Online Video: Objects in the Mirror May be Closer than they Appear

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Online now represents ~9% of U.S. video viewing, and is growing at a 50%+ pace.  That audience is attracting advertising, with YoY streaming ad growth accelerating to more than 100% in recent months and suggesting that online will blow past the 5% share of the total video ad market forecast for it at the start of the year.  WebTV leaders have pledged $700M+ toward original content, completing the self-reinforcing cycle by attracting even bigger audiences.  Against this, TV audiences have stagnated with a tepid ad revenue rebound from the 2009 drop strengthened by the temporary impact of the Olympics and a well-financed campaign season.  However, forecasts still suggest cable spending, already 2% of the consumer budget, will outpace household income, expectations incongruous with larger and faster growing items, like health care and education, and the increasingly viable online alternative.  We believe that plans to throttle online competition through aggressive pricing and usage policies, or to extract supernormal pricing for broadband will be thwarted by regulation and/or wireless competition. While it will take years for our scenario to play out, we believe that the end game will be apparent before the end of 2013, with obvious consequences for investors.

Online video viewership continued its sharp rise in 1H12, driven, in part, by the rapid growth in tablets and connected TVs.  Netflix reported streaming more than 1 billion hours of video to its roughly 24 million subscribers in June, up 50% in 6th months.  YouTube delivered more than 1.2B hours of video to US households in May and total US Internet video streaming is over 4B hours/month, both growing 50%+ YoY.  The installed base of tablets in the US has grown over 50% since year end to more than 51M, while the number of TVs able to connect to the internet has risen 30% to 12M, helping to fuel the ongoing rise in the web video audience.

The traditional TV audience is stagnant, with TV households and viewing hours both in slight decline for the first time in history.  The number of U.S. households using TVs to watch traditional channelized television has dropped for the past two years after 20 years of strong, uninterrupted growth.  Also unusually, the number of hours watched per person declined 0.5% YoY for 4Q11, yielding total US TV viewing at roughly 43.4B hours/month.  As such, online now accounts for more than 9% of all video viewing in the US, with Netflix accounting for 2%+ on its own.

Online now tops 5% of video advertising, and growing at a 117% YoY pace.  2013 TV ad growth could disappoint 3.5% analyst expectations, 2014 could be even worse.  Online video advertising volume was up 117% YoY in May.  At the same time, U.S. television ad spending is forecast up 5.1% for 2012, driven by the Olympics and the Presidential election and consistent with the 5.8% growth in upfront ad commitments made a year ago.  However, ad commitments for the new season starting in September were up only 1.6%, reflecting the hit to political spending post November, the weak economy and, perhaps, competition from online players presenting for the first time at the upfronts.  Given the online video trajectory, 2013 and 2014 could be painful for TV advertising.

More than $700M total investment in original programming by web players, adds further fuel to accelerate cycle, reminiscent of ‘90’s push by cable nets.  Netflix, YouTube, Hulu, Amazon and Yahoo have each committed tens of millions of dollars toward producing original video content for their sites, with dozens of smaller players like Funny or Die, Machinima, Blip, My Damn Channel, and others already delivering their own material.  The strategy echoes the efforts by HBO, The Disney Channel, MTV and others to develop their own original content franchises during the growth era for cable networks.  We expect this push by the web nets to be similarly successful.

3.4% forecast CAGR for cable fees (2.1% of avg. HH income) will be squeezed by healthcare (5.7%) and education (1.9%), and by churn to web video.  Cable rates have risen 6.5%/yr over the last two decades, bringing the average monthly video bill to nearly $90, more than 2% of the average U.S. after-tax household income.  Typical industry forecasts suggest 3-5% annual growth in video bills through the end of the decade, in line with the long term trend, but improbably given weak forecast HH income growth and the likely continued 6%+ annual growth of health care and education expenses.  Negotiations between networks and distributers are becoming contentious – e.g. AMC v. Dish, Viacom v. DTV.  As online content becomes more compelling, higher cable prices or reduced channel offerings risk driving cord cutting.

Carriers may employ usage limits, expensive surcharges and throttling against online video – we expect regulation and/or competition to blunt these tactics.  The cable industry often points to its dominant 83% share of residential broadband as a potent weapon to blunt the threat of online video.  Imposing usage limits with expensive surcharges or performance throttling for overages could squelch demand for online video, and allow cable operators to favor their own on-demand services.  Price hikes on high usage tiers could boost cable profit from online demand, to the detriment of consumers.  Given the cable industry’s poor consumer reputation, we believe these tactics will draw considerable regulatory scrutiny.  Moreover, we believe that wireless 4G LTE Advanced services will offer viable competition for residential broadband before the end of the decade.

This scenario, good for online players and bad for cable, satellite and most networks, will play out over 5-7 years, but should become evident to investors much sooner.  The self-reinforcing cycle of growing online viewership, rising advertising dollars, and improving programming will accelerate, and is now big enough – i.e. 10% of video viewing, 5% of video advertising – for its impact on traditional channelized TV to be apparent.  Audience ratings and advertising revenues for networks may disappoint, particularly once the Olympics and elections are past.  Fee negotiations and shifting ad spend may drive some networks to embrace web video more enthusiastically.  Cord cutting may accelerate, even with economic recovery.  Any of these indicators of the real threat of online video could reverse the current investor enthusiasm for television.

For our full research notes, please visit our published research site.

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