Apple (NASDAQ:AAPL) is betting the farm on subscription services like video, news and music. Some of the bullish analysts have forecasted that the next phase of growth in its Services segment will lead to bullish momentum in Apple stock.
This growth will come from subscription services as Apple tries to leverage its massive install base. Apple Music has shown rapid growth and a possible Apple News subscription platform also looks promising. However, video streaming is a completely different ball game.
Apple wants to build a strong original content library. It has already entered into partnerships with a number of major artists and producers. It is trying to balance the brand image of the company with the themes of the original content. This will be very challenging as the streaming competitors make bigger investments and launch a greater variety of original content on their own streaming platforms. Investors must look at these challenges and consider the possible headwinds that might bear down on Apple stock as a consequence.
Hollywood Calling
Apple wants to showcase its all-inclusive family-friendly image within the original content. At the same time, it wants gripping storylines and dramas. It will be challenging for the management to balance these two opposite objectives. A big part of Netflix’s (NASDAQ:NFLX) success in the streaming industry was because of its original content. Netflix was able to launch content, which would be unthinkable for Apple. It would be difficult for Apple to agree to a series like Orange Is The New Black or even House of Cards.
Tim Cook has himself visited sets in Vancouver and LA. He has also given notes to producers on the changes he would like. According to recent reports, Apple executives have been “very involved”, which has led to delays in the production.
This level of nitpicking by Apple is because it wants to protect its brand image. Competitors like Netflix, Hulu, Amazon (NASDAQ:AMZN) and HBO do not face a similar issue and can offer a wider variety of content. Even though Apple has a massive cash pile, which it can use to ramp up the production of its original content, the flexibility within content production provides competitors a big advantage.
Marginal Incremental Revenue
While launching the video streaming service, Apple will also offer the ability to subscribe to other digital media services. This will allow users to access different video streaming options in a single place. The entire payment processing would be seamless, which should improve the user experience. However, it should be noted that most of the streaming services are already present on Apple’s App Store. They pay a high commission rate on the App Store, which has helped the revenue growth in Services segment.
Fig: Six of the top ten revenue contributing apps are streaming based. Source: SensorTower Research
We can see from the above image that a large number of the highest grossing apps have been from the streaming industry. Netflix has already moved its payments processing outside the App Store. Netflix will also not be a part of the new video streaming app from Apple.
If all these apps are moved to the new video streaming platform, it would end up eliminating their commissions on the App Store. This revenue will then be added to the new video streaming platform. Hence, video streaming revenue would not provide incremental revenue for AAPL. It would be more like taking from one pocket and putting in another.
Impact on Margins
CNBC has reported that HBO is holding out in favor of better terms from Apple. Netflix and Hulu will not be joining this service. Apple will also need to invest heavily in the maintenance of the platform. In the App Store, the margins were very high as most of the app development was handled by streaming providers. By integrating all the diverse streaming options in a single video platform, Apple would need to increase investment in technology.
This can end up hurting the margins. In a WSJ article, Ben Schachter of Macquarie Capital estimated that the App Store had a gross margin of over 90%, while Apple Music had a gross margin of 15%.
It remains to be seen how high the margins will be within the video streaming app. But even in the best case scenario, the incremental revenue would be very low. The absence of Netflix and Hulu from this platform will also limit its long-term popularity. Falling margins will also be a big headwind for AAPL stock.
Video Is Different Than News and Music
Bullish analysts have pointed to the growth in Apple Music as a possible sign that the video streaming app will also succeed. However, we should note that video streaming is very different than news or music. Apple is already facing challenges in building an attractive original content library. It was reported that Apple has kept a $1 billion budget for original content. However, this is very small compared to the billions that are poured by Netflix and Amazon. AT&T (NYSE:T) and Disney (NYSE:DIS) will also end up increasing their investment in the early stages.
This will lead to a heavy reliance on third-party streaming providers. Amazon already provides a wide range of options in Amazon Channels. It is unlikely that a competitor like Amazon will allow its market share to fall.
It should be noted that both Netflix and Amazon took several years before they were able to churn quality Emmy winning content. Both these giants faced lower restrictions in maintaining a brand image, which Apple does. Hence, it would be too optimistic to imagine that Apple’s original programming will be a big success from day one and help Apple stock achieve a bullish trajectory.
Source: Morgan Stanley, Appleinsider
Morgan Stanley’s Katy Morgan is bullish about Apple’s subscription segment. This is one of the main reasons why she has a strong buy rating for Apple Stock. She has mentioned that the subscription segment should allow the company to report more stable EPS growth. However, we should keep in mind that the growth in video subscription will come out of a transfer of revenue from streaming apps in the App Store. The challenges faced by Apple in original programming are also quite huge. This should end up reducing the growth potential of the Services segment in the near term. Heavier investment in original content will also hurt the margins of this segment.
Investors should look at the possible impact of these initiatives on the top line as well as the bottom line.
Investor Takeaway
Apple is ramping up its original programming efforts. But it is facing pushback from Hollywood as the company tries to ensure that the content themes are in line with Apple’s brand image. In the early stages, Apple would be heavily reliant on other streaming channels to gain customer traction. But this will merely lead to a transfer of funds from the App Store to the video streaming platform. Hence, any incremental revenue would be marginal at best.
Netflix and Hulu will not be a part of Apple’s streaming platform. AAPL also faces competition from Amazon. This can lead to downward pricing pressure on the commissions for this video streaming platform. We could see a short-term negative impact on margins due to the heavy investment on its video streaming platform. This can lead to negative sentiment around Apple stock.
As of this writing, Rohit Chhatwal did not hold a position in any of the aforementioned securities.
