Apple (NASDAQ:AAPL) and Netflix (NFLX) have already done much to turn the world’s media consumption on its head. Netflix has blazed a trail that has successfully convinced millions of viewers to abandon the staid television time slots of old dished up by traditional paid-TV satellite and cable services for streams of original and highly acclaimed subscription programming, delivered on demand across 190 countries. The $100 billion media industry long dominated by Comcast (CMCSA) and AT&T's (T) DirecTV now has a crowded content market with over 496 scripted original series produced last year alone. Content companies like Netflix, Amazon (AMZN) and Disney's (DIS) Hulu and HBO are major players.
Enter this week’s newly unveiled streaming service Apple TV+, slated to go live this fall. A redesigned software update due in May is projected to connect viewers with Samsung’s (OTCPK:SSNLF) Smart TV as well as with myriad streaming devices on the Amazon, closely held Vizio, Roku (ROKU), South Korea’s LG Electronics and Sony (SNE). And all of this is on top of the ever-enduring lure of 1.4 billion Apple devices — including about 900 million iPhones across the globe.
About 300 popular news, food, sports and entertainment magazines will be on offer as will subscriptions to the Los Angeles Times, the Wall Street Journal, the Toronto Star, all matched with premium digital sites like The Skimm and TechCrunch through Apple News+.
Apple TV will include network programming from satellite and cable services, HBO, Showtime, Starz and CBS, provide access to premium channels and also offer the rental of movies. Game subscriptions through Apple Arcade will launch later this year on iPhones, iPads and Macs from developers, including Sega, Konami, Disney and Lego.
The Apple Card, a collaboration with Goldman Sachs (GS), is largely a virtual credit card specific to the iPhone. The card will charge no fees and pay a daily cash reward of up to 2% on iPhone purchases and up to 3% for Apple products and services with the resulting cash being automatically deposited in a digital wallet that is resident on the iPhone. The card makes use of machine learning to organize and summarize user spending. A physical card hewed from titanium without visible account numbers, security codes or expiration dates will also be available for payment on items outside the Apple Pay universe.
Monday’s announcement of a bundle pricing package of $9.99 for Apple News+ is likely the low-end tip of a premium service offering that will have a plethora of pricing levels, now the subject of intense industry speculation for the foreseeable future. Apple’s 1.4 billion customer base is most certainly a market attraction. The lure of Apple’s market heft bore down heavily on bundle participants, with Apple taking an estimated 50% cut on all subscriptions, splitting what is left based on future readership counts. Apple’s cut under the deal is even larger than the 30% subscription cut secured through its App Store — a fee that is currently being challenged by Spotify (SPOT) in Europe on antitrust grounds. This means certain implied risks being taken for newsprint media producers since each Apple user will generate but a fraction of the revenue of a full-priced subscriber. The possibility of full-priced digital subscribers to the Times, the Star and the Journal bolting to the heavily-discounted Apple platform cannot be dismissed. Who will actually foot the bill for Apple’s discounted platform of offerings remains a glaring bone of contention moving forward. The New York Times and Washington Post, among other national news providers, dropped out of the running for the project for many of these aforementioned reasons. Pricing on Apple Arcade is yet to be announced.
Figure 1: Apple against the S&P 500
Apple (red-green bars) peaked in early October at roughly $230/share before flipping negative (red shaded area) in the waning days of December as the market skidded into negative territory for the balance of the year. Year-to-date, Apple's shares have flipped to the upside (green shaded area), though still in the rear-view mirror of the S&P 500 (black dotted line) at about 16% below its October peak. Market reaction to Monday’s announcement remains mixed.
Historically, Apple’s corporate mojo rarely extended beyond the sale of its own hardware. Rarer still is the company’s outward emergence from the shadows of proprietary furtiveness and into the klieg lights of Hollywood in its latest foray into the entertainment industry in quest of securing future revenue growth. Back in 2003, the launch of the iPod with iTunes came at a time when record companies were dealing with the havoc of internet piracy and had yet to settle on a digital marketing format. Steve Jobs smelled a business opportunity like blood in the water, which created a truck-sized opening for the iTunes platform. Interestingly, Jobs fought a tenacious battle to keep both the iPod and iTunes from running on rivals’ devices which arguably became a hallmark of Apple’s marketplace success. Apple’s hardware and software were to be linked to one another, giving the company exclusive control over user experience.
That said, the technical difficulties of seamlessly integrating different operating systems are daunting by most measures, as Apple engineers found out in past attempts at merging Apple Music’s iOS with Google’s (GOOG) (GOOGL) Android operating system. In the past, Apple controlled both the hardware and the software, making for a seamless integration across Apple devices, maximizing the user's experience. Under Apple TV+, the company's control of both hardware and software will henceforth no longer be the case. The overall user experience within the proposed bundle is now infamously couched in the realms of Donald Rumsfeld’s unknown unknown. That said, falling short of seamless integration is a technical risk that could easily — and quickly — torpedo the entire project.
Apple’s service line in its net sales by product segment has long been a balance sheet oddity. That line cleared $37.2 billion or just over 14% of the company’s $265.6 billion revenue stream through the end of 2018. Technical issues aside, the trick here appears simple enough: Convince Apple device owners not only to shell out $1,000+ for an iPhone update every two years but also to fork out in the interim monthly charges ranging from $10 to as much as $40 for its premium one-stop content and game shopping. Here is where scale, indeed, becomes the upside watch-word of the equation. Apple was forced to reverse the Jobs credo, witnessed by the company’s unprecedented lengths to break out of its autarchic past, blasphemously including long-time hardware and content rivals in its streaming service. The move underscores just how important collaborative ventures with erstwhile competitive rivals will be to future revenue streams. And with good reason: The company reported its first decline in product sales through the end of the 2019 holiday buying season in over a decade, dropping to $73.4 billion for the three months through December — a 7.24% YOY decline. Services, at $10.9 billion, were up over 19% over the same period. Clearly, forcing Apple users to buy Apple devices to access new service offerings was a boon for Apple growth in the past. That credo is now viewed as an impediment to future growth. Times have certainly changed.
None of Monday’s announcements came as a surprise to either markets or investors. In fact, much of Monday’s roll out will hit markets — from credit cards to content to streaming to newsstand offerings — that are already approaching advanced stages of saturation. While assembling an impressive array of Hollywood celebrities, there was no mention of exclusive Apple content deals with the assembled artists. The sizzle reel clips that danced on the enormous stage backdrop screen highlighted past roles rather than offering glimpses of future Apple collaborations. The 300 newspapers and magazine offerings pale against Amazon’s Kindle newsstand which already offers 2,402 blogs, 12,073 magazines and 166 newspapers. While a virtual credit card and a titanium physical card may offer up pizzazz in some quarters, the annual rate on the Apple card of 13% up to 24% is all too ordinary. The current average annual interest rate on US cards is around 18%.
To truly compete, Apple needed to roll out something that hasn’t been done before, something unique, creating the very panache that drove the company to its current market heights. Apple’s TV+ offering looks a lot like Amazon Prime, where original content mixes with partnered content from the likes of HBO, Starz and Showtime. For Amazon Prime viewers, about 26 million strong, that mix is free. The 85% of Apple’s current revenue stream through the end of 2018 that came from hardware sales whose stratospheric growth trends of old are now largely in the past was the all too obvious white elephant on stage amidst the dazzle of a tradition-laden Hollywood upfront presentation. Apple TV+ will most certainly not be offered up for free. And it remains to be seen just how many of those 1.4 billion Apple users will be drawn into Apple TV+, and at what cost.
The rise of Netflix spawned an unprecedented industry-wide consolidation in both the content and streaming space over the past year at a cost in the hundreds of billions of dollars. Ironically, Monday’s Apple announcement precedes that of Disney by several weeks where industry watchers expect the company to announce its own fall roll out of Disney+, replete with catalog and archival offerings as well as those from last year’s $71 billion acquisition of 21st Century Fox (FOX) (FOXA). Throw in Disney’s controlling interest in the streaming service Hulu and you have a major competing rival hitting the market at the same time - with a lot more content to offer movie aficionados here and far. Similarly, AT&T spent $85 billion for Time Warner’s (TWX) vast catalog and archival holdings, renaming its new media company WarnerMedia. A fall launch of its programming remains to be announced.
Meanwhile, Netflix maintains a formidable lead in global streaming paid subscriptions with over 139 million through the end of 2018. Over the past five years, the company’s compounded annual growth in total paid memberships comes in at just under 21%. That growth in paid subscriptions increased total revenue to the company by 24% to $7.65 billion through the end of 2018. The cost of those revenues rose to $4.0 billion, an increase of 16% for the period. The cost of revenues reflects the growing cost of amortization of streaming content, including the costs associated with original content and programming. Added together, the cost of revenues came to about 74% of total revenues for the period.
Netflix continues to spend with aplomb on streaming content. Through the end of 2018, the company listed $10.4 billion in long-term debt, up dramatically from $885.8 million through the end of 2014 for a growth rate of just under 64% for the period. Long-term debt grew 59% in 2018 YOY alone. Another $9 billion of content debt is yet to hit the balance sheet. The company’s annual interest expense, however, remains tame at 3% of total revenues through the end of 2018 despite a 77% increase in total interest expense since the end of 2017. A low interest rate environment certainly has helped. So long as the company’s subscription growth rate outpaces its annual interest rate expense, Netflix will continue to spend heavily on original contenting programming. Unsurprisingly, Netflix’s Achilles heel unquestionably stems from its borrowing costs that currently average about 300 basis points above the Libor overnight rate. To date, however, the company’s strategy has both underscored and cemented the company’s lead in an industry it continues to define largely in its own terms. So far, so good.
By way of contrast, Apple has put up a scant $1 billion downpayment on content and original programming for its fall launch of Apple TV+, with a reported five shows in various stages of completion and another half dozen to be completed in the months to come. The Apple iTunes store has been charging Netflix a 15% premium on all subscriptions booked by its service. That arrangement was cancelled this past November. Apple users may still download a Netflix offering over an Apple device, but payment arrangements are now sent outside the Apple space.
Netflix opted out of Apple’s bundle, which speaks volumes on the emerging competitive battle over distribution that is about to go live with the Apple TV+ launch this fall. Netflix and Apple have mapped out consciously different positions in the ensuing drama. Apple has been forced into a more horizontally integrated market ordering with both hardware and software rivals in the mix. At the same time, Netflix looks to a more vertically integrated market with the hopes of controlling as much of the distributional pipeline as possible moving forward. Netflix wants its users to watch its service through its streaming pipeline which means controlling the user experience to the greatest extent possible. The payback is the constant stream of user information and behavior, data that is critical for shaping future content offerings across the country and around the world. The competitive environment being etched out will be brutal and the user churn will likely be measured by the level of original content each of the combatants are able to bring to the fore - always no more than a few keystrokes away for users worldwide.
Figure 2: Netflix against the S&P 500
Netflix (red-green bars) peaked in early July, almost two months before the peak of the overall market in the closing days of the 3rd quarter. The company fell hard from its summer market high, digging a hole whose depth closed in on 47% to the downside in the waning days of December. The S&P 500 (black dotted line) fell just short of 20% from peak to trough over roughly the same period. Since the beginning of the year, Netflix reversed course in dramatic fashion, up almost 33% through Friday’s market close (29 March) - a full 20 percentage points atop the greater market. The company is still in correction territory, down 14% from its July peak.
There is little doubt that Apple brings balance sheet and infrastructural heft to the marketplace in its quest of securing competitive advantage in the content, streaming and gaming space. True, Apple has about $136 billion in cash equivalents. The company generates about $27 billion from operations. Its borrowing costs are roughly half that of Netflix at about 140 basis points above Libor. Still, for the first time in more than a decade of product launches, Apple will not be christening technology’s latest and greatest. Nor will it be creating much that is really new as it leaps from the starting blocks this fall. Apple will need to show the market, decisively, that the company is serious in this endeavor. Apple will need to spend money, and lots of money, in relatively short order to make up for its late entry to its new field of play. It will need to sustain that spending well into the future. Hollywood will be ecstatic with the attention and the pungent aroma of money.
Apple’s future depends on the successful roll out of a seamless, horizontally integrated service program across myriad platforms and operating systems. The surface of bringing content and services to its 1.4 billion device users has, for all intents and purposes, yet to be scratched. The seamless technological link between iOS and myriad operating systems and platforms that have been included in the company’s bundling package has yet to be forged. Annoying technical bugs and glitches are an inevitable byproduct of this Herculean effort. And more Spotify (SPOT) challenges lurk under each and every stepping stone along the way. Europe has most certainly obliged that process by providing a fecund and nurturing regulatory environment for such challenges. Legacy, brand, panache, reputation — all are important. Alas, Apple has little time for resting on past laurels. Apple’s success is far from assured at this juncture. In the interim, there will be Netflix.
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Disclosure: I am/we are long NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.