Smaller Streaming Services May Have to Join Larger Platforms, Analyst Forecasts

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"Smaller-scale services like Starz and AMC Networks' might be better off folded into larger platforms," writes Wells Fargo's Steven Cahall.

When will the much-discussed "Streaming Wars" in the entertainment industry turn into the "Streaming Profit Wars"?

"The tide in media has shifted with nearly every traditional company joining the streaming fray," Wells Fargo analyst Steven Cahall wrote in a Friday report with the title "Deep Dive Into Streaming Margins: The Struggle Is Real."

"While the equity market tends to prefer direct-to-consumer (DTC)/streaming to all things linear, we also think investors are increasingly looking to differentiate amongst services in valuations," he said. "The reasoning is sound: not all DTC is created equally."

Cahall went on to analyze and predict the financial performance of entertainment giants and their streaming services, along with music streamers, with a focus on operating margins. Cahall's conclusion: "We're bullish on the DTC outlook for Disney/Netflix, bearish for Lionsgate/AMC Networks/Pandora/Spotify, unconcerned for Discovery/Fox Corp. and waiting to see on ViacomCBS."

The analyst forecast subscribers, average revenue per user, gross profit margins and operating profit margins from year 1 into the future to find that scale matters or, in other words, that "in streaming the bigger, the better." He also explained that profit margins in streaming differ depending on whether services focus on video or audio and on global or niche offers.

At more than 200 million subscribers, Netflix has operating profit margins of about 18 percent, up from 4 percent at 50 million, Cahall noted. "Many video DTC services will never get to 100 million or even 50 million subs, and our work shows that profitability will be a future challenge at smaller scale," he wrote. "Competition is fierce: we think Netflix has defined consumer expectations with a 'golden ratio' of more than $1 billion in annual content spend for every $1 of monthly customer average revenue per user (ARPU). Only Disney looks set to match it, though Discovery+ and Paramount+ could if the price is right."

Cahall argued that Disney, with Disney+, Hulu and ESPN+, has "most upside to DTC operating margins," making him "incrementally bullish on Disney for the long-term," while Lionsgate and AMC Networks have the most downside. "Based on company guidance and our own estimates we have Disney getting to 335 million subs in fiscal year 2024 with a blended 2 percent DTC operating margin," he forecast. "Netflix will be at 30 percent operating margins at a similar scale. We think Disney has significant optionality on whether to juice future subscriber growth or pull forward profitability."

But the analyst isn't so optimistic across the board. "On the flipside, our analysis suggests Lionsgate's Starz OTT op margins in the mid-teens may not be sustainable given stiff competition. We wonder if smaller-scale services like Starz and AMC Networks' might be better off folded into larger platforms a la WWE Network into Peacock. We're comfortable with Discovery's DTC given it's all incremental, with a similar view to Fox."

Ahead of ViacomCBS' investor day next week that will focus on its upcoming Paramount+ launch and broader streaming strategy, Cahall wrote: "Next week the ball is in ViacomCBS' court to convince the market that Paramount+ can be a success."

Given the stock's strong gain of nearly 70 percent this year, "we think a minimum of 55 million DTC subs is in the price," according to the analyst. "We're in favor of a go big strategy with the totality of its content assets, and a move away from licensing. If it does, 75-100 million-plus DTC subs is not out of the question. If the strategy proves uncompelling it will be easy for investors to get negative after the recent rally."