In the midst of the sudden merger and acquisition activity that has run through the traditional media and entertainment studios, it is interesting to note that during the past two years, the market capitalization of the old media's current nemesis, Netflix (NFLX, Financial), has almost quadrupled, matching media giants Disney (DIS, Financial) and Comcast (CMCSA, Financial).
That figure may change in the near future as Netflix's current price gives it an astounding price-earnings ratio of 98; the S&P 500 trades at a price-earnings multiple of 16. Nonetheless, this is a sign that the entertainment industry will never be the same again.
The story of how this occurred while the Hollywood studios and cable TV entertainment media behemoths slumbered indicates that the current struggle to compete with the one-time DVD mail order company is going to be much more difficult than originally anticipated and that the competitive challenges posed cannot entirely be met by sheer size alone.
Many of the mergers are predicated on the combined companies’ abilities to gain scale to be able to afford the massive expense of providing original content. Both Comcast and Disney are eyeing Twenty-First Century Fox (FOXA, Financial) for their ability to secure its in-house libraries of content that can be delivered by the direct-to-consumer approach.
The staggering amount of debt that would be incurred in order to finance the offers to purchase Fox's studios by Disney and Comcast may in the immediate future cripple or severely diminish those companies' cash flow, which is needed for creating original content to match the maddening pace of Netflix's aggressive production schedule. According to data from Dealogic and Moody’s Investors Service, if Comcast’s bid for Fox is successful, the combined debt between both the Comcast and recent AT&T (T, Financial) mergers could exceed $350 billion. Most of this would be financed through junk bonds in a rising interest rate environment.
By taking on what could eventually prove to be crippling debt, the amount of money available for original content may not be sufficient to match the current direct-to-consumer offerings currently provided by Netflix for a global audience. After a federal judge approved the AT&T-Time Warner merger, shares of Disney, Comcast and AT&T all initially dropped. This signifies that the Street is concerned these legacy media companies in their quest to compete with the new kid on the block, which has upended the industry, will lead to overspending without sufficient payoff, making the increased debt loads unsustainable.
Additionally, Netflix's revenue increase in the U.S. enhanced its revenue that has been applied rapidly to content production. But the only way Netflix could justify the rate increase was delivering on its promise to increase its own programming. It has lived up to its word: increasing the number of its original offerings exponentially.
Another problem that mergers and acquisitions for legacy media won’t solve is the new mad rush for talent. Netflix has recently been flexing its muscle in securing successful Hollywood producers and directors with proven track records with enticing astronomical seven-figure contracts. This has precipitated an unforeseen bidding war for talent.
The exodus from the traditional Hollywood studios of homegrown talent has been particularly disrupting and unanticipated for the incumbent media companies. Two years ago, this was not a problem that appeared on the horizon. The increased cost for securing and maintaining existing talent in the midst of the talent arms race has become prohibitively expensive and will only add to the necessary expenses incurred for producing original content for consumers, whose appetite for these offerings has been voracious.
Finally, Netflix grew into a streaming media powerhouse because that was its sole focus. Once it exited the mail order business, it placed all its bets on the viability of digital streaming media. Its entire business strategy was based on expanding this delivery system directly to consumers. Its risk has paid off: it now has the success and experience in developing and delivering high-quality streaming video programming that is far ahead of its new competitors.
By comparison, legacy media is comprised of old-line and established studios and cable companies, for whom the digital streaming model is an entirely new venture. Old business habits die hard. There is a question of how much the new media conglomerates' traditional business models will interfere with their ability to innovate and to ramp up to speed with Netflix, which enjoys a sizable lead over its new competitors. Given Netflix's head start, time is of the essence for the old media studios; they are late to the party and must deliver streaming original content quickly and efficiently if they hope to remain in the game.
Disclosure: I have no positions in any of the securities referenced in this article.
