Hollywood Spent Billions to Chase Netflix. the Strategy Could Be Wrong.

  • Media companies are trying to get to streaming profitability but their underlying businesses are in worse shape than previously thought. 
  • Their legacy linear TV business is declining faster than ever as they carry large debt loads.
  • The remedy is to cut content spending, which throws the whole business model out the window.

For years, the media and entertainment industry bet that by building a sound streaming strategy, they could outrace declines in the legacy TV business. But what if that thesis turned out to be wrong?

After cheering on Hollywood players for massively spending on streaming content, Wall Street is looking less impressed. Netflix lost subscribers in 2022 for the first time before rebounding in the second half of the year. Stocks of giants like Warner Bros. Discovery, Disney, and Paramount Global plunged in the past year. And some assumptions about bets made on streaming are starting to look questionable. 

First, the decline of linear is becoming clearer. People have been cutting the cord for a long time, but now the decline is accelerating. Just 49% of registered voters had traditional TV, according to an October Harris poll for Samba TV, which also found that 1 in 4 of those who haven’t cut the cord planned to do so in the next six months. 

That means networks’ historically high-priced ad businesses break down. Live sports is still propping up viewership, but sports rights are only getting more expensive, which will eat into broadcast, regional, and cable networks’ margins.

S&P recently downgraded long-troubled AMC Networks, raising the specter of default risk, while also issuing a warning to other media and entertainment companies. Given the uncertainty of streaming’s profitability and the worsening linear TV picture, they could be next.

“Four, five years ago, we thought these streaming businesses could all get to profitability,” S&P’s Naveen Sarma told Insider. “Now that’s looking a lot harder. Bottom line is, the media business isn’t as good as it used to be.”

How valuable is content after all?

Content may still be king. But another warning sign for these companies is that in streaming, content may not be as valuable as once thought. 

Look at Netflix. Part of the case for Netflix was that it could take local hits and turn them into global hits by streaming them to subscribers everywhere — but those global hits are rare, so Netflix doesn’t get as much out of its international content as it had hoped, Stratechery’s Ben Thompson recently pointed out.

“What’s really interesting is there aren’t that many global hits, meaning that everyone in the world watches the same thing,” Netflix co-CEO Ted Sarandos said on the company’s 4Q earnings call. “‘Squid Game’ was very rare in that way. And ‘Wednesday’ looks like one of those too, very rare in that way. There are countries like Japan, as an example, or even Mexico that have a real preference for local content, even when we have our big local hits.”

Netflix also gets less value from its older content while new, must-see shows are the key to getting and keeping subscribers — a reason Thompson and other analysts have said its profit number is misleading.

A quick accounting lesson — Wall Street traditionally measures media and entertainment companies’ performance by their EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a proxy for cash flow.  

EBIDTA takes into account amortization, an accounting tactic that lets companies spread the cost of the content over the time in which they expect it to generate revenue. If they expect a show to keep producing value for five years, they can spread the cost over that period. But EBITDA can give a misleading picture of a company’s financial performance by masking high debt and weak cash flow because you don’t immediately see the impact of wild spending on the company’s financial picture. 

And what if the show loses its value much faster than the company thought? In that case, investors could be in for a nasty surprise, and it’s a scenario some analysts fear many media companies are in because streaming platforms require constant replenishment with fresh content.

Another way to evaluate a company’s performance is to look at free cash flow, which measures its ability to generate cash after taking care of its operating and investing needs. There’s less room for fudging with free cash flow. That also has its downsides because it can overweight the financial hit that new investment in content brings to a media company. 

But looking at free cash flow, it becomes obvious quickly that some entertainment companies’ financial picture has weakened in recent years because spending on content hits their cash flow harder and faster than it does EBITDA (see: Warner Bros. Discovery, Disney, Paramount).

“These companies are all highly leveraged cash flow to debt,” Michael Nathanson, senior analyst at MoffettNathanson, said in a Stratechery interview. “The only way you manage cash flow to debt is by spending less on content. And when you spend less on content, the whole flywheel breaks down.”

No one knows how profitable streaming will be

All these companies are revisiting their spending on content now — either reducing budgets or at least slowing their growth. Netflix can now push other revenue levers like advertising (which it’s doing) and licensing content to other platforms (which it hasn’t discussed but could consider). But for traditional media companies, whose legacy revenue streams are contracting and are trying to make the transition to streaming, no one really knows when streaming will be profitable and how much.

“There’s still a big debate about what the right long-term margins are in this business,” Citi’s Jason Bazinet told Insider. “The old business did 35% margins and Netflix does approximately 20% margins. I think the preponderance of investors say it’s going to be worse than the linear business. The question is, how much worse.”

The most pressing danger is that a continued spending slowdown on content will give people less reason to subscribe. Consumers start to question how many services they need, and subscriber growth doesn’t materialize. The break-even point for streaming profitability gets pushed further down the road. 

Scale may be the only way out. AMC Networks is in an especially tough position. It avoided getting acquired for a long time by building up a network of boutique streamers like Shudder and Sundance Now. But it’s in a tough spot as a small media company without other businesses like theme parks to prop up linear revenue declines. The company just cut a whopping 20% of staff in a restructuring. A sale of the company seems increasingly likely, though its diminished stock price would weigh on the price. 

And AMC Networks’ challenges aren’t unique. It seems inevitable that more of these companies will be forced to sell, perhaps to a Comcast or Apple. That day could come sooner than people think.

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