scale-driven moats of media companies are severely threatened. Hit content (both produced within traditional Media companies and at independent studios) becomes even more valuable since it’s needed to attract audience attention while non-traditional buyers, such as SVOD services like Netflix, Amazon, and others, also compete to license/own rights to it.
In addition, with greater customer choice comes the need for better product-customer fit in the form of content-viewer matching, customer service, and convenience. “Delighting” the customer is the catch phrase probably most associated with Apple’s products but is apt for almost all internet-driven/competitive customer experiences where choice is unlimited and switching as close to costless as they’ve ever been.
The best summary of the impact of broadband Internet is that the moat is quickly migrating from control of Distribution in the Media business to control of Attention.
The most successful and most talked about attention-takers since 2010 have been YouTube, Facebook, and Netflix. We’ll use charts compiled by Matthew Ball and the team at Redef to illustrate the point below. We’re big fans of their insightful work and highly recommend reviewing their in depth publications on the Redef.com website.
Netflix is the most interesting one to talk about first, given the ability to compare its service directly to traditional video services, as an example of a company that has acted as the classic disruptor in the media space. It came out with a limited, low cost streaming service at a price point well below any cable bundle, but has been a technology, user interface, and service leader with its offering. This graph below illustrates how disruptive technology generally finds its market beginning by serving the low end of an “over-served” market as discussed in Clay Christensen’s classic book The Innovator’s Dilemma.
Netflix’s service was initially seen as non-threatening by the rest of the industry (or at least there isn’t much evidence in their actions that they saw Netflix as a serious threat prior to 2012). After launching its streaming service in 2007 as a free add-on and shifting the main focus of its business to streaming from a DVD by mail service (2011), it has seen great success in winning audience attention, albeit at the cost of its profitability.
Its disruptive strategy of offering a limited content but “good enough” VOD (Video On Demand) solution at a low $7.99/month service allowed it to grow from 21.7MM US subscribers in 2011, when it first charging for the streaming service, to 45MM US subscribers in 2015. It could be argued the streaming service aided the legacy DVD business growth from 9.4MM subscribers in 2007 to 21.7MM in 2011 as a cost free value-enhancer. It’s very likely that Netflix truly believed this service to be a complement to traditional TV in the beginning but over the past couple of years it certainly has become a more competitive solution for a significant part of the US population.
Source: Matthew Ball at Redef.com
The fact that most subscribers already had a Pay-TV service and yet found it deficient enough to find Netflix’s value proposition compelling enough to subscribe to, makes Netflix’s achievements even more impressive. We can see that engagement, or audience attention, showed steady increases over time as content, quality and selection and increasing numbers of internet connected devices engaged customers for longer periods of time everyday. Experimentation also played a key part as Netflix allowed people to binge watch entire seasons of shows they licensed and later produced as soon as they were launched (vs. traditional model of weekly episodes) and as it continuously refined its matching algorithms to improve its committed content utilization while increasing its customer engagement.
Netflix used the new broadband Internet channel paid for by its customers to effectively create a new “bundle” of video content. It collated a set of content that would traditionally have been categorized by channel and instead used the new technology to present the content as categories and sub-categories to allow the right audience to find relevant content. It also used real time data collected from individual user viewing to make suggestions for new content based on the viewing habits of other subscribers with similarly viewed content (sometimes obvious fits, and sometimes unexpected). More recently, it leveraged its massive trove of subscriber viewing data to select and price bids for exclusive content it wanted to buy rights to.
It essentially used the new Internet technology to overcome the traditional bandwidth limitation for distribution (bypassing the traditional gatekeepers/moats) and realigned its offering to fit a more natural way for people to categorize content (by category vs channel) and delivered it on demand (convenience). Broadband Internet service enabled all of those aspects of its new service. In addition, the need to fit its product to the customer online led it to create easily used search features (instead of kludgey programming guides) and algorithms to help users find the right content fit (better matching of content and viewers). In addition, its customer service is easy and a great experience — it’s easy to sign up and easy to cancel and accessing the service is seamless across all devices. Initially this was only available on a computer (inconvenient and limited), but quickly extended to all connected devices including TV’s (ubiquitous access, super-convenient). By 2014, it’s service became the bar to beat for video service from its humble beginnings in 2007.
It’s online and offline marketing prowess, developed over the previous decade in selling its DVD subscriptions, enabled it to cost effectively reach consumers with an Internet connection with its message. As it developed its own content, it was able to create the buzz around its new content to draw additional customers. It stood out from the crowd of content choices available to the consumer with enough of a draw to get them to subscribe.
Over just 5 years, with growing subscribers and attention, Netflix has effectively grown to become the 6th largest Media network in minutes of content delivered per month in the US.
Source: Matthew Ball and Tal Schacher at Redef.com
However, Netflix’s success in grabbing its subscribers’ attention has come from other traditional networks’ audience share. Though we highlight Netflix here, the same can be said of other internet based media companies as we’ll see shortly.
Source: Matthew Ball at Redef.com
Even more dramatic than a whole market view in terms of share, is the impact Netflix has had within its subscriber base, in which it captures an average 60% share of their viewing time (20% share of total household hours/33% Share of households) for about 12% of their Pay TV video bundle price (assuming $80/month Pay TV service average and $10/month Netflix). Of course some significant portion of subscribers use Netflix 100% of their time while those subscribing to the traditional cable bundle likely spend significantly less than 60% of their time, but the overall theme is that Netflix is offering a substantial and broad offering to its subscribers that appears to offer much more value than the cable bundle. Part of this may also be the fact that Netflix does not include advertising in its content, which further enhances its value by optimizing its customers entertainment time.
Source: Redef and Ensemble Capital Management
Netflix is an example of a video content provider that’s leveraged the wide open Internet “channel” to get to the end customer and effectively built the capabilities (marketing, service, payments) to effectively grab the customer’s attention with its content offering.
In contrast to the traditional value chain diagram we showed earlier, it realigns its value delivery elements and capital investments in order to create a new model that better leverages its access to the customer without physically owning the connection. Again, Stratechery.com’s Ben Thompson has created a nice diagram that illustrates the change well. Netflix has moved closer to the customer over a now virtual network and uses its ability to attract those customers and their subscription dollars to buy the product that will continue to retain and grow the subscriber base. It integrates the roles of both Distributor and Media companies to create greater value for the customer. By controlling the growing subscriber revenue base, it can reinvest in both more and better content and technology, enhancing its value for all subscribers, while continuing to fuel greater subscriber growth through marketing efforts at a scale than ever possible before.
YouTube, Facebook, and SnapChat are among others that have done similar things to get around the traditional moat that only large media companies could access in the past. Given the proliferation of connected devices and especially smartphones, short form content that these new platform cater to has taken off and account for large portions of the 5 hours/day the average American spends on their connected device while pressuring the time they have left to watch TV.
Source: Matthew Ball and Tal Schacher at Redef.com
If video over the internet is a big growth engine going forward and growing in importance for audience attention, then the contrast between the traditional Media companies’ share on traditional TV and new internet-focused media companies online tell a clear story of a starkly different landscape. The 2% white bucket in the graph below that includes TV Everywhere refers to Pay-TV content viewed through apps vs through a subscriber’s set top box, and reflects Pay-TV’s lack of success thus far in capturing audience attention away from its traditional TV stronghold.
Source: Matthew Ball and Tal Schacher at Redef.com
However, there is a new element here in that virtual distribution over the Internet, with a direct relationship with the end user, allows a Media company to target customers globally on a direct basis. Previously, Distributors had to build out physical infrastructure to access each customer, which makes the undertaking a lot more capital intensive and took a long period of time. For traditional Media companies, despite some global presence via regional distribution, their revenues have traditionally been heavily dependent on their home region presence (with Discovery Communications being a major exception). However, new content providers offering service over the Internet (commonly referred to Over The Top or OTT), have the ability to create a global scale service, which changes how we need to think about scale economics and its impact on business profitability. All of the new Internet media companies target global scale content and distribution economics, with a target customer measuring in the billions, an order or two magnitude larger than the scale of the traditional players. This past January, Netflix announced it would be available in every country in the world except China while International subscribers are likely to surpass its US subscriber base sometime in 2017, only 6 years after launching its first market outside of the US.
So if important elements of the traditional moats (scale, capital, distribution) in the Media business have been blown away by the Internet, what are the implications of future businesses in the space and are there any moat-led investable (i.e. sustainably high-ROIC) companies left in the video content creation and delivery space as the changes we’ve discussed play out? What will future moat characteristics look like? What elements of the value chain will become more important and less important in terms of value creation? Will any of the traditionally successful large players be able to adapt or will they cede their leadership and, more importantly, their outsized ROIC to the new internet-focused media companies?
Tune in next time for our view into the future of media!
Ensemble Capital’s clients own shares of Discovery Communications (DISCA), Netflix (NFLX), and Time Warner (TWX).
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