Apple Needs a User-Friendly Model to Face Brutal Pay-TV Economics

Apple’s surprising hire of former Time Warner Cable executive Peter Stern has rekindled speculation that the tech giant will attempt to build a pay-TV business. But there are significant challenges around the sector, particularly profitability for providers starting from scratch.

There’s a direct correlation between the percentage of video revenue used by major pay TV providers to cover the cost of programming and the scale of those companies. The largest providers, such as Comcast and DirecTV, pay the least, but even for them programming costs are rising as a percentage of video revenue.

The resulting pinch on profitability is best viewed by examining the second quarter of 2015, which gives us the broadest base of pay-TV companies to look at prior to more recent consolidation. Note that the smallest businesses here are unprofitable at an operating-margin level, and even the medium-sized businesses generate only 10%-20% margins off 10 million subscribers.

sources: Company Reporting, jackdaw research Analysis

Apple must reckon with the fact that scale matters enormously in this business. A good chunk of revenue in the traditional pay-TV business comes from equipment and other non-content fees, which Apple wouldn’t charge on a monthly basis.

Apple would likely face high and climbing programming costs due to its small scale, and would generate low margins as a result. The most lucrative pockets of the TV industry are elsewhere; broadcasters, station owners, and cable networks all generate significantly higher margins because they benefit from content exclusivity, as well as, in some cases, dual income streams of subscribers and advertising.

Apple may be banking on two things to offset these disadvantages. First, its famously superior user experience might help convince subscribers to pay more for the same content just for the privilege of finally ditching their cable company. Second, Apple might see such a service not as a major money-maker in its own right but as a way to add value to its ecosystem of devices and services, and thus to drive hardware sales.

*New Charter refers to the company after the May merger with Time Warner Cable and Bright House. The data shown here include historical information on a pro forma basis. Additionally, the original Charter continued to report through Q1 2016.
sources: Company Reporting, jackdaw research Analysis

The key here is that Apple can’t simply undercut traditional pay-TV providers — it will have little margin to work with as it is, and competing on price has never been the company’s strategy. Rather, Apple needs to focus on improving the experience of watching TV, putting its know-how to work on creating unique ways to consume the same old content and combining it with the apps on its platforms in a way that truly sets it apart — potentially justifying higher, not lower, prices.

Jan Dawson is the founder and chief analyst at Jackdaw Research, an advisory firm for the consumer technology market.

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