the rajam report

It’s been over 2 years since Apple and the TV Market was published, before Apple TV 4’s launch. With Apple TV 4K’s release in 2017 and reports of Apple spinning up an original content division, it’s a good time to examine the state of Apple’s video products, and where they could go next.

While the nature of Apple’s problems in this market are clear, how it will remedy the situation is less obvious. A closer look reveals the complexity of the challenge before it and the first true test of the company’s priorities in the Services era.

State of the Industry

Before focusing on Apple, it’s helpful to understand the broader market. With regard to the US video/TV market there are two trends that are relevant to this discussion.

Traditional Pay TV is in Secular Decline

2017 was not a great year for the Pay TV¹ ecosystem. Here’s Paul Bond at The Hollywood Reporter, reporting on Q2 2017 Earnings (emphasis added):

Craig Moffett at MoffettNathanson estimates a whopping 941,000 subscribers cut the cord during the quarter, up from 809,000 in the same time frame a year earlier, a clear indication cord-cutting is accelerating. “The rate of pay TV subscriber erosion worsened, rising sequentially from 2.5 percent last quarter to 2.7 percent in the second quarter, the fastest rate of decline on record,” notes Moffett.

Jan Dawson of Jackdaw Research arrived a similar conclusion for the same quarter:

It doesn’t take a genius to see the trend here: these companies collectively lost nearly 2.5 million traditional pay TV subscribers in the past year, up from about 1.5 million a year earlier, and from just over half a million a year before that. In other words, the rate of cord cutting in traditional pay TV services is accelerating at a rate of roughly 1 million additional lost subscribers per year.

Q3 2017 wasn’t much better. Todd Spangler, reporting for Variety:

Cord-cutting has taken its toll on cable and satellite operators, which continue to shed subs at an accelerating pace. In the third quarter of 2017, however, the overall pay-TV ecosystem actually inched up when “virtual” subscription TV services are factored in — by a meager 0.6%, but growth nonetheless.

[…]

Traditional cable operators like Comcast and the satellite-delivered services of Dish Network and DirecTV dropped a collective 872,000 (versus 559,000 in the year-earlier period). That marks a 3.1% year-over-year decline in the segment. Note that from Q1 2014 through Q3 2017, traditional pay-TV ops have lost 9 million subs overall.

Pay TV’s best days are behind it.

Subscription Streaming Services are Growing

While Pay TV has been on the decline, subscription streaming services (often referred to as Subscription Video on Demand (SVOD) services) have been on the rise. There’s no better poster child for this segment than, of course, Netflix.

Peter Kafka, reporting on Netflix’s Q4 2017 results for Recode:

A quick look at Netflix’s Q4 results: It added 8.33 million streaming subscribers around the world. The company had told Wall Street that it would add 6.3 million. “Beautiful,” per the company’s investor letter.

Netflix had told Wall Street it would add 1.25 million subscribers in the U.S. and another 5.05 million internationally. Instead, it added 1.98 million in the U.S. and another 6.36 million outside the U.S

Hulu is seeing growth too. Anthony Ha, reporting for TechCrunch:

Hulu announced today that it ended 2017 with more than 17 million subscribers in the United States.

That’s an increase of a little over 40 percent from the 12 million subscribers that Hulu announced back in March 2016.

Meanwhile, Disney is preparing to go all in on its own subscription streaming offerings. It’s acquired a majority stake in BAMTech, pulling all of its movies off Netflix, and launching direct-to-consumer streaming services.

Apple’s Offerings Today

Apple has three video products. Here’s how each of them are doing, based on public data, reporting, and analysis.

iTunes Store

This is Apple’s transactional video on demand² storefront for Movies and TV Shows, which now carries 4K HDR Movies.

Ben Fritz and Tripp Mickle, reporting on the iTunes Movies business for the Wall Street Journal in July 2017

Apple Inc.’s iTunes Store—already struggling against rising competition for music listeners—is losing the battle for video viewers as well.

[Apple’s] market share for renting and selling movies has been falling for several years, tumbling to between 20% and 35% from well over 50% as recently as 2012, according to people with knowledge of the matter.

An Apple spokeswoman, who didn’t dispute the market-share estimates, said Apple is focused on providing customers with video content across subscription services such as Netflix and HBO, as well as iTunes, where she said movie purchases and rentals have increased over the past year and hit their highest level in more than a decade.

Stripping away the weird framing from the WSJ, this report tells us a couple of things:

• Apple’s share in the digital movie market has decreased as a result more (e.g. Comcast selling movies on their X1 box)
• Per the Apple spokeswoman, transaction volume continues to grow and is at it’s highest levels, so the market-share estimate isn’t the bad news it implies

In other words: there’s growth here, but its in a segment of the market that’s become more commoditized and is not growing the way subscription services are. Apple’s own statement for this story makes it a point to highlight subscription services offered via the App Store. Subscriptions benefit from bundle economics, which allow providers to offer more content at a lower cost to consumers, while also creating a recurring revenue stream.

Put another way, there’s a reason Disney, Netflix, and Amazon aren’t going crazy for transactional VOD.

TV App

Apple’s video aggregation platform which indexes content across multiple apps and presents it to the user in a consistent, clean UI. While there doesn’t appear to be any public data on TV app usage, Nilay Patel captures the current state of this product well:

It’s a little anemic right now, but the TV app really is the beginning of an entirely new TV home screen experience, especially with the addition of live sports and breaking news alerts.

With the addition of the Sports tab and Amazon Prime Video, the TV app is one step closer to being the one stop shop for video on Apple’s platforms. The only major service that’s missing is Netflix.

Apple TV

Back in 2015, Matthew Panzarino had this to say about the then unannounced Apple TV 4’s prospects:

A mid-market breakout box offering is one thing, but a huge, rumbling platform with an upward trajectory of living-room dominating apps and third-party content is another beast. If, obviously if, Apple is successful with the Apple TV, it could be in a position to dominate content in a way that no other ‘smart’ TV platform has before it.

At the time, it seemed like it would play out this way.

It did not.

Tim Bradshaw, from the Financial Times reporting on Apple’s Q1 2017 earnings:

…sales of the Apple TV set-top box, which was relaunched in September 2015 with the promise to “revolutionise” the television viewing experience, declined year-on-year, Mr Maestri said.

A “non-hobby” product line seeing year-on-year declines during the holiday quarter is unusual for Apple. During the same time span, Apple Watch (for which Q1 2017 was also its second holiday quarter) had its best quarter yet.

Market share estimates from July 2017 continued to paint a less than stellar picture of Apple TV’s performance:

Apple TV’s conspicuous absence from Apple’s Q1 2018 earnings release and corresponding earnings call implies that Apple TV 4K’s launch did little to change this trend³.

John Gruber articulates the sentiment behind this data:

… with Apple TV, I’m hearing from a lot of people who are in the Apple ecosystem — people who own MacBooks, iPads, and iPhones — who just don’t want to spend $200 for an Apple TV when they can get a Roku or Fire TV for a lot less.

This pricing disparity becomes even more glaring when you plot out the discrete price ranges on a chart⁴:

Gruber (emphasis added):

… for people who don’t buy movies from iTunes — and generally don’t buy movies period, choosing only to stream from Netflix, Hulu, YouTube, Amazon Prime, etc…

— what does Apple TV offer to justify costing over twice as much?

The Problem

In summary, here’s where Apple’s video products stand:

• iTunes Store: Continuing to perform well, but the market is moving to subscription video services
• TV App: Industry leading content aggregation on iOS and tvOS
• Apple TV: The best streaming media box, but isn’t a market leader like other Apple product lines

At its core, Apple’s business model is simple: it sells highly differentiated products at high margins. That differentiation is derived from best in class integration of hardware, software, and services, with an emphasis on the customer experience.

Apple’s best products are successful beyond pure measures of product quality. In other words, people can say these products are best in class, but their success in that regard can be corroborated by objective metrics such as profit share, market share, revenue, sales, and customer satisfaction within their respective categories.

Why hasn’t this happened for Apple’s video efforts?

At the end of the day, differentiation in the video market is derived from content. Content is why the market has tolerated mediocre products and customer service from cable companies for so long. Content is why Netflix went from losing 800 thousand customers in a single quarter over “Qwikster” to being the leading streaming video service. The best hardware and software mean nothing in this market without content. Even the best designed user interface at some point has to defer to content.

Today, there is no meaningful exclusive video content on Apple platforms. Apple, thus far, has relied on its design and engineering prowess to differentiate its video offerings.

It’s clear this strategy isn’t working.

The iTunes Store is arguably the best transactional video storefront, but that alone is not enough to stop consumers from adopting subscription services. The TV app has a great UI and cross app integration, but that does not justify the $150 price to get it on your TV. Apple TV is the best designed, most capable streaming video box on the market, but that isn’t enough to justify its premium pricing when the same streaming services are available on every other platform with a significantly lower cost of entry.

In hindsight, 2015’s Apple TV relaunch (“The future of TV is apps”) was an attempt to bend the video market to Apple’s traditional strengths by positioning tvOS as another general purpose computing platform⁵ and that alone would justify Apple TV’s premium.

The reality is that TVs aren’t computers, and there are only 2 use-cases that have broad appeal: Video Consumption and Console Gaming. And while many of us have dreamed the “Apple TV disrupts consoles” dream, the realities of App Store economics and policy missteps around controller support at launch have yielded a situation where the top grossing tvOS apps are streaming services, the top tvOS games are ports of iOS games, and premium priced, console caliber tvOS games are non-existent.

And so, for Apple, the future of TV is TV.

Why This Matters to Apple

As Apple continues to diversify its revenue streams beyond iPhone, Services have become a big area of focus. Tim Cook, on Apple’s Q1 2017 Earnings Call:

Services are becoming a larger part of our business, and we expect the revenues to be the size of a Fortune 100 company this year.

We feel great about this momentum, and our goal is to double the size of our services business in the next four years.

One year later on the Q1 2018 Earnings Call:

It was another very strong quarter for services, with revenue of 8.5 billion dollars up 18 percent over last year, and we’re on pace to achieve our goal of doubling our 2016 services revenue by 2020. The number of paid subscriptions across our services offerings passed 240 million by the end of the December quarter. That’s an increase of 30 million in the last 90 days alone, which is the largest quarterly growth ever.

We had an all-time record quarter for the App Store, with our best holiday season ever.

[…]

In addition to the App Store, several other services had their biggest quarter ever, including Apple Music, iCloud, and Apple Pay, all of which saw growth in both active users and revenue.

It is clear that Video is the next big service opportunity.

To illustrate this point, consider the following data points:

• From Q4 2016 through Q3 2017, the top four traditional US Pay TV Providers⁶ saw $90.981 billion in revenue from their video businesses, and had 76.186 million video subscribers ⁷
• Comcast, the largest US Pay TV provider, ended FY 2017 with $23.129 billion in annual video revenue and 21.303 million residential video subscribers
• Netflix ended FY 2017 with $6.153 billion in annual US Streaming revenue and 54.75 million subscribers

These figures, contextualized with broader industry trends, illuminate the opportunity here: as consumers transition from Pay TV to streaming services, their monthly video spend is up for grabs. Apple, as it was with music, is in a great position to make a play for those dollars. In doing so, it could establish a significant revenue stream (pushing it closer to achieving its goal of doubling Services revenue by 2020) while also providing further differentiation for its products.

To do this, Apple needs to evolve its video offerings beyond what it has today.

Where Apple Can Go

For many years, it seemed that Apple’s Streaming TV service was going to be a skinny bundle, something akin to linear TV on the internet. From the Wall Street Journal in 2016:

By late 2014, the discussions had gone cold. Apple changed directions again, hoping to assemble a “skinny bundle” delivered over the internet.

Apple’s Mr. Cue began pitching Disney, Fox, CBS and other media companies on the streaming-TV service. The goal was to attract consumers who have dumped their cable-TV supplier with 25 popular channels, anchored by the broadcast networks.

Apple sought access to full current and past seasons of hit shows, as well as some global rights so the service could work outside the U.S., say people familiar with the talks.

It’s for the best that this didn’t pan out. The decline of the traditional Pay TV not simply about cost, it’s the market rejecting the paradigm of linear television. In an on demand world, it just doesn’t make sense.

Meanwhile, there’s been an awakening in Cupertino. Apple is actively addressing their lack of differentiated content by bringing Jamie Erlicht and Zack Van Amburg on board to run Apple’s original content efforts, earmarking $1 Billion for original video content, and ordering series into production.

What’s less known is how this content is going to be brought to market. Apple’s objectives for original content are likely to:

• Provide content-based differentiation for Apple Hardware (particularly Apple TV)
• Drive usage of Apple video products (TV app on iOS/tvOS)
• Add value to the other Apple services via bundling
• Drive Services revenue growth

How Apple goes about addressing these objectives is not simple:

1. Content development and production are not things Apple has done before. Will these shows even be good? Based on Netflix, Amazon, and Hulu’s progress on this front, success is possible but not guaranteed.

2. Even if Apple’s shows are good, would that be enough to support Apple TV’s pricing? In the current market, content is used to differentiate services, not hardware. Amazon, for example, uses original content to drive Prime subscriptions. It could care less whether you watch it on a Fire TV or another device. To that end, Fire TV’s raison d'être is to be a first-party endpoint for Prime Video and is priced and positioned accordingly.

   With the exception of the console gaming market, no company has leveraged content as a differentiator to support premium hardware the way Apple would be with Apple TV. Would Apple be willing to give up some margin or ship a lower priced Apple TV to make it more accessible? How much compelling content would be enough to push a consumer to go for Apple TV over its cheaper competition?

3. If growing Services revenue is a high priority, will this original content be available on non-Apple platforms (like Apple Music on Android, or iTunes on Windows)? Content services benefit from having the widest distribution, but this approach conflicts with objective of leveraging original content to differentiate Apple’s products. Put more explicitly: if this content is available on other platforms, which exposes Apple to the upside that both Netflix and Amazon are reaping, why should a consumer watch them on Apple’s platforms?

4. How does differentiation via iOS and tvOS factor here? While tvOS had a big splash when it launched in 2015, the last 2 release cycles have been fairly low key, with it barely being mentioned at WWDC in 2017. What features can Apple build that make tvOS a better ecosystem citizen, in the way that watchOS is? Something like tight HomePod integration comes to mind.

The core tension here is between Apple’s vertical, differentiated hardware model and the more horizontal nature of content services. In the streaming video market, all of the services are ubiquitous and have no loyalty to any particular hardware platform. Similarly, the streaming hardware market has become commoditized⁸. Even Amazon, a player in both of these markets, has never faced such a test.

Apple ultimately has to decide what is more important: Apple TV as a premium hardware product line or a streaming video service that runs across all of its platforms.

Where Apple lands will say a lot about company’s priorities going forward.