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25 April 2019

Content production costs could derail Disney’s assault on Netflix

Disney, of the big media groups gunning for global streaming glory, has Netflix most clearly in its sights with its plans for an ad-free SVoD service this fall. All other contenders have advertising in the mix somewhere, while Disney has stated that even ESPN+, the streaming version of its ESPN sports channel, will only carry very limited ads. Disney has also promised an ad free bundle combining its three main streaming properties of ESPN+, Hulu and Disney+.

By contrast, Comcast’s current OTT services such as Sky’s Now TV carry ads, as well its forthcoming NBCUniversal OTT SVoD service due for launch early 2020. Advertising will play an even stronger role for AT&T on the back of its Xandr analytics group in the forthcoming Warner Media streaming service, which will feature its “two-sided business model blending SVoD with AVoD.

AT&T hopes it can get the best of both models by extracting the highest subscriptions possible from SVoD customers wanting to avoid ads, while offering a low cost or free AVoD service to entice those customers unwilling to pay much or anything. The problem with such double-barreled approaches can be that consumers are confused and gravitate towards either pure SVoD providers like Netflix, or AVoD-only offerings that have gained greatest traction in some developing markets like India. AT&T’s theory is that developed countries, notably its own domestic US market, will segment naturally between higher net worth SVoD customers and those including perhaps recent Hispanic immigrants who will go for AVoD without there being any confusion.

Meanwhile, even Netflix has experienced pricing pressure resulting partly from ad subsidies for rival services in some of its developing markets, such as Malaysia and again India. The threat posed by the forthcoming Disney+ is that pricing pressure will be exerted for the first time in core developed markets, including the US and eventually Europe. That is why Netflix shares fell about 4% after Disney+ US prices were set at $6.99 a month just two weeks ago, $2 below Netflix’ basic plan of $8.99.

Less understandable was the 10% surge in Disney’s share price to a new record high, adding $21 billion to its market capitalization. The markets clearly liked Disney’s aggressive positioning but it does beg the question what the impact will be on the group’s cash position over the next few years. Disney is following Netflix itself here by gambling on gaining market share rather than profitability, but in its case this coincides with the international expansion in both content production and distribution. While the initial launch on November 12th will be in the US, Disney has stated debuts in Western Europe and Asia Pacific will follow within months or even weeks around the turn of 2020.

As we have stated before, Disney is heavily US centric for movies and series and as a result is saddled with very high content production costs, in stark contrast with Netflix which has laid down international roots and struck up collaborations on the ground, including foreign language material. Netflix is several years ahead of Disney on that front and, as the latter catches up, content costs will escalate in those territories partly because of the growing competition. So, Disney’s aggressive pricing combined with loss of revenue associated with pulling its content from Netflix will itself constrain investment. The company faces operational losses even though planned expenditure on original content specific to Disney+ is quite modest compared to Netflix; $1 billion for 2020 rising to the mid-$2 billion range. The company is targeting between 60 million and 90 million subscribers worldwide by 2024, one third from the US, and even then only expects the service to just break even, as Disney CFO Christine McCarthy indicated recently.

Those numbers are somewhat higher than our research arm Rethink TV predicted in its recent forecast headlined Disney, AT&T, Comcast stumble in the Netflix slipstream. It put Disney+ on 50 million subscribers worldwide by 2024 and even that is considerably more than Netflix achieved five years after its streaming launch at the end of 2012. That was about 33 million or two thirds as many.

Disney+ then is set to be a huge success on the back of its powerful content portfolio now that it has 21st Century Fox as well. Rethink TV only sees the NBCUniversal streaming service reaching 4.8 million subs by 2024, less than 10% as much, while AT&T’s Warner Media service will be on 7.4 million. Figures anticipate AT&T reaching a total of 24 million OTT subs by 2024, including other properties such as HBO Now, but even that is barely half Disney+. Comcast will still be on about 29 million subs by 2024 even counting Sky Now TV in Europe.

Disney also has ESPN+ to factor in on the live sports side and level of success there will depend on how this is positioned against the main ESPN channels bundled in with pay TV services. Currently ESPN+ is a parallel service which began in the US by focusing on sports that are relatively niche there and so affordable, but which are also calculated to attract a significant aggregate following.

Disney launched ESPN+ a year ago in April 2018 precisely to test its OTT strategy of taking its content D2C rather than via third parties. Opinion over its value for money at $5 a month has been divided ever since, for while this is less than pay TV providers pay per subscriber for the full ESPN package, it has been deliberately designed to avoid cannibalizing that. It has therefore avoided any overlap and concentrates mostly on niche or quirky output so far, although also with some premium content thrown in, leading to a rather split identity.

However, this has to be seen as a developing strategy and we believe ESPN+ will usurp the main ESPN package over the coming years and that the level of content will improve. Already it has drawn in a steady trickle of US subscribers by covering soccer, for example, with all out-of-market Major League Soccer regular season games. It also offers hundreds of matches per year from United Soccer League, UEFA Nations League, English Football League, and Italy’s Serie A, so has become the go-to service for US soccer junkies, whose numbers are rising again not least through Hispanic immigration despite President Trump’s attempts to rein that in.

ESPN+ has also targeted US tennis fans by being the only service there to cover three of the four annual grand slam tournaments, the Australian Open, Wimbledon and the US Open. It has also embraced hockey fans with coverage of over 180 NHL games during the regular season.

Most intriguingly though, ESPN+ has placed a bet on the increasingly popular Mixed Martial Arts (MMA) and in particular the US league funded by the Ultimate Fighting Championship promotion company based in Las Vegas, owned and operated by parent company William Morris Endeavor. ESPN has forked out $1.5 billion on exclusive UFC rights over a five-year period and there are growing signs this could pay off with MMA in line to become an Olympic sport in 2028.

According to UFC, admittedly not an impartial source, MMA has 260 million fans worldwide, which is substantial considering that Golf weighs in at number 10 on 450 million, although that may rise in the wake of Tiger Woods’ recent triumph at the 2019 Masters.

ESPN+ then hopes MMA coverage will engineer international growth given the sport’s growing popularity worldwide, as well as driving up US numbers. The Achilles Heel though again is costs, given that Disney itself expects ESPN+ to register operational losses of $650 million in both fiscal 2019 and 2020. McCarthy has targeted 2023 to reach break-even point but that is betting on fairly optimistic growth rates higher than almost any analyst predictions, hoping for 4 million subs by the end of 2020.

Morgan Stanley is at the bullish end of analysts and has forecast 2.7 million paying subscribers for ESPN+ by the end of fiscal 2019 and 3.9 million by the end of fiscal 2020, rising to 6.7 million in 2022.

Moffett Nathanson’s outlook is more realistic, predicting that ESPN+ will end fiscal 2019 flat, with just 2 million subscribers, growing to 4 million by 2022 and 5 million by 2023.

Rethink TV has ESPN+ on 3.2 million by the end of 2019, rising to 5.7 million in 2024, which takes account of these investments, but hints at losses continuing throughout this period. And this is without any major bid for the most valuable sporting rights, such as premier league European football in the host countries. Disney’s bid for global dominance in SVoD, never mind live sports, looks like being drowned in proliferating content costs, even though it will become a significant force.