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Life after lockdown – a closer look at streaming shares

Emilie Stevens, Equity Analyst, kicks off our series looking at how the current crisis has turbocharged existing trends by taking a closer look at the world of streaming.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is not personal advice. If you’re unsure whether an investment is right for you, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

What’s changed?

Watching and listening to what we want, when we want to, was already increasingly normal. But with large parts of the world confined to their homes in response to coronavirus, demand for streamed content has reached new heights.

But while dizzying subscriber growth is good news for now, the path to longer term profitability looks more challenging for a lot of the big names.

Total paid subscriber numbers

Sources: Netflix Q1’20 Results, Amazon Business Insider, Feb 2020, Spotify Q1’20 Results, Disney Q2’20

Netflix – a global fight

Netflix was a streaming pioneer. Being early to the game saw it grow rapidly, and it can now boast 183m paid subscribers in around 190 countries. But continuing to increase that scale is key to its survival.

That’s because Netflix’s business model relies on spreading its costs over a larger subscriber base. More subscribers mean more cash in, hopefully enough to cover the cost of all the new content (not something it’s achieved so far). But attracting new subscribers is a far more competitive game now, with a lot of big hitters joining the fight.

Studios realised they could do the platform part themselves – and Netflix isn’t much without content. In response the group moved to making TV and films itself, spending gargantuan sums ($14bn last year) to do so.

There’s an argument to say Netflix is front loading content spend now, so it can reap the rewards of a big content catalogue in years to come. In line with this Netflix said last year’s cash flow was going to be the most negative it’ll ever be. But we think there are a few reasons to question that.

Thanks to lockdown, users are likely to be burning through the content backlog at a faster rate than planned. Fresh content is key to keeping current subscribers out of the reach of competitors, as well as enticing new ones, so this throws the front loading theory into doubt. Tiger King probably doesn’t have the same enduring appeal as The Lion King.

Competition in the sector brings more challenge. Price competition is one of them, which could disrupt Netflix’s historical approach of increasing prices at regular intervals. Combined with those sky high costs needed to keep subscribers happy – it doesn’t bode well for profit or cash generation.

And while Netflix is the market leader in key developed markets, these geographies alone are unlikely to generate the subscriber growth it needs. Overseas subscribers are key. Netflix is ahead of the pack here, so far launching more non English titles than peers. But it can’t afford to stand still, there’s local competition in these regions too – particularly in India.

While lockdown has provided a boost in subscribers, it’s a mistake to assume it’s a net benefit for Netflix. Fending off competition won’t be easy or cheap. The group’s still some way off the capital light subscription model investors were expecting and there are no guarantees.

Value of Netflix's content

Source: Netflix Annual Reports, 2015 – 2019.

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Disney – disrupted

The pandemic is somewhat of a mixed picture for Disney.

While the recent launch of Disney+ couldn’t have gone better, reaching 50m subscribers in under 5 months, lockdowns are disrupting the group’s main profit centres. Parks have been closed across the globe. The networks business, home to a host of regional US channels as well as the likes of ESPN, has also been hit by the pause on sports and declines in advertising spending.

While Disney has the financial clout to stomach the disruption for now, these divisions provide the cash to fund Disney’s ventures. So even from a purely streaming focused perspective getting back to business is crucial.

Although still early days, we’re excited by Disney+ and the group’s other streaming bids – ESPN+ and Hulu. They’re another way for Disney to squeeze more cash from its killer back-catalogue of content. And unlike a new theme park, once the platform’s up and running, adding new content is relatively straight forward, not to mention virtually free.

There are a few other benefits Disney has up its sleeve. An existing global presence and resonance is a big one. The group’s acquisition of Fox brought with it India’s most popular streaming service – Hotstar. India’s streaming market is still in a relatively nascent stage but as the second most populous country in the world – there’s certainly room for growth.

Another is sports. The lack of live sports is disrupting ESPN’s play at the moment. But it’s worth pointing out that Disney’s sports content gives them an edge in the streaming market, where its competitors would have to fork out large sums to acquire or compete. Of course it will be some time before sports stadiums will be full again – but we continue to see these sporting assets as valuable in the long run.

Disney’s content before platform approach makes it different to Netflix and we think that’s a favourable position to be in. While it’ll take a few years for the streaming business to contribute meaningfully to group profits, it’s not having to build out a new library, which should help reduce risk.

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Spotify – a sustainable stronghold?

Spotify’s monthly average users recently hit 286m. Roughly half of them are premium customers paying monthly for access, the other half are on the free ad-supported version.

The business of music is more cost and cash efficient than video. Video productions require millions in upfront costs, before really knowing if it’s a blockbuster or not. In contrast, content costs for Spotify are largely variable as it pays record labels a flat fee as music is streamed. This makes for a less risky business model, and in a competitive environment we’d argue that’s a more favourable option.

Spotify controls the demand for music rather than the supply, and that’s a valuable position to be in. Like Facebook, the group has a close relationship with its customers, which advertisers are willing to pay for. But while subscription revenues are proving resilient over the pandemic so far, ad revenues have deteriorated as advertisers pull back in light of the global economic challenges.

It would be remiss not to mention the competition. But while Apple and Amazon are relatively big players, for these two, streaming is very much part of the package, rather than their raison d'être. In some ways that makes them less of a threat but it’s worth remembering they’ve got big enough pockets and customer bases to turn up the dial if they wanted to.

Big pockets is something that Spotify is working on. A cash generative model means it’s self-sufficient when it comes to cash (no need to borrow, unlike some). But rising operating costs to fund marketing campaigns, promotions and new products means Spotify hasn’t been consistently cash flow positive – although it expects to this year.

On the whole listening is proving resilient over lockdown, and Spotify’s expectations of growth for the year ahead remain largely unchanged. The next quarter’s results will be more telling, with a significant chunk having been in lockdown. But rather than derailment, the pandemic seems more like short term disruption.

Global share paid music streaming subscriptions in 2019

Source: Counterpoint Research, April 2020

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Takeaways for investors

On paper streaming is an attractive business model. Recurring revenues paired with a capital light and scalable platform makes for a cash generative business. However, while coronavirus has sped up the adoption of streaming there are reasons for caution.

As it stands, booming subscriber numbers aren’t yet translating to booming profits for firms. Competition is fierce, which adds pressure for companies to have the best content, the best technology, at the best price.

With interest rates at historic lows, lending to companies on the promise of future profits tends to be both plentiful and on more favourable terms. While we don’t foresee an interest rate climb in the immediate future, it’s worth bearing in mind that companies which can’t fund themselves will struggle if economic conditions shift and as with any investment there are no guarantees.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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