A Guiding Framework for a Brave New World

All sectors of the economy focused on distribution are dealing with some form of “cord cutting” or “cord nevering”—effectively, customers shifting their spending to digital substitutes. In retail, this manifests as rising ecommerce market share. In financial services, commercial banks now must compete with online-only challengers who are not burdened by a legacy branch network.

However, for the media business, disruptive innovation in terms of channel shifting isn’t new. Due to technological innovation, the media industry has—about every 20 years, give or take 10—destroyed its established distribution channel via new entrants that use the “next gen” pipes to the consumer. In the 1950s, broadcast television terrified the film industry. In the 1970s, cable television—originally pitched as “ad-free subscription TV” (sound familiar?)—spooked broadcasters. In the 1980s, satellite television was supposed to disrupt the growing cable systems (but didn’t). From then on, until the mid-2010s, there was a “Golden Age of Cable” during which television programming was distributed by a mix of cable, telecom, and satellite businesses that offered a homogenous product under conditions of natural monopoly (or at least regional oligopoly): these companies spent enormous sums on the infrastructure required to serve cable television at scale and thereby gained leverage with local municipalities, customers, and to varying degrees the content providers themselves. There was little-to-no consumer choice or competing substitutes other than traditional broadcast television (think “rabbit ears”), whose offering was limited in comparison. The product on offer was undifferentiated—all distributors (MVPDs) sold the same product, which was effectively a bundle-of-bundles or megabundle, with networks offering bundles of channels to distributors in exchange for carriage fees. During this period, the pay TV industry enjoyed significant growth, with cable TV homes tripling from the early 1980s to the mid-2010’s and the basic tier cable package price growing from ~$9/month to almost $70/month. This generated a virtuous cycle in which everybody won, both programmers and content providers (Figure 1). As a result, the “balance of power” between content—including sports teams—and media companies was in equilibrium.

Today, there is a new distribution disruption. This time, the “next gen pipe” to the consumer is high-speed internet. Due to increasing penetration of broadband and the successful launch of Netflix, streaming emerged as a genuine challenger to the Golden Age industrial set up in the mid-2010s. Streamers operate in a competitive, fragmented marketplace, where competition is just one click away. Due to competition and low switching costs, it has been difficult to replicate anything close to legacy cable’s Golden Age distribution moat without simply competing for content. Now, nearly all network incumbents have a streaming service that competes with other streaming services and traditional cable, from which customers can self-curate a selection of “channels” depending on their own willingness to spend and content preferences. Churn has been high (~50% annually)—subscribers generally top out at 3-4 streaming services, possibly also a skinny bundle for live TV, and generally add or subtract services as their favorite programming is launched, wherever it is. This is the Brave New World (Figure 2).

Going forward, as we will argue in the below, the economics of video distribution will be different. The Golden Age’s quiet equilibrium between content and networks is broken. The leverage that cable networks had over customers is gone; the implicit partnership at the heart of the legacy bundle is converting to rampant competition; and content’s power to determine who wins and who loses in the “streaming wars” is growing.

Importantly for the sports business, the leverage that the network ecosystem had over content creators—there was only one place to get content to fans!—is gone. That, plus the advent of the “streaming wars” and the need for must-have content, has fueled growth in media rights values even as sports viewership has grown only modestly and declined via linear channels.

We want to explore what all of this means for video economics long-term, especially as it relates to the sports business. Specifically, we will tackle the following questions:

Tackling these questions will illuminate some puzzling aspects of the current market, like why sports rights have continued to escalate despite cord cutting.

Ultimately, media networks are curators—they are analogous to consumer retailers. This analogy is simplistic—there are few key differences—but to a first approximation this is accurate.

Intuitively, media networks and consumer retailers share the same key levers of value creation:

By their nature, retailers are subject to constant competitive threat. Retail margins have never been particularly high—historically 8%+ EBIT margins, now closer to 4%+, with gross margins in the ~30% range—i.e., margins after the costs of procuring and selling inventory. Hence, firms in retail need to develop durable competitive advantages to combat what would otherwise be persistent margin pressure—typically achieved via scale, both horizontal and vertical, or unique technology or know-how in supply chain and inventory management.^[1] Operating a media network introduces several unique challenges not shared by typical retailers (especially online retailers). However, given the changing competitive dynamics we highlighted above, we believe it is unlikely that run-rate margins can remain at this level without a dramatic reduction in competition for subscribers.

Where will long-term margins end up? For an indication, we can look to (a) currently scaled or near-scale streaming platforms and (b) large retail comps (Figure 3). Gross margins for the streamers average 35%—i.e., gross profit after programming costs to artists or content producers are paid or amortized. Retail gross margins average 31%. Both are significantly lower than the 52% average gross margins of the five dominant linear programmers (Disney, FOX, Comcast, Paramount, and Warner Bros. Discovery). Over time, we expect gross margins for media companies across both streaming and linear to converge to 35-40%, not quite to retail levels, given the unique complexities and long-duration risks of running a media company, but lower, driven by the arms race for content.

For the five dominant linear programmers, plus Netflix, global media revenue totaled $213 billion on approximately $112 billion of global content spend (Figure 4).^[2] This represents a 48% gross margin for these media companies on a blended basis—52% for linear (three-quarters of total revenue) and closer to 33% for their streaming operations, based on our rough estimates. Assuming total media take rates decline to 35-40%, content spending for these providers should go up $25 to 45 billion over the next five years, assuming modest growth in the total revenue pie. In addition, Apple and Amazon are estimated to have spent $16 billion on content acquisitions and originals in 2021, with analysts expecting this to grow considerably. Depending on Apple and Amazon, content spending should grow by an incremental $45 to $75 billion over the next five years—a 6-9% CAGR.’

On top of increasing content spend, there are two other challenges to keep in mind, both beneficial for content suppliers. First, the streaming business requires more reinvestment in sales & marketing, given higher levels of subscriber churn, and requires ongoing investment into video technology. As we have emphasized in past writings, streaming is simply a more expensive business. Higher churn raises the stakes for acquiring and retaining must-have content, which is ultimately what powers successful marketing—in fact, marketing expense and content expense are increasingly hard to distinguish. Second, as already alluded to, Amazon and Apple are unique challengers: multi-trillion tech conglomerates with multiple, often disparate business lines and uniquely sticky relationships with wide swaths of the global population: 1 billion iPhone users; 200 million Amazon Prime members and 1 million+ business customers of AWS. These companies are not spending on content just to sell content—e.g., Amazon can rationalize content spend by using data gleaned from a user’s watch habits to improve its advertising offering (a $31B business) or improve sell-through on Amazon.com or use it as a platform to advertise for Amazon products and services directly. Apple has built a fast-growing recurring fee bundle combining third-party app fees processed via the App Store, Apple Music, iCloud, fitness and health services, and others all tied to the ubiquitous Apple hardware ecosystem. In total, just the Apple services business generated $68B in 2021—more than any other media company we covered above. Apple TV+ represents the video “leg” of this overall content bundle, the existing scale of which suggests Apple has plentiful sources of cash with which to compete on content. Competition from Amazon and Apple is uniquely “cost-insensitive” as they do not need to immediately (or possibly ever) make money on a direct subscription+ad basis to justify major investments.

Ultimately, two factors determine content spend: (1) the size of the revenue pie and (2) competition for content. Over the last few years, the size of the pie has grown modestly, but as the Golden Age’s distribution moat faded, differentiation and customer retention once again required competing for content. Forecasting what happens requires answering the same questions: how big will the pie be? and will content creators retain their leverage advantage?

At first glance, what this means for sports is obvious: content spending is going up, so let’s rejoice. And it is worth underlining the positives briefly.

Sports, especially in the U.S. and Europe, represent unique, evergreen properties for which subscriber interest is dependable. In this sense, sports rights play the same role in content portfolios as government bonds do in financial portfolios: the assets are expensive (i.e., they trade at low yields), but returns are easy to forecast. Sports is the “safe-haven asset” of the content kingdom and has an important portfolio benefit: owning sports gives you a quasi-guarantee of subscribers and hence the flexibility to take more risk elsewhere in the content portfolio, which is required to rationalize entry into the space. Interestingly, the growth of on-demand streaming has catapulted the value of “riskier” scripted programming (think tent pole scripted series or multi-year exclusives with prominent stars), improving the relative value of bond-like content assets of late.

Sports is a content niche that both (a) enjoys mass appeal and cultural ubiquity and (b) attracts a definable and otherwise hard-to-access audience segment. And in a streaming world, the best growth strategy is accumulating as heterogenous an audience as possible—i.e., to replicate as closely as possible the Golden Age bundle. Heterogenous audiences unlock bundle economics—accumulating niches is how you get your hardcore sports fans to pay fees for historical dramas and your young professional, educated female demo to pay for mixed martial arts or motorsports.

But while these benefits are not going away, and are arguably strengthening, media companies trying to reach scale in the Brave New World are aware of this dynamic as much as leagues are. Like all business, the media industry is repeated game, where both sides have access to roughly the same information. Leagues and teams should expect more consolidation in the media industry over the next few years as a reaction to the changes in the balance of power. More important, just because sports as a class can expect to be buoyed by increasing competition does not mean all sports and all packages will equally benefit. Within these two realizations lies strategies for coping with the Brave New World.

Within every current advantage lies the seeds of a potential disadvantage. Let’s review what we mean:

On top of this give-and-take dynamic, not all sports and packages are created equal. We would highlight the following:

What should leagues do to get ahead of this? Our advice is that leagues should be looking to use the windfall from the current moment to reinvest in the foundations of their IP and fanbase:

Our recommendations for teams focus on managing the local rights market and tech disruption are:

[1] Walmart is legendary for maximizing both levers. T.J. Maxx enjoys 10%+ EBIT margins driven by investment excellence in the global secondary market for excess inventory. As mentioned, some retailers have captive supply chains that, while they introduce new risks, enable the retailer to capture margin they would otherwise need to give away. A less common differentiator is brand—most retailers have the same, cookie-cutter brand message (“more for less”) and need to compete hard on price.

[2] We exclude the multi-platforms Apple and Amazon—who together contributed another ~$16 billion in additional content spend in 2021, but for whom content spend is rationalized differently than just subscriber fees and advertising. We will revisit this shortly.

©Arctos Partners, LP, 2024. All rights reserved.

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