The Secret to Apple's Ecosystem

Apple’s ecosystem remains misunderstood. While consensus has come around to accepting the sheer size of Apple’s ecosystem (a billion users and nearly 1.6 billion devices), there is still much unknown as to what makes the ecosystem tick. From what does Apple’s ecosystem derive its power? Why do loyalty and satisfaction rates increase as customers move deeper into the ecosystem? Apple’s ecosystem ends up being about more than just a collection of devices or services. Apple has been quietly building something much larger, and it’s still flying under the radar.

Products

No company is able to match Apple in offering a cohesive and strategically forward-looking product line. Computers small and light enough to be worn on the body are sold next to computers so large that built-in handles are required. More impressively, all of these products are designed to work seamlessly together.

The Grand Unified Theory of Apple Products outlines how each of Apple’s major product categories is designed to help make technology more personal - to reduce the barriers that exist between technology and the user.

 
 

Products are designed to handle tasks once handled by more powerful siblings. New form factors are then able to handle new tasks in unique and different ways. It is the pursuit of making technology more personal that ends up being responsible for devices like Apple Watch and AirPods. The same dynamic is also paving the way for Apple to eventually sell wearables for the face in the form of smart glasses. (More on The Grand Unified Theory of Apple Products is found in the Above Avalon Report, “Product Vision: How Apple Thinks About the World,” available here for Above Avalon members.)

With 1.6 billion devices in use, it may be natural to conclude that devices are the source of Apple’s ecosystem power. This has led some to position the iPhone as the sun in Apple’s ecosystem with other products being the planets revolving around the sun. However, this is a misread of the role Apple devices are actually playing in the ecosystem. Just because the iPhone is used by more people than any other Apple device, it is incorrect to assume that will always be the case, or more importantly, that other devices are in some way inferior to the iPhone when it comes to handling workflows. There is something much larger at play here than just a billion users enjoying Apple hardware.

Services

With a $55 billion revenue annual run rate and 518 million paid subscriptions across its platforms, there is no longer a debate as to Apple’s ability to succeed with services. However, there is still a lack of consensus as to what role services play in Apple’s ecosystem. Decisions like bringing Apple Music to third-party speakers and the Apple TV app to third-party TV sets have confused many with some going so far as to conclude that Apple’s future is one of a services company.

In such a world, Apple devices lose much of their value to cheap third-party hardware. This school of thought is responsible for claims that Apple gave up selling accessories like the Apple TV box and HomePod because customers can access Apple content distribution services on cheaper non-Apple hardware. It’s difficult to think of a bigger misread of how Apple thinks and operates as a company than to claim that Apple’s future is one of a services company.

There are now others who look at Apple’s financial success with services as a negative - a sign of Apple milking existing users of as much profit as possible. This school of thought positions paid services as a long-term liability to the Apple ecosystem.

A Toolmaker

While consensus credits products (hardware) as the source of Apple’s ecosystem power, services are increasingly viewed as a hidden risk factor that can crack holes in the ecosystem. Neither are true. Nearly a billion people are not using iPhones simply because they enjoy the hardware. Vice-versa, having 518 million paid subscriptions is not a sign of Apple users needing to pay some kind of tax or bounty to remain in Apple’s ecosystem.

From where then does Apple’s ecosystem derive its power? What makes a customer want to move deeper into the Apple ecosystem?

To answer these questions, we need to step back from any one product or service and instead look at Apple as a company. It is still common for people to call Apple by whatever is its best-selling or most popular product at any one time. This also applies to whatever product is responsible for revenue growth. As a result, we hear all too often phrases like Apple is an iPhone company, a services company, or even a wearables company. The problem is that Apple shouldn’t be defined by any one product, but rather the process that led to Apple having an ecosystem of products and services.

Apple is a design company selling tools that can improve people’s lives. These aren’t just any tools either. Instead, Apple is very selective in selling tools that are able to foster experiences that people are willing to pay for - something that has become increasingly rare in the consumer tech space. By having a design-led culture, Apple is able to put the user experience front-and-center during product development.

This experiences mandate ends up being responsible for Apple’s high loyalty and satisfaction rates. The 975 million people with an iPhone aren’t likely to remain iPhone users because of stellar hardware or compelling software powering that hardware. Instead, loyalty is driven by the experiences associated with using an iPhone.

An Experiences Ecosystem

The secret to Apple’s ecosystem is that instead of selling products or services, Apple ends up selling experiences made possible by controlling hardware, software, and services.

Instead of thinking of Apple’s ecosystem in terms of the number of people or devices, a different approach is to consider the number of experiences Apple is offering. This is where Apple’s true ambitions become visible. By using an iPhone, a customer doesn’t just receive one experience per day. Instead, nearly everything that is consumed on the device has the potential of leading to a good (or bad) experience. This is why Apple’s control of hardware, software, and services plays such a crucial role. Apple’s ecosystem likely consists of tens, if not hundreds of billions, of experiences in a single day.

Having an ecosystem of experiences ultimately represents the biggest challenge to Apple competitors. Coming up with an iPhone alternative isn’t good enough for enticing users to jump from the Apple ship. Instead, competitors need to come up with even better experiences than those found in the Apple ecosystem. As a user moves deeper into the Apple ecosystem - in pursuit of additional premium experiences - competitors need to figure out a way of recreating that growing list of experiences. Can it even be done? When looking at the wearables industry, the answer as of today is “no.”

Non-Apple Hardware

One of the most intriguing aspects of Apple’s ecosystem is how nearly half of Apple users still only use just one Apple device: an iPhone. The idea that every Apple user owns a multitude of Apple devices and services is wrong. The implication is that Apple’s billion users own (and use) quite a bit of non-Apple hardware. Today, non-Apple hardware used by iPhone owners include TV sets, cheap stationary speakers, and CarPlay-equipped automobiles.

Since Apple’s product strategy and organizational structure rewards saying “no” more than “yes,” there will likely always be opportunities for other companies selling hardware to participate in the Apple ecosystem. This ends up being a Trojan Horse for Apple.

Instead of needing to have a new customer jump with both feet into the Apple ecosystem from Day 1, something that isn’t likely especially as the next marginal customer will be coming from the middle tier of the market, Apple merely needs this customer to buy or use one Apple tool.

Management is confident that one tool will eventually turn into two tools and then three since humans gravitate toward premium experiences. As one’s Apple tool collection grows, the number of experiences made possible by those tools increases. This has the impact of increasing customer satisfaction and loyalty. And the flywheel continues to turn. In order to get this flywheel moving in the first place, Apple must build bridges allowing new customers to move deeper into the ecosystem. Decisions like making Apple Music available on non-Apple hardware and bringing the Apple TV app to Samsung TVs are examples of such bridges.

Evolution

When thinking about how Apple’s ecosystem will evolve, the focus shouldn’t be on which new devices or services Apple can come up with, but rather on how Apple can offer new experiences to its customers. The blueprint for creating such experiences is already known: leveraging control over hardware, software, and services.

Technology’s battle lines are currently being redrawn with the goal being to capture the most valuable real estate in our lives: our health, homes, and transportation. Bets on software that completely reimagines the way we approach these verticals will likely prove to be good bets. Timing remains the big unknown.

This raises a question: How will Apple approach new verticals and industries? Would Apple attempt to recreate entirely new device lineups for each industry? Will The Grand Unified Theory of Apple Products be torn apart?

Instead of selling a $80,000 electric car or moving head-first into selling a range of first-party smart home hardware, Apple’s current ecosystem provides clues as to how the company can approach these new industries.

  • The point of Apple entering transportation wouldn’t be to sell cars, mopeds, or bicycles. Instead, it would be to sell experiences that Apple customers can consume on the road.

  • The point of Apple moving deeper into smart homes wouldn’t be to sell a plethora of small home gadgets and trinkets, some of which may require an electrician to install. Instead, it would be to sell experiences that Apple customers can consume in the home.

Apple developing an autonomous car remains difficult for many to wrap their minds around. The idea of Apple one day getting into housing is still considered a fantasy by most. However, such ideas make a lot of sense when thinking about how we consume experiences during the day.

An autonomous car is nothing more than a room on wheels. A house is a series of rooms connected to each other. With each, Apple would be looking to create environments that can support new experiences.

This brings us back to Apple’s current suite of products and services. It is incorrect to assume that Apple entering new industries would result in the company throwing its current products out the window. Instead, those tools stand to play major roles in delivering experiences in new industries.

Apple’s interest with Project Titan isn’t to beat or copy Tesla, but rather to figure out a way to have personal gadgets provide compelling experiences on the road. Such experiences could include Apple Glasses being used to find the right autonomous Apple Car to enter while Apple Watches can be used as identification for entry. Once inside the vehicle, the digital assistant found on the wrist or in front of our eyes could then be used to convert the car’s hardware to suit our needs. A similar dynamic would be found with smart homes - relying on personal gadgets, especially wearables, to come up with premium experiences in the home. We are seeing the early stages of this with products like HomePod and the way the device can be seamlessly used with Apple Watch.

The idea that Apple would enter the transportation and housing industries simply to come up with more areas for its users to engage with wearables may seem preposterous today. However, the idea that a single company would be able to deliver hundreds of billions of experiences per day by selling tools consisting of hardware, software, and services was similarly once a fantasy.

Listen to the corresponding Above Avalon podcast episode for this article here.

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For additional discussion on this topic, check out the Above Avalon daily update from July 23rd.

Above Avalon Podcast Episode 164: Competing with Spotify

We are entering a new chapter in music streaming. In episode 164, Neil discusses how Spotify’s attempt to evolve from a dedicated music streaming service to an audio company ends up reflecting broader changes in the music streaming space. Additional topics include Spotify earnings, the music streaming war between Spotify and Apple Music, the problem with Spotify’s current business, roadblocks / advantages facing Spotify as it evolves into a different kind of company, and why Apple shouldn’t ignore Spotify’s evolution.

To listen to episode 164, go here

The complete Above Avalon podcast episode archive is available here

Above Avalon Podcast Episode 156: Apple's Content Distribution Arm

Content distribution has been a major theme for Apple in 2019. In episode 156, Neil goes over how Apple’s revised content distribution arm is structured. Neil also goes over his estimates for how much revenue and gross profit Apple’s content distribution arm can generate by FY2022. Additional discussion topics include the difference between Apple’s paid content bundles and content platforms, Neil’s initial estimates for the number of subscribers Apple will be able to grab for Apple TV+, Apple Arcade, and Apple News+, and why Apple’s new paid bundles will likely have lower profits than the App Store.

To listen to episode 156, go here

The complete Above Avalon podcast episode archive is available here

Measuring Apple's Content Distribution Arm

Apple has had a busy year expanding its content distribution arm. With the addition of Apple News+, Apple Arcade, and Apple TV+, Apple has revamped its paid content bundle offerings. Combining these new bundles with platforms like the App Store and iTunes, Apple will be in a position to have a content distribution arm bringing in more than $30 billion of revenue per year by FY2022.

Mapping Out Apple’s Content Distribution Arm

There are two parts to Apple’s content distribution arm: paid bundles and platforms. Paid bundles offer users access to third-party content (first-party content in the case of Apple TV+) for a set price each month. Platforms offer users the ability to consume a wide range of third-party content via paid and free downloads, in-app purchases, and paid subscriptions.

Exhibit 1: Apple’s Content Distribution Arm

 
 

Paid Bundles

  • Apple Music. Launched in 2015, Apple Music now has more than 60 million paying subscribers in more than 100 countries. In the U.S., an individual membership that includes a music catalog of 50 million songs goes for $9.99 per month ($99.99 per year) with student ($4.99 per month) and family ($14.99 per month) pricing also available.

  • Apple TV+. Apple’s new direct-to-consumer paid video streaming service will launch on November 1st in more than 100 countries. Built into the Apple TV app, Apple TV+ will include nine original video series and movies at launch, and new series and movies will be added each month. Apple is spending approximately $2 billion per year on original video content. An Apple TV+ subscription will go for $4.99 with Family Sharing although Apple is having a limited time promotion of one free year of Apple TV+ with a qualifying Apple device purchase. A detailed look at Apple’s TV+ strategy is available here.

  • Apple Arcade. Launched two weeks ago at $4.99 per month with Family Sharing, Apple Arcade offers subscribers access to approximately 70 exclusive games, and new titles will be added each month. Available in more than 150 countries, Apple Arcade utilizes a new business model for the App Store with Apple funding game development although ownership rights remain with the game developer.

  • Apple News+. Launched this past March, Apple News+ offers subscribers access to approximately 300 paid magazines and a handful of news publications. Built into the Apple News app, Apple News+ monthly subscription pricing of $9.99 includes Family Sharing with access for up to five other people. Apple News+ is currently available in the U.S., Canada, UK, and Australia.

Platforms 

  • App Stores (iOS, tvOS, macOS). With 2.2 million iOS apps available to download, the App Store remains a cultural phenomenon. Various business models are supported through the App Store including paid and free apps, ad-supported, in-app purchases, and paid subscriptions.

  • Apple TV App. The new Apple TV app offers “channels” through which users can subscribe to approximately two dozen third-party video bundles.

  • iTunes. Despite Apple deemphasizing iTunes by breaking out functionality into different apps, the platform still represents a source of paid download revenue. 

  • Apple Books. Apple offers a wide range of paid and free titles.

  • Apple News. Launched in 2015, Apple News offers users a wide selection of free and ad-supported written content from around the web. Apple News has 90M monthly active users thanks to prime real estate on Apple devices and a heavy emphasis on human curation.

  • Apple Podcasts. Apple is the leading distributor of podcasts with more than 600,000 available. Apple currently doesn’t directly monetize the Apple Podcasts app.  

Subscription Estimates

In order to measure the size of Apple’s content distribution arm, one can first estimate the number of subscriptions Apple will generate from its four paid content bundles. Those totals can then be used to derive revenue estimates. The final step is to come up with growth trajectories for Apple’s various content platforms.

Exhibit 2 includes my estimates for the number of paid subscriptions Apple can achieve for its four paid bundles within three years, or by the end of FY2022 (September 2022). These estimates assume additional refinement and a certain amount of evolution such as an improved user interface for Apple News+, a larger video catalog for Apple TV+, and a continuously expanding number of games in Apple Arcade.  

Exhibit 2: Apple Paid Content Bundle - Subscription Estimates (YE2022)

 
 

One important consideration found with these paid bundles is that each supports Family Sharing. While my estimates call for the four paid bundles to have a total of 188 million paid subscriptions, Family Sharing will mean that the number of Apple users having access to at least one paid bundle will likely exceed 350 million. This amounts to roughly one in three Apple users having at least one paid subscription to Apple Music, Apple TV+, Apple News+, or Apple Arcade.

Additional explanation regarding my paid bundle subscription estimates follows:

Apple Music. As shown in exhibit 3, it took Apple a little less than three years to reach 40 million Apple Music subscribers with the service available in more than 100 countries. Apple is currently adding 1.3 million to 1.4 million Apple Music subscribers per month. My 95 million Apple Music subscriber estimate by FY2022 reflects Apple being able to maintain the current growth rate over the next three years.

Exhibit 3: Number of Apple Music Subscribers 

Tailwinds for Apple Music subscriber growth include the paid music streaming pie continuing to expand and Apple seeing continued success competing against Spotify in developed markets. Growth headwinds include Apple already experiencing some of the easier subscriber growth in the U.S.

Apple TV+. Apple has a few things going for it when it comes to grabbing a significant number of Apple TV+ subscribers in the coming years.

  1. Netflix and Hulu have shown that many U.S. consumers see value in paying for direct-to-consumer video streaming bundles. In addition, the market will likely support a number of players and not just Netflix. A similar phenomenon is observed outside the U.S. as Netflix follows a localized content strategy.

  2. Apple went with an aggressive $4.99 per month launch price for Apple TV+ as well as a limited time promotion of one year free with a qualifying Apple device purchase. Such a promotion will introduce quite a few Apple users to Apple TV+ in a very short amount of time.

My 55 million subscriber estimate for Apple TV+ assumes Apple sees stronger adoption for the service than it achieved with Apple Music over the same amount of time. For context, Disney expects Disney+ will be able to grab 60 million to 90 million subscribers by 2024. However, that range is likely conservative.

Apple Arcade. According to Apple, 500 million people visit the App Store each week. After taking into account Family Sharing, the number of families accessing the App Store each week may be closer to 350 million. My 30 million paid subscriber estimate assumes nine percent of families outside of China who frequent the App Store will sign up for Apple Arcade over the next three years.

Apple News+. My 8 million subscriber estimate reflects Apple continuing to evolve News+ in the coming years. Limited availability will remain a major headwind for subscriber growth as it reduces the addressable market to a fraction of Apple’s billion users. In addition, my 8 million subscriber estimate is influenced by larger headwinds found with consumers not seeing value in many of the magazines included in Apple News+. At the end of the day, the scale associated with paid written news simply isn’t in the same league as video and music streaming. For context, the two largest news sites in terms of the number of digital subscribers, the NYT and WSJ, have 3.0 million and 1.8 million digital subscribers, respectively.

Revenue and Gross Profit Estimates

When estimating revenue and gross profit for Apple’s four paid content bundles, the accounting treatment associated with revenue sharing arrangements needs to be considered. Apple reportedly relies on a 50% revenue share arrangement with Apple News+. Similar to how App Store revenue is reported on a net basis, Apple will only report its share of Apple News+ revenue. Apple will report Apple Music, Apple Arcade, and Apple TV+ revenue on a gross basis as those services do not include any type of revenue share arrangement.

Exhibit 4: Apple Paid Content Bundle - Revenue Estimates (FY2022)

 
 

For this exercise, my gross profit estimates reflect costs tied directly to each paid content bundle. For Apple Music, the approximately 70% of every dollar that is paid out to music rights holders is taken into consideration. For Apple TV+ and Apple Arcade, the amount of cash spent on content is taken into consideration. It is important to point out that SG&A costs are not reflected in these calculations.

Exhibit 5: Apple Paid Content Bundle - Gross Profit Estimates (FY2022)

 
 

Apple’s Other Content Distribution Businesses 

With estimates for Apple’s content bundles in hand, attention turns to estimating the amount of revenue generated by Apple’s content platforms. While Apple does not break out the amount of revenue generated by the App Store or iTunes, management has provided various financial clues that allow one to back into accurate App Store revenue estimates.

In FY2019, my estimate is that the App Store will be responsible for approximately $13 billion of revenue and $8 billion of gross profit. Apple reports App Store revenue on a net basis, reporting only its share of revenue although the full costs to run the entire App Store (84% of apps don’t bring in any revenue) are passed through the income statement. After taking into account every other content distribution platform, including iTunes, my estimate is that Apple will bring in close to $15 billion of platform revenue and $9 billion of gross profit in FY2019.

When forecasting revenue trends for Apple’s content platforms over the next three years, it is important to consider the possibility of Apple’s new content bundle offerings cannibalizing a percentage of paid downloads and in-app purchases. For example, a portion of App Store revenue will likely flow to Apple Arcade over time while iTunes revenue continues to decline due to Apple Music. Assuming 10% of App Store revenue ends up being cannibalized by Apple Arcade, my estimate is that Apple’s various content platforms will see 6% growth year-over-year leading to $16 billion of revenue in FY2022.

Adding my $15 billion revenue estimate for Apples four paid bundles with my $17 billion revenue estimate for Apple’s platforms leads to an overall content distribution arm expected to bring in $32 billion of revenue and $15 billion of gross profit per year by the end of FY2022. 

Exhibit 6: Apple’s Content Distribution Arm - Revenue and Gross Profit Estimates (FY2022)

 
 

Risks

The following items represent risk factors to my estimates:

  • Industry dynamics. The single largest risk factor is mostly out of Apple’s control – the degree to which people will be willing to pay for written content from traditional magazines, rent music and videos, and pay a set price each month to access games.

  • Competition. My estimates do not assume much adoption among users in China. Accordingly, China / WeChat do not represent risk factors to my estimates. Instead, Amazon’s digital content distribution aspirations represent a much larger risk. 

  • Regulation. There are a number of parties looking to attack the App Store on antitrust grounds. At this time, my estimates do not reflect any material adverse change to App Store economics from these efforts.

Takeaways

Based on the preceding estimates, there are a number of takeaways:

  1. A $32 billion revenue run rate per year is roughly double the amount of revenue Netflix currently earns in a year. However, when considering Apple’s overall business, the content distribution arm will likely represent approximately 11% of Apple’s overall revenue. This reinforces the view that content distribution will continue to represent a relatively small fraction of Apple’s overall business.

  2. Apple’s paid bundles will likely have lower profit margins than Apple’s content platforms given how Apple is funding original content for Apple TV+ and game development. Apple Music revenue being reported on a gross basis also pressures overall margins found with the paid bundles.

  3. The App Store will likely remain the most profitable piece of Apple’s content distribution arm for the foreseeable future given that revenue is reported on a net basis.

  4. While Apple’s overall content distribution arm will be highly profitable, it likely still won’t be as profitable as Apple’s other services including AppleCare+, iCloud, Search Ads, and Licensing. While different accounting treatments (net vs. gross revenue recognition) play a role in driving down profitability, the larger factor is that Apple will need to continue investing in Apple TV+ and Apple Arcade.

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The Apple TV+ Strategy

There is an opening for Apple to find success in paid video streaming. Letting others wage the content arms race, Apple will look to create a curated feed of compelling visual storytelling. Priced with sustainability in mind, Apple TV+ will be positioned as a way to push Apple’s broader video distribution platform forward. Combining Apple TV+ with other curated collections of content, Apple is developing a different kind of content consumption arm for hundreds of millions of highly engaged and loyal users. Apple TV+ has much higher odds of success than consensus assumes.

Content Distribution Arm

Apple has been in the business of distributing content to its users for decades. However, 2019 is shaping up to be the year of Apple reinvigorating its content distribution arm. To reflect the growing momentum found with subscriptions and to take advantage of certain ideals found with privacy and curation, Apple has been unveiling a revised content distribution arm that provides users access to human curated collections of media and entertainment. This content will be provided by both Apple (video) and third parties (news, video, music, games).

  • Apple News+ (human editors curating stories from hundreds of paid magazines)

  • Apple Music (human tastemakers creating playlists consisting of songs)

  • Apple Arcade (human editors developing a curated collection of games)

  • Apple TV+ (human producers creating a curated portfolio of visual stories)

Apple TV+ Details

Despite Apple remaining secretive and cagey about Apple TV+ details, we can have confidence in the service having a few key attributes.

  • Apple TV+ will be a paid service. Apple’s language at its March event implied that Apple TV+ would be tied to a subscription (i.e. not free). Last month, during the company’s 3Q19 earnings call, we received another major clue from Apple CFO Luca Maestri that Apple TV+ would be a paid service. Maestri said Apple TV+ will boost Apple Services revenue. Given that Apple had previously said Apple TV+ would be ad-free, the only way Apple TV+ could boost Services revenue is through paid subscriptions.

  • Apple TV+ will have a limited amount of content at launch. Apple TV+ will lack a back catalog of content at launch. Obtaining rights to an expensive back catalog would have led to a bidding war and plenty of leaks to the press. While the exact number of Apple TV+ shows that will be available at launch isn’t known, Apple highlighted five at its March event, and there are reportedly another 30 or so projects under development. Apple has shared four trailers for shows said to launch this fall (For All Mankind, Dickinson, The Morning Show, and Snoopy in Space).

  • Apple TV+ will have a free trial. Maestri disclosed on Apple’s 3Q19 earnings call that Apple TV+ will have a free trial. Such a trial would be unnecessary if Apple TV+ was available for free. In addition, the presence of a free trial may provide some clues as to how Apple plans on releasing new show episodes going forward. Apple has previously said that new series will be released on a monthly basis.

Early Skepticism

Consensus continues to struggle with some basic questions pertaining to Apple TV+. For example, the idea of Apple getting into original video in the first place still makes some people uncomfortable. However, much of the skepticism surrounding the service boils down to one thing: Apple is viewed as not having enough content to justify charging users.

One of the oddest criticisms that has been floating around is that there are now too many paid video bundles for consumers. This is a classic example of “the grass is greener on the other side.” The dream was for consumers to access their favorite TV channels a la carte. That vision is becoming a reality, but not quite in the way we expected. There are now ways to subscribe to individual “channels,” but they are large bundles of content fueled by content budgets in the billions of dollars per year. Nevertheless, some think that subscription fatigue will make it difficult for Apple TV+ to find a seat at the paid streaming table.

Strategy

Consensus thinks that if it wants to have a chance of Apple TV+ competing, Apple needs to dramatically increase its video content budget (likely around $2B per year) while keeping subscription pricing artificially low. The error found in such thinking is that Apple TV+ isn’t like other paid video bundles. Apple will look to fight a different battle.

Instead of competing in a content arms race or grabbing as much user attention as possible (both battles will be brutal), Apple will look to position Apple TV+ as a way to strengthen its broader video distribution platform.

Apple TV+ is positioned as an exclusive curated feed of content only available in the Apple TV app. Instead of paying to access a lot of mediocre video content that won’t be watched, for roughly the same price each month, subscribers will access a handful of exclusive stories that the entire family can watch together.

The Apple TV app, available on hundreds of millions of iPhones, iPads, Macs, Apple TV boxes, and various third-party smart TVs and streaming sticks / boxes, is designed to be a depository for a user’s video consumption. Success for Apple will be measured by the number of subscribers turning to the Apple TV app for video consumption. Similar to how Apple Card is leading users to become familiar with the Wallet app, Apple TV+ is a way to push the Apple TV app forward. As long as subscribers use the Apple TV app, Apple wins even if the subscriber watches content from HBO, Hulu, or Disney (since Apple earns revenue from those third-party subscriptions).

One problem for Apple is that the video streaming leaders, including Netflix, have no interest in playing ball when it comes to the Apple TV app. These companies want users to spend time on their own platforms, not Apple’s. This has resulted in the Apple TV app lacking the kind of deep integration with third-party content bundles that Apple management wanted. However, recent developments in the paid video industry are beginning to raise the question of whether or not the decision to bypass Apple’s home for various third-party video “channels” was the best business decision.

Industry Dynamics

There are five fundamental issues plaguing the paid video streaming market, and each one stands to be taken advantage of by Apple.

  1. Subscription pricing is subsidized. Most companies are subsidizing paid bundle pricing in an effort to grab as many users (and their data) as possible. Given the amount of money being spent on content, a Netflix subscription in the U.S. probably should be more like $20 per month, not $13. Disney could have easily priced Disney+ at $15 to $20 per month rather than $7 given that a subscription includes access to the company’s evergreen library of content. This dynamic ends up helping new entrants like Apple as odds are good that consumers will subscribe to a few inexpensive bundles instead of one large expensive bundle.

  2. User growth is prioritized too much. Companies are making questionable product and business strategy decisions in an effort to grow as quickly as possible. It’s time to start wondering if binge-watching, a development aimed at hooking people onto platforms for as long as possible, has actually been a positive development in the video space. The more bundles that embrace weekly release schedules for new shows, the more a central location such as the Apple TV app (where shows from various bundles appear when available) makes sense.

  3. Mediocre content is becoming a problem. There is a finite amount of time each day. Companies are desperate to fill as much of it as possible with content. This battle for our time will lead to paid video bundles becoming bloated with mediocrity. This will result in users wanting more curating and filtering to focus on just the premium content - another tailwind for relying on something like the Apple TV app.

  4. Data capture is a ticking time bomb. The degree to which video streaming companies are collecting viewer data has not received the attention it deserves. Data capture has been positioned as a selling point under the guise of something leading to better content recommendations. However, the failure found with “smart recommendations” represents a major hole in the claim that such data collection is even needed in the first place. Apple’s data privacy stance with its revised content distribution arm is being underestimated.

  5. Value propositions are lacking. Not enough is being done to truly set paid video bundles apart from the competition. It is likely that churn will become a notable problem in the industry as consumers hop from bundle to bundle depending on which new shows are available. If this occurs, we will likely see more shows released on a weekly or even monthly schedule. While this will be done in an effort to reduce churn, it will likely lead many to crave a central depository for the newest shows.

The Difficult Truth

A harsh reality is unfolding in paid video streaming: There isn’t a sustainable business model for a standalone streaming service looking to compete in a content arms race. Netflix is trying to make a go at being a standalone paid video streaming service while also significantly ramping up content spend. It is noteworthy that Netflix has also taken actions to move away from Apple’s content distribution arm that include bypassing iTunes payment and not wanting much to do with the Apple TV app.

One way of assessing how Netflix’s business model is performing is to look at the company’s free cash flow. The situation doesn’t look good.

Exhibit 1: Netflix Free Cash Flow (Annual Totals on a Trailing Twelve Months Basis)

Netflix is burning through billions of dollars each year, and there is no light at the end of the tunnel. Netflix management will argue that negative free cash flow is merely a consequence of the company placing a huge bet on original content (higher costs up front). However, the company makes no attempt at suggesting free cash flow will turn positive anytime soon. Instead, Netflix plans on continuing to issue debt to fund its ballooning content budgets. This simply isn’t sustainable. Something has to give.

The $140 billion question facing Netflix is whether or not the company will be able to reduce its content spending and raise subscription pricing once it has achieved much of its user growth. There is reason to be skeptical. Competition for engagement is going to be brutal, and most companies playing in the paid video space are looking for other ways to monetize users and the intellectual property (IP) behind paid video streaming bundles. This will pressure Netflix’s ability to raise pricing.

  • Disney has three viable and profitable ways (movie tickets, theme parks, merchandise) to monetize the IP underpinning Disney+.

  • Amazon positions Prime Video as an add-on to a Prime subscription.

  • NBCUniversal is treating its upcoming ad-based video subscription service as another way to keep cable subscribers.

Given how easy it is to switch from paid video bundle to paid video bundle throughout the year, churn has the potential of ravaging the industry. Based on Netflix’s most recent earnings release, the churn effect is real, and we haven’t even seen genuine competition in the paid video streaming space. It is time to start wondering if Netflix would benefit from integrating into the Apple TV app and once again supporting iTunes for payment.

Long Game

Based on Disney’s aggressiveness with Disney+ (a $13 per month bundle consisting of Disney+, Hulu, and ESPN+ is going to make waves) and recent actions on the part of NBCUniversal and WarnerMedia to bring home the most valuable IP, it’s clear that companies are ready to wage war against the first-mover: Netflix.

Apple finds itself in a different situation as it both produces original video content and distributes third-party video bundles. From Apple’s perspective, competition in the paid video streaming space is a great thing. By having power move from one or two companies to a number of players, Apple’s strategy to become the “bundler of bundles” stands to benefit. It also doesn’t hurt to have an ecosystem of a billion users and 1.5 billion devices.

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