It was only a few years ago that it looked like TV was a dying medium. More users began to consume content illegally via Google's YouTube (GOOG), torrents and file sharing mediums, while other users used TiVo (TIVO) to skip commercials and lower the bid for advertising dollars. There was a very legitimate problem for content creators to maintain control and, therefore, profitability over movies, music and television.
While dorm-room heroes and content hoarders may still be downloading massive torrents ranging from the complete series of "ALF" to movies yet to be released, thanks to faster Internet, Xbox (MSFT), and Apple (AAPL) applications, the way content is being consumed is once again being altered. Xbox Live now offers movie and TV rentals, and how can we exclude Netflix (NFLX) and HBO GO? Hulu applications allow consumers to view media on larger screens than just laptops with less resistance to downloading media illegally.
Furthermore, iPads are being used as primary Internet browsing devices. Unlike desktops and laptops, which have extensive hard drives and easy-to-use applications for stealing media, iPads and tablets have a limited amount of storage and lack the same download functionality. Therefore, the previously listed applications, as well as the iTunes store, are now primary mediums for consuming media on mobile devices. These applications provide users with very little resistance in the path to consumption and provide users with high-definition media in a matter of seconds.
We've yet to mention Redbox, a subsidiary of Coinstar (CSTR), which has also underscored the return to paying for content. Redbox has over 33,000 kiosks for consumers to spontaneously pick up movies or TV shows for around $1.20 (plus tax) each. Though these kiosks may require travel and more effort, the kiosks' convenient locations provide another easy route for consumption. These mediums have sent Blockbuster into bankruptcy and have allowed content creators to push back on bootleggers and content sharers. Now let's take a look at the companies that could lead the next generation of content consumption.
Redbox, the physical DVD/Blu-ray rental kiosk, represents the transition between bricks-and-mortar rentals and online streaming. These kiosks can be placed inside drug stores, gas stations, grocery stores and everywhere in between, and the kiosks do not require the same large capital expenditures that Blockbuster stores required.
Although Redbox may be wildly successful while the market waits for movie consumers to become more comfortable with online streaming, there's reason to worry about the long-term viability of the business model. Of course, with 33,000 kiosks, the odds are quite good that most consumers live very close to a kiosk. However, we believe the success of content distributors depends on creating low barriers to resistance for the end users. Cable TV has been so successful because it requires almost no effort. Even a five-minute trip to the local Redbox could impair Coinstar's success over the long term.
Coinstar's management noticed the future lies in streaming, as the company announced a partnership with Verizon (VZ) in February to create a combined streaming and retail operation. The new product will be available in the second half of 2012, and the product will be a direct competitor to Netflix. Even though this is a clear step in the right direction, we aren't too excited about shares of Coinstar until this partnership shows some traction. We're also skeptical that Coinstar will be able to pay enough to gain content exclusivity or speed to market. Chanos may still be right.
The profitability of the mediums delivering the content remains unclear. Google doesn't actually break down profitability metrics for YouTube, but it remains uncertain if the division actually makes a profit. It generates an unbelievable amount of traffic and hosts tons of advertising, but the costs of hosting such a tremendous amount of data and traffic may hinder profitability permanently. Additionally, YouTube has to deal with constant lawsuits and removal of copyrighted material, which takes away from the site's content and costs the company millions of dollars in legal fees and compliance.
YouTube also houses a number of "web stars" and in-house productions exclusive to its site, in addition to indexing movie clips, sports highlights, and music. The ease of use of the site, as well as the massive amount of unique, searchable content gives YouTube an interesting position in the market. Many of its contributors are dependent on the site, and their loyal followings are consistent demographics that advertisers can target.
YouTube's extensive archive and reputation as a destination is why we like the business over the long term. We think YouTube has a differentiated position in the content aggregation market, though it might take a while to find the right business model. YouTube must also figure out whether or not the firm needs to create its own content to add value to the YouTube network. Unlike Hulu, YouTube doesn't really have full (popular or recent) TV show episodes.
Although we think YouTube could be a critical part of Google's long-term success -- it's even its own division -- we wouldn't factor it into an investment decision as much as we might factor in Android and the long-term viability of the search business. We're big fans of Google's valuation, and the firm puts up a solid score on our Valuentum Buying Index (click here for more information on how to read our reports).
With 22.8 million unique subscribers, an online library, and a dying mail-order business, Netflix is a business in transition. Though it has a significant number of subscribers, the company is struggling to remain profitable because it has to pay so much for content. The company has to pay hundreds of millions of dollars to increase its content offerings.
We do believe Netflix has some great distribution channels. Users can access Netflix through a variety of Blu-ray players, Xbox Live, the Playstation Network (SNE), mobile devices, and laptops. Wi-Fi-enabled TVs provide users with one of the simplest ways of accessing any of these content middlemen, in our view.
Nevertheless, as Hulu, HBO Go, and Xbox all compete for these same dollars, we think the company will have to pay more to acquire exclusive content or receive content before competitors. Ultimately, for a company struggling to remain profitable, we are unsure whether Netflix will be able to beat out some of its deep-pocketed competitors. Comcast (CMCSA) is even rolling out more extensive online offerings for its cable customers.
To push back, Netflix has started developing exclusive content on its own, which could be quite expensive. The company has brought the cult classic "Arrested Development" back for another season on exclusive terms. In this sense, we see the company trying to copy HBO's push to evolve from being just a content provider. However, Netflix runs the risk of developing expensive shows that consumers do not like, and the firm doesn't have the reputation that HBO has for developing and producing great content. That said, if Netflix can replicate HBO's success, we think it can drive subscriber growth and add value to the brand. Starting with a show that resonates with a large group of devoted fans is a low-risk move, in our view.
Over the long term, we think the content creators will be able to charge higher prices to Netflix, making it even harder for the company to become profitable. We'd stay away from Netflix because the rising costs of content, and fierce competition from Apple could really impair profitable growth. Our initial call on Netflix at its peak was perhaps one of the best we have made -- view our initial valuation report on Netflix calling it absurdly overvalued at over $250 per share here.
Apple has the enviable position as the market leader in mobile devices. Admittedly, Android may have a larger market share than iOS, but we believe most consumers, especially in the U.S., will leave Android and Blackberry (RIMM) for iPhones. The iPad is also the dominant tablet on the market.
The lethal iPhone/iPad, in tandem with the iTunes store, gives Apple an enormous advantage. Not only does it dominate two platforms for selling content, but it also owns a platform for collecting and selling the content. The iTunes store reached $5.4 billion in sales during the 2011 fiscal year. Not only does the store provide users with high-quality music and video, but it literally takes just a click and is attached to the user's credit card.
We believe the iTunes store is the path of least resistance in consuming media on a mobile device. If the company can achieve some reasonable adoption of Apple TV, we think the company could become a living room aggregator akin to Xbox. We think Apple is the biggest threat to both Hulu and Netflix, in that iTunes is so much easier to use than both of the their services. Apple's a la carte model and favorable relationships with content creators (some say Apple saved the music industry) will prevent content costs from skyrocketing. With over $100 billion in cash, Apple could easily buy an established content creator or make its own.
We continue to believe Apple is a compelling investment opportunity, and we think the content aggregation business could be an unexpected tailwind for the company. With only $5.4 billion in sales in 2011, iTunes isn't a huge part of the company's revenue stream, but it did grow 33% last year. iTunes is yet another reason why Apple is the largest company in the world (by market capitalization).