The Artificial Fantasy of Virtual Pay-TV
One of the biggest questions for the future of online video is the role of virtual MVPDs (online pay-TV services, or “vMVPDs”, such as SlingTV, DirecTV Now, YouTube TV, Hulu with Live TV, etc.). Since launching three and a half years ago, these vMVPDs have acquired more than 6MM monthly subscribers – meaning they now serve more than one in 16 pay-TV homes in the United States and one in 20 total homes.
And not only are vMVPD subscriber counts doubling annually, this growth seems to be single-handedly staving off the decline of Pay-TV.
While vMVPD services may not be growing the pay-TV business (pay-TV penetration has dropped from its 88% peak in 2010, to 79% today), it seems hard to argue that they haven’t been both popular and successful. But behind topline statistics, these services will need to demonstrate four things to be viable over the long-term: (1) They solve meaningful, ongoing consumer problems; (2) They can defend against growing substitutes – most of which were responsible for the decline of traditional MVPDs themselves; (3) They can sustainably address emerging supplier interests and incentives; and (4) They can be profitable. While a lot can and is changing in OTT video today, each these four needs remains unsolved today and faces a challenging future.
#1 – Consumer Problems
According to MoffettNathanson, the number of homes without pay-TV (i.e. cord cutters or cord nevers) has grown from 14MM (13% of all homes) in 2010 to 26MM (21%) today. This isn’t great, but overall growth in the number of US homes means that the total number of pay-TV subscriptions is down only 3MM from 98MM (3%).
However, subscriptions are a lagging indicator of value. Consumers don’t drop habit-based products until their habits have changed significantly. And that’s where the quickly-escalating, near-term threat is revealed. The leading indicator for pay-TV isn’t subscriptions, but usage – and it’s imploding. Fast. The majority of homes may still have pay-TV, but its overall relevance and consumer demand continues to erode – and at both a predictable and terrifying rate.
Crucially, overall video consumption isn’t down (most estimates show it has grown by 15-20%). It’s only free-to-air and pay-TV that’s in decline (inclusive of DVRs, cable VOD, TV Everywhere, etc.). Furthermore, this decline has little to do with access to pay-TV – 95MM US households still have pay-TV in their homes and can access it on more devices than ever. Nor is it due to those who have churned out of pay-TV – a 9% decline in penetration isn’t significant enough to distort aggregate usage to the degree shown above (and notably, the drop in penetration rates brings us back to the levels experienced in early 2000s, when per capita consumption was still 15% higher than it is today). Furthermore, reduced viewing can’t be about pay-TV pricing either, as there’s no incremental fee per hour watched. As a result, the aforementioned 95MM pay-TV homes are therefore choosing to reduce their consumption of something that’s already paid for and free on a marginal basis.
The truth of these declines is that consumers simply don’t find pay-TV to be as good a use of time as it once was. We can debate whether pay-TV viewership (which averages five hours per person per day) was inflated to begin with as there were no real substitutes in the home, but this doesn’t change the significance of the decline.
This drop is particularly important because vMVPD services are largely positioned around how much cheaper they are than traditional pay-TV ($20-45 per month versus $80+). Yet a price reduction only helps the 79% of homes that already have pay-TV keep pay-TV (if you watch 30% less than you did five years ago, a price correction is due). What it doesn’t do is suddenly make these homes want to watch more TV nor does it suddenly make pay-TV a better use of their time. To point, studies show that vMVPDs have convinced only 25%-33% of cord cutters to return to Pay-TV. As such, the majority of vMVPD subscribers are cannibalized from traditional MVPDs. And given that prices are 50-70% lower, vMVPDs don’t deserve much credit for their success here, nor in attracting former cord cutters. In fact, vMVPD prices are so low that they are often sold at a negative gross margin. This alone shows the extent to which audiences don’t really want vMVPDs – they’re effectively being paid to buy them.
In addition, insiders have confirmed to REDEF that vMVPD subscribers are watching 30-50% less TV than traditional TV subscribers. This isn’t a surprise as the services are designed for households that rely heavily on ex-pay-TV services such as Netflix and HBO Now (until the mid-2000s, pay-TV represented 90%+ of a household’s total video time). However, this also means that vMVPD pricing doesn’t fix the disconnect between rising pay-TV prices and declining usage. If pay-TV usage has fallen by 40% among millennial-led households (which prompted many to cut the cord), and then those that adopt vMVPD services use it even less than they used traditional MVPDs, the pricing is still too high. Yes, vMVPD interfaces are better than those offered by set-top-boxes and it’s easier to watch live TV on an iPad – but overall, the data shows that these services haven’t made pay-TV fundamentally more attractive, or stopped usage decline. This leads us to the second challenge.
#2 – Substitutes
Where is the time going and why do people no longer love pay-TV? The answer is Netflix, Hulu, Amazon, YouTube and D2C services such as HBO Now – predominantly ad-free, on demand, binge released platforms that are getting better (in terms of product, content and value) and more popular with each day. vMVPDs don’t really change this dynamic. Improved OTT access/search and lower prices don’t make virtual pay-TV better than these substitutes, in part because it doesn’t address pay-TV’s core customer problems (linear scheduling, ad loads, weekly release schedules, fragmentation, etc.). And Apple’s video offering, which is likely to be essentially free to the company’s 1B+ active users, hasn’t even launched yet.
It’s true that the 25-33% of former cord cutters that returned to pay-TV due to vMVPDs suggests that some minutes are being won back. However, this pales in comparison to the minutes lost by the other 66-75% that have left their cords cut. Which brings us to challenge three.
#3 – Supplier Incentives
It can be argued that as long as some desirable content (especially live sports) remains locked in the pay-TV ecosystem, the pay-TV price is moderated, and its product experience made more tolerable, vMVPDs will thrive. However, every content owner in the pay-TV ecosystem has significant incentives to build its own OTT/D2C platform outside it. Some of these services are still (i.e. for now) tethered to pay-TV (such as FX+ and AMC Premiere), but many others aren’t (HBO Now, Starz, Showtime, ESPN+, CBS All Access, Disney’s forthcoming streaming service, Disney’s Hulu) and others are already being teased.
This goal is, after all, why every media company is either buying or being bought by another media company. While increased size helps negotiate higher affiliate fees and greater distribution with MVPDs (virtual or not), it is primarily intended to help content companies go around these providers. To go direct-to-consumer.
As networks embrace ex-pay-TV distribution and their subscribership grows, even more substitutes to vMVPD video viewing will emerge (challenge 2). More importantly, the existence of these alternatives will erode the very value prop of vMVPDs (i.e. access to must-have content that has historically been available only on pay-TV). This includes the most important pay-TV content: sports. Disney’s Chief Strategy Officer and Head of Direct-to-Consumer, Kevin Mayer, recently told Recode that the company isn’t contractually prohibited from making ESPN available direct-to-consumer, it just doesn’t make business sense. But it will someday. And when ESPN makes a break for it, much of the most valuable sports content will be available without a pay-TV subscription.
This connects to challenge four. Networks also know that while vMVPDs are keeping the pay-TV business from decline, their economics are unsustainable (notably, traditional MVPD margins have fallen 20 percentage points since 2010). To solve this, vMVPDs will inevitably need to reduce the number of networks they carry (which is bad for networks), reduce the fees they pay each network (also bad), or increase their consumer prices (which will harm total subscriptions, which is bad for networks). Alternatively, several vMVPDs may be shut down, thereby allowing one or two to dominate the market (bad again). Regardless of how one views the future of vMVPDs, cable networks need to invest in a future without them.
#4 – Unsustainable Economics
Today, no vMVPD is believed to be gross margin positive, with some leaders severely underwater. JP Morgan estimates that the three fastest growing services (DirecTV Now, with 44% of new subscribers, Hulu with Live TV, 27%, and YouTube TV 14%) will lose $6, $3 and $8 per subscriber per month next year – and that’s before accounting for marketing and technology costs, distribution fees, and other operating expenses. Furthermore, the primary cost driver for these services (programming fees, or the “cost of goods sold”) are expected to grow at 7% per year (and will grow even faster if/as more media consolidation occurs). As a result of these losses, it’s hard to put much stock in the claim that vMVPDs have stemmed the decline of Pay-TV. That’s true, but only narrowly.
Of course, it’s not a surprise to distributors that they can’t generate a gross profit on $40 pay-TV packages that include the most-watched TV channels. Not only was this cost problem easy to estimate, but numerous would-be vMVPDs shut-down their “skinny OTT” bundle programs for this very reason (Intel planned to launch the first vMVPD some five years ago, but sold their technology to Verizon after determining it couldn’t solve for negative gross margins; two years later, Verizon decided against launching their own vMVPD for the very same reason). To address this challenge, however, vMVPDs typically outline three core strategies.
The first argument is that vMVPDs will be indirectly monetized. DirecTV Now’s primary purpose is not to generate profits itself, but to enhance AT&T’s core business, AT&T Mobility, by way of growing subscriber additions, reducing subscriber churn and increasing average revenue per customer. Hulu with Live TV, meanwhile, helps to float the core businesses of each of its corporate parents: cable network affiliate fees. With every subscriber month, Hulu with Live TV passes along consolidated financial losses to its owners Disney (which owns 30% and therefore loses $0.9 per subscriber month), Fox (30%, $0.9), NBCUniversal (30%, $0.9) and WarnerMedia (10%, $0.3). But at the same time, these same players sell more than $14, $12, $12 and $5.50 each (and per subscriber per month) in programming (these exorbitant fees are also why Hulu with Live TV loses money in the first place). This may seem sustainable, at least for the time being, but recall that Hulu with Live TV’s subscribers are primarily being cannibalized from traditional pay-TV – and were thus already compensating these companies. On the plus, however, Hulu with Live TV likely aids Hulu SVOD customer retention and helps drive gross margin positive add-ons such as Showtime and HBO Now.
But behind the scenes, DirectTV Now and Hulu encounter deeper per subscriber losses for these benefits. Under their indirect monetization strategy, AT&T Mobility customers with unlimited data plans receive a stunning $15 discount on DirecTV Now’s $40 offering and get HBO (which is typically $15 and costs DirecTV roughly $10) for free. As a result, per customer gross profit losses end up between $21 and $31 per month. It is hard to imagine how the impact of this bundle on AT&T Mobility churn could be worth $300 per year (notably, churn is all ready at record lows in the wireless industry). Furthermore, DirecTV Now continues to steal subscribers from the traditional and still +40% gross margin pay-TV ecosystem and AT&T, with 25% market share, has the most to lose.
And as part of its $40 Live TV offering, Hulu throws in its $8 SVOD service for free. Accordingly, Hulu’s effective loss isn’t $3 per subscriber per month, but more than $11 (and keep in mind, Hulu already loses money on the $8 offering). YouTube TV is a little different as it doesn’t subsidize another business. Instead, it helps YouTube grow its share of premium video advertising and bolster its overall video offering (which includes Live, eSports/gaming, UGC, vlogging, etc.). That said, YouTube TV also has the worst initial per subscriber losses ($8) and includes full access to YouTube’s original series (such as Cobra Kai) – which are supposed to drive the company’s core (and gross margin positive) subscription business/platform, YouTube Premium (née Red).
The second strategy banks on advertising. Typically, MVPDs control roughly two of every 16 minutes of advertising shown per hour of television. This inventory has historically generated only modest revenue (in part because it is often used to cross-promote the MVPD’s other products, such as high-speed internet and home phones). However, vMVPDs hope to use targeted advertising and dynamic ad insertion technology to generate substantially more ad revenue than is possible through traditional linear TV (which essentially sends all viewers the same ad irrespective of their interests or demographics). To point, The Information reports that YouTube hopes to ultimately generate $16 per subscriber per month in advertising. Given Google’s expertise and dominance in digital advertising, this seems achievable given Comcast generates $10 today, while Charter does $8. However, this revenue is entirely reliant upon viewership. The less audiences use pay-TV, the fewer opportunities YouTube TV will have to offset their negative gross margins (which, thanks to substantially higher prices, Comcast and Charter don’t have). In addition, vMVPDs must also contend with the fact their customers also watch an estimated 50% less TV than those that use traditional MVPD pay-TV. And with ad loads overall dropping, even their two minutes of available inventory might shrink. Accordingly, some doubt YouTube will be able to cross the $7 mark (and currently generates less than half as much today). And by the time they do hit $7 (or even $16), gross margin losses will likely have grown well beyond the $8 mark. Online advertising has also been a centerpiece of AT&T’s advances into digital (e.g. AdWorks, a $2B acquisition of AppNexus) and its long-term DirecTV Now strategy, though the company has made no long-term ad revenue estimates.
The final argument pertains to the expected benefits of “scale”. Many vMVPDs argue that if they get large enough, they will be able to leverage their newfound market power to (1) force programming fees down; (2) slowly remove high cost networks (i.e. offer a “skinnier bundle”) or replace high-cost networks with lower-cost substitutes (e.g. swap CNBC with Cheddar, Scripps with BuzzFeed); or (3) transform their vMVPD offering into another, more profitable, video-centric business. The first thesis requires a given distributor to hold an unprecedented share of total pay-TV subscriptions. Here, AT&T benefits from the fact that it already holds roughly one in four pay-TV subscriptions via DirecTV, DirecTV Now and U-verse. To achieve comparable scale, Hulu, YouTube, SlingTV, et al would not only need to acquire more than 50% of all vMVPD subscribers going forward, they would also need more than half of all MVPD homes to convert to vMVPD service. But even then, it’s worth highlighting that despite AT&T’s present day scale, it can’t operate an even gross margin profitable service before discounts. In addition, this market dominance wouldn’t happen overnight – it would take years. Accordingly, substantial share gains would prompt even greater supplier consolidation and prompt even greater supplier investment in D2C distribution.
If vMVPDs can’t achieve the scale needed to drive down per network fees, they’ll look to cut them back. However, it’s not clear how much demand exists for a cheaper pay-TV offering that lacks Pay-TVs must-watch, exclusive content (e.g. NFL, NCAA) and most valued networks (e.g. Turner). And by removing this content, vMVPDs would be placing their (increasingly undifferentiated and of lower value) offering in more direct competition with (even) lower-cost, larger library, OTT aggregators such as Netflix and Amazon. The exclusion of key networks (which are expensive because they’re valued by consumers) would also intensify the need for all networks to go direct-to-consumer, thereby exacerbating substitute competition. And although the idea of swapping out high cost networks with lower cost, digital-era brands is appealing, it’s not as intuitive as it sounds. It’s easy to overestimate how many of these networks’ free viewers (many of whom watch because these networks are widely distributed for free, especially on social platforms) would support them on a paid basis, even when aggregated. To point, prior efforts to bundle a variety of low-cost/free video networks into paid (or unpaid!) subscriptions haven’t scaled (Vessel, VRV, Go90, etc.).
Generally, I’m a strong advocate of the third scale thesis. However, this strategy is usually deployed in growth areas – social networking, ride sharing, SVOD, etc. It’s rather different to bet on a declining business (bundled subscriptions of traditional TV networks) when its ostensible successor (SVOD) is thriving and hope that some point later on, you can transform your large money-losing enterprise into another… as yet unidentified thing that probably still looks like the old thing. This is an unfalsifiable thesis, of course, but there are many reasons to be skeptical. For example, AT&T Communications CEO John Donovan has been clear they don’t know what that thing looks like or how it’s priced. In an August 2018 interview, he told The Information “But I don’t think [any vMVPDs have] it figured out… And that’s why I said [DirecTV Now is] a placeholder, because we needed to have something in that sort of mid-range price point… What we’re trying to do is figure out how should we reshape it over time.” And Donovan remarked that while reducing or changing programming fees is “obviously a really important part of the conversation, but nobody’s in a position to dictate anything.” In a 67 page investor relations presentation in May 2018, Sony mentioned PlayStation Vue only twice, once under the heading “Challenges and improvements,” stating Vue’s “Market & future business model remains uncertain.” In addition, the “losing money until you have scale” approach is typically used by companies that have yet to implement or emphasize monetization (Facebook, Amazon), or have predominantly fixed costs and therefore achieve significant operating leverage as they grow (e.g. Netflix, Spotify) or have substantial control over how much they lose per customer and when (Uber). Pay-TV is already highly monetized (both in terms of subscription revenue and ad revenue), the primary costs are variable not fixed (i.e. programming fees), and costs are contracted for years at a time (with larger annual increases baked in). As a result, vMVPDs not only lose money on each subscriber added, they lose just as much with each subscriber as they did with the one that preceded him or her.
While the major television networks are no doubt elated that there are so many digital pay-TV distributors willing to buy and sell their channels at a substantial loss, this arrangement isn’t sustainable. These companies simply cannot continue to sell their content at prices disconnected from the revenue they generate forever. Nor can their profitability depend indefinitely on someone else’s indifference to their own. Over time, these buyers (or their shareholders) might suddenly tire of the losses (in Q4 2017, Sling TV and DirecTV Now’s owners recorded revenue declines 5.4% and 5.3% in their video businesses, with EBITDA dropping 21.5% and 11.2%) or simply find a better way to cross-sell or upsell the rest of their business. The ongoing erosion in the appeal of pay-TV will only accelerate this trend. And in the interim this type of loss-leading devastates those who want and need to make vMVPD services a sustainable, long-term business (i.e. the already unprofitable pureplays such as SlingTV, which have largely stopped growing). As a popular Twitter personality recently put it, “Amazon passing on launching a streaming MVPD because it didn’t see a way to make money is a hell of an indictment of the business model.” This point is uniquely notable given the presently unfalsifiable argument that vMVPDs have long-term strategic value. If Amazon had one (or Apple, which also considered but passed on a vMVPD offering), the prevailing narrative would say that as with Prime Video, these losses are justified by cross-monetization or other video ambitions. Yet these two players – which use SVOD not just to support a diversified video business (e.g. EST, 3rd party SVOD channels, a proprietary video offering, connected TV device) but also their broader core business (ecommerce, mobile devices, etc.) – don’t see the merit.
There is a classic solution to the losses problem: increase prices or reduce discounts. However, the value proposition of these services is deeply rooted in how much cheaper they are than standard video subscriptions (i.e. MVPDs). As a result, the net price increases needed to achieve positive gross margins would likely have a substantial impact on vMVPD subscriber growth and churn. So significant, in fact, we would likely see pay-TV penetration return to its pre-vMVPD rate of decline. Alternatively, we’ll see more of these services try to cut out $10-15 of programming fees out of their bundles. This may work, as vMVPD subscribers already value and watch less TV than traditional TV subscribers, but at this point, these services aren’t pay-TV as currently defined. They are literally paid television subscriptions, but it’d be disingenuous to treat them as part of the classic Pay-TV/MVPD ecosystem. They don’t represent much of a lifeline to the major media companies, either.
Booting Up and Shutting Down
Ultimately, it’s important to distinguish between the durable future of pay-TV and the significance of vMVPDs. Even if the rate of pay-TV subscriber losses were to quintuple, there would still be more than 75MM pay-TV homes in 2023. Yes, these viewers will be increasingly old, linear TV ad spend continues to decline, and MVPD margins continue to contract – but traditional pay-TV revenues are still likely to exceed $90B annually in the United States. Data shows that vMVPDs are slowing the decline of Pay-TV, which is great, but does it change the end-state? That’s hard to see. To do so, they’ll need to demonstrate they solve a key customer problem, defend against their increasingly numerous substitutes, placate suppliers and become financially sustainable. Otherwise, it’s simply a transfer payment from distributor’s pockets to the network’s (in addition to sustaining a questionable narrative that pay-TV is as popular and well penetrated as ever).
Overall, vMVPDs feel like how one might have imagined internet TV in the late 1990s or early 2000s – it’s the same product, but digital and wire-free. And had these vMVPDs risen to prominence a decade ago, the world might look different today (or at least be controlled by different giants). Instead, we’ve seen new networks (such as Netflix) and aggregators (Prime Video) fundamentally rethink core TV and MVPD theses, and grow so large they will soon reach as many homes as pay-TV itself. That doesn’t mean vMVPDs don’t have a future. They do. But as prices increase, they’ll just come to feel like marginally cheaper, more user-friendly and easier-to-install versions of their antecedents. This will help sustain pay-TV, but it doesn’t reinvent or change it.
Hulu, AT&T and YouTube are right to invest billions in the future of video. But to this point, they’d be better investing in what it can be rather than what it was. After all, most consumers and content owners already are.
Matthew Ball (@ballmatthew)
