Last week, Wall Street turned sour on video streaming. Very sour.
On Tuesday, investors sent shares of Netflix plunging 35 percent after the retailer posted a larger-than-expected drop in its third-quarter subscriber count and warned investors that it may be unprofitable for several quarters as it ramps up its international operations. On Wednesday it was Amazon’s turn: After third-quarter profits came in lower than expected, its shares fell 13 percent, wiping out $2 billion in market value. The company said it would likely lose money in the fourth quarter as it spends heavily to roll out its mobile media streaming platform, Kindle Fire.
There were, of course, local factors at work in each retailer’s results. Much of Netflix’s subscriber loss, for instance, was self-inflicted, a result of its clumsy handling of a major price hike and its now-aborted plan to split itself in two. Amazon, meanwhile, made a decision to sell Kindle Fire tablets at a loss in order to build the base of devices connected to its Amazon Prime subscription streaming service.
Taken together, however, what the sell-offs amount to is a massive repricing by Wall Street of the risks and rewards associated with the streaming video business. This has uncertain but potentially far-reaching implications for streaming service providers and content owners alike.
Once seen as a nearly sure-fire bet, valuations tied to subscription-based video streaming are suddenly up for grabs as investors try to wrap their heads around the very different-looking cash flows produced by the licensing and streaming of digital content compared with the familiar and highly predictable flows generated by the sale and rental of physical media.
Why the sudden uncertainty? Partly it’s due to growing uncertainty within the business itself over how to put a value on streaming rights. The non-sale of Hulu, for instance, was due at least in part to an inability of its network owners and potential buyers to settle on a mutually acceptable valuation for the streaming rights to the networks’ programming. Netlix’s flirtation in with the Qwixster spin-off added to the doubts by forcing investors, at least briefly, to think about how much value to assign to its legacy DVD business and how much to assign to its streaming business.
And though often seen as essentially the same business by other means, DVDs and streaming are very different animals.
Selling and renting DVDs is a highly predictable and easily modeled business. Retailers can make extremely accurate projections of the ultimate demand for a title, given its box office results and a few other factors, and can buy the precise number of copies needed to satisfy that demand. The revenue life of those copies is well understood and their cost can be amortized on a simple, straight-line business (or counted as a simple cost of goods sold in a sell-through scenario). The variable costs associated with renting the copies are minimal and scale lowers a retailler’s cost of goods in a predictable, more or less linear ratio.
Most critical, gross margins, free cash flow and other key metrics are largely under the direct control of the retailer.
With streaming, that granularity is lost. Streaming rights generally are not sold a la carte. Instead, entire slates of content are licensed as a package over a period of years, often sight-unseen. While a retailer may be able to forecast its subscriber or user base with some degree of accuracy, it’s much harder to model how much a particular title or slate of titles will be worth to the retailer over time.
That makes it difficult to determine whether a retailer like Netflix is overpaying or underpaying for content rights, which makes its future gross margins and cash flows difficult to model. While that makes life harder for investors it also presages more contentious negotiations between retailers and content owners over rights fees, which can only add to the confusion.