Putting the (Insta)cart before the (Grocery) horse: A COVID Favorite's Reality Check!

After years of rumors of an imminent IPO, Instacart has finally filed for a public offering of it’s shares, aspiring to raise about $600 million from markets, at a pricing of about $9-$10 billion for its equity. Coming in the week after ARM, an AI chip designer, also filed to go public, but with an estimated pricing of $55-$60 billion, it is an indication of how much the ground has shifted under Instacart since the heady days of 2020, when Instacart was viewed by some Americans as the only thing that stood between them and starvation. At that time, there were some who were suggesting that the company could go public at $50 billion or more, and pricing it on that basis, but reality has caught up with both the company and investors, and this IPO represents vastly downgraded expectations for the company’s future.

The Back Story

    To value Instacart, you have to start with an understanding of the business model that animates the company, as well the underlying business that it is intermediating. I start with this section with the Instacart business model, which is not complicated, but I will spend the rest of the section exploring the operating characteristics of the grocery business, and its online segment.

The Instacart Business Model

    The Instacart business model extends online shopping, already common in other areas of retailing, into the grocery store space. That is not to say that there aren't logistical challenges, especially because grocery store carry thousands of items, and grocery shopping lists can run to dozens of these, with varying unit measures (by item, by weight) and substitution questions (when items are out of stock). Instacart operates as the intermediary between customers and grocery stores, where customers pick the grocery store that they would like to shop at and the items that they would like to buy at that store, and Instacart does the rest:

Instacart hires store shoppers who gather the items for the order, checking with the customer on substitutions, if needed, and for those customers who choose the pick-up option, have them ready for pick-up. If home delivery is chosen as the option, a driver (who, in many cases, is also the shopper) delivers the groceries to the customer's home. Customers get the time-savings and convenience from having grocery shopping (and delivery, if chosen) done for them, but they pay in the form on both delivery fees and a service charge of 5-10% of the bill, depending on the store picked and the number of items in the basket. Instacart also offers a subscription model, Instacart Express, where subscribers in return for paying a subscription fee (annual or monthly) get free deliveries from the service.

    For grocery stores, Instacart is a mixed blessing. It does expand the customer base by bringing in those who could not or would not have shopped physically at the store, but stores often have to pay Instacart fulfillment fees, which they sometime pass through as higher prices on products. In addition, grocery stores lose direct relationships with customers as well as data on their shopping habits, which may be useful in making strategic and tactical decision on product mix and pricing.

    I will approach the analysis of the Instacart model's capacity for growth and value creation in four steps. In the first, I will look at the grocery business, both in terms of growth and profitability of grocery stores, since Instacart, as an intermediary in the business, will be affected by grocery business fundamentals. In the second, I will examine the forces that are pushing consumers to online grocery shopping, and the ceiling for that growth is much lower than it is than in other areas of retailing. In the third, I will focus on how the competition to Instacart, within the online grocery retail space, is shaping up, and the consequences for its market share. In the final, I will examine the operating costs faced by Instacart, especially in the content of how the fee pie will be shared by the company with its shoppers and drivers.

1. The Grocery Business

    When you are looking for an easy company to value, where you can safely extrapolate the past and not over indulge your imagination, you should try a grocery store. For decades, at least in the US and Europe, the grocery business has had a combination of low growth and low margins that, on the one hand, keep pricing in check and on the other, make the business an unlikely target for disruption. Let's start by looking at growth in aggregate revenues, across all grocery stores in the United States over the last three decades:

You will notice that revenue growth rate has been anemic for most of the thirty years covered in this analysis, and that even the spurts in growth you have seen in 2020 and 2022 have specific reasons, unlikely to be sustainable, with the COVID shutdown explaining the 2020 jump, and inflation in food prices explaining the 2022 increase.

    On the profitability front, the grocery business operates on slim margins, at every level. The gross margin, measuring how much grocery stores clear after covering the costs of the goods sold, has risen slightly over time, perhaps because of growth in processed and packaged food sales, but is still less than 25%. The operating margin, which is after all operating expenses, and a more complete measure of operating profitability has been about 5% or less for almost the entire period.

If you are an intermediary in a business with slim operating margins, as Instacart is, the low operating profitability of the grocery business will limit how much you can claim as a price for intermediation, in service fees.

    To complete the grocery business story, it is also worth looking at the players in the business, and it should come as little surprise that it is dominated by a few big names. The biggest is Walmart, which derives close to 56% of its $400 billion in total revenues in the US, from groceries, but Target and Amazon (through Whole Foods and Amazon Fresh) are also big players. Krogers and Albertsons have emerged as the grocery store giants, by consolidating smaller grocery companies across the country: 

The fact that the grocery business is dominated by a few big names will also play a role in the Instacart valuation story, by affecting the bargaining power that Instacart has, in negotiating for its share of the grocery pie. In sum, the overall grocery pie is growing slowly, and the slice of the pie that is profit for those in the grocery game is slim, effectively limiting the valuation stories (and values) for every player in that game.

2. The Online Option

    Grocery shopping is different from other shopping, for many reasons. First, customers tend to favor a specific grocery store (or at most, a couple of stores) for most of their grocery needs. One reason for that is familiarity with store layout, since knowing where to find the items that you are looking for can make the difference between a 20-minute trip to the store and a hour-long slog. Another is location, with customers tending to shop at neighborhood stores, for much of their needs, since groceries do not do well with long transportation times. Second, for non-processed food, especially meats and produce, being able to see and sometimes touch items before you buy them is part of the shopping experience, with online pictures of the same products operating as poor substitute. For these reasons, grocery retail remained almost immune from the disruption wrought on the rest of brick-and-mortar retail, at least in the United States. Even so, there has always been always a segment of the population that has been open to online grocery shopping, sometimes because of physical constraints (homebound or unable to drive) and sometimes because of time and convenience (busy work and family schedules). That segment was viewed as a niche market, and until 2020, conventional players in the grocery business did not pay much attention to it, with the exception of Amazon. It was the COVID shutdown in 2020 that changed the dynamics, as online grocery shopping became not just an option, but sometimes the only option, for some. 

As a company that was built exclusively for this purpose, Instacart had a first-move advantage and saw customers, order and revenues all soar during the year. Caught up in the mood of the moment, it is easy to see why so many extrapolated Instacart’s success in 2020 into the future, forecasting that the shift to online grocery shopping would be permanent, and that Instacart would dominate that business.

      As COVID has eased, though, many of those who shopped for groceries online have returned to physical shopping, but it is undeniable that there are some who have decided that the convenience of online shopping exceeds any disadvantages, and have continued with that practice. In fact, while there is uncertainty on this front, the projection is that the percent of grocery shopping that will be done online will increase over time:

There are two points worth making about the trend towards online shopping. The first is that the ceiling on online grocery retail will remain much lower than the ceiling on online shopping in other areas in retail, with even optimists capping the share at 20%.  In short, the growth in online grocery sales will be higher than total grocery sales growth, but not overwhelmingly so. The second is that while some have persisted with online grocery shopping after 2020, it is less in deliveries and more in pick-ups, which will have implications for the market shares of competitors in the space.

3. The Competition

    In the first few months of the COVID shutdown, Instacart was dominant, partly because its platform was designed for online shopping, and partly because in a grocery market, where many stores were out of stock, it offered shopping choices to shoppers. That dominance, though, was short lived, since the grocers woke up quickly, and started offering online shopping services to their customer, with the tilt towards pick-up over delivery. The cost savings to customers was significant, since most grocery stores dispensed with service fees and used employees as shoppers, for their online customers. In the aftermath of COVID, the grocery stores have cemented their dominance of online grocery market, as can be seen in the market shares of the biggest online grocery retailers:

Walmart and Amazon are the two largest players in the online grocery market, and Instacart, while it has lost market share since 2020, is firmly in third place. Kroger's and Albertsons, the two largest grocery story chains, have also improved their standing. Instacart, as the only pure intermediary in this group, allows customers access to multiple grocery store options, and more choices when it comes to delivery, but even one that front, it is starting to face competition from Uber Eats, DoorDash and GrubHub. In short, Instacart will be lucky to hold on to its existing market share, even if it plays its cards right, leaving its growth at or below the growth in the overall online grocery shopping market.

    On a personal note, and it qualifies purely as anecdotal evidence, we (in my household) have not used Instacart since the peak COVID days of 2020, as we have returned to physical grocery shopping for products where it matters, while preserving online shopping for products which are staples, but only for pick up, rather than delivery. Since we shop at Ralph's, a Kroger subsidiary, we use their online shopping app, since it costless, matches in-store discounts and comes with a Ralph employee as a shopper, that is familiar with what we usually buy. I know that there are others who have stayed with Instacart, perhaps because of the grocery store choices it offers or because of its delivery options, but we have little interest in either, and perhaps are closer to the norm than the exception.

4. Operating Economics

    The revenues that Instacart collects from customers, either in service fees or in subscription revenues have multiple costs to cover. By far, the biggest is the cost that the company faces in hiring and paying thousands of shoppers and drivers to operate its system. Like ride-sharing companies, the question of how Instacart categorizes these workers, and the resulting costs, will determine what it will be able to generate as operating profits:

1. Pay versus Commission: Instacart has traditionally paid its shoppers based upon the batches of work done (with a batch including shopping, packing and loading a customer order) and payments for deliveries made, with tips from customers accruing as additional income. In effect, that makes almost all of these expenses into variable costs, rising and falling with revenues, reducing risk to the company but also limiting benefits from economies of scale, as it gets bigger.
2. Independent contractor versus Employee: Instacart has argued that the shoppers and drivers who work for it are independent contractors, rather than employees. That distinction matters because an employee categorization will open up Instacart not only to additional costs (social security, health care etc.) but also to legal liabilities, for employee actions. Many states are pushing Instacart (and others users of independent contractors, like Uber and Lyft) to reclassify their workers as employees, and in 2023, Instacart paid $46.5 million, to settle a California lawsuit on this count. 

As a company built around a technology platform, Instacart also has significant spending on R&D, as well as on customer support services.  In many ways, the operating expense issues that Instacart faces parallel the issues that Uber and Lyft have faced in the last few years, and I do believe that, over time, Instacart will have no choice but to deal with their shoppers as employees, with the accompanying costs. 

The Instacart IPO

    To value Instacart ahead of its IPO, I will start with a look at the prospectus filed by the company, which will give me a chance to unload on my pet peeves about how these disclosures have evolved over time, then look at the operating history and unit economics at the company, before settling in on a valuation story (and valuation) of the company.

Prospectus Pet Peeves

    About two years ago, I wrote a post on what I called the disclosure dilemma, where the more companies disclose, the less informative these disclosures become. As part of the post, I talked about trends in IPO prospectuses over time, and the Instacart prospectus gives me a chance to revisit some of those trends that I highlighted. 

1. Disclosure Diarrhea: Apple and Microsoft, when they filed for their initial public offerings in the 1980s, had prospectuses that were less than 100 pages apiece; Apple weighed in at 73 pages and Microsoft had only 52. In 1997, when Amazon filed for a public offering, its prospectus was 47 pages long. I noted that prospectuses have become more and more bulky over time, with Airbnb's 2020 listing including a prospectus that was 350 pages long. With appendices, Instacart's prospectus stretches on to 416 pages.
2. “Tech” and AI: In common with many other companies that have gone public in the last decade, Instacart is quick to label itself a technology company, when the truth is that it is a grocery delivery company that uses technology to smooth the ride. In keeping with the times, the prospectus mentions AI multiple times, I counted 32 mentions of AI in the prospectus, and I remain skeptical that AI will (or should) alter grocery shopping in fundamental ways.
3. Adjusted EBITDA: I have written about the absolute foolishness of adding back stock-based compensation to get to adjusted earnings, noting that stock-based compensation is not a neutral non-cash expense (like depreciation) but one that an expense-in-kind, where you give away equity in your company to employees, either as options or as restricted stock. Needless to say, Instacart plows right ahead and not only adds back stock-based compensation but makes a host of other adjustments (see page 126 of prospectus). Since Instacart makes money without these adjustments, they only draw attention away from that good news.
4. Share count shenanigans: On page 19 of the prospectus, Instacart headlines that its share count will be 279.33 million shares, if the underwriters exercise their options, but two pages later (on page 21) the company discloses that it does not count restricted stock units, which are shares in existence that still have restrictions on trading or waiting to be vested, options and shares issuable on conversion of preferred shares. Adding these exception together, you get an ignored share count of 43.62 million, which brings the total share count to 322.94 million shares.

To give the company credit on useful disclosures, the company has followed the lead of other user-based companies in providing a cohort table (see page 111) on platform users (tracing how usage changes as users stay on the platform) and on unit economics (the size of an order, with the costs of filling it), but that good disclosure is hidden behind layers of flab.

An Operating History

    For young companies, you learn less by browsing through financial history than with much more mature companies, but it in instructive to look at the pathway that Instacart has taken to arrive at its current position.  For close to seven years after its founding in 2012, Instacart struggled to find its footing with customers, as relatively few were willing to jump on the online grocery shopping bandwagon. Coming into 2020, the  company had about 50 million subscribers and $215 million in revenues, and the $5.1 billion that customers spent on groceries on its platform was a tiny fraction of the $800 billion US grocery market. In a turn of fortune that I am sure that even Instacart did not see coming, the COVID shutdown changed the shopping dynamics. As homebound customers desperately looked for options to shop for and get groceries delivered at home, Instacart stepped into the fray, allowing user numbers, the value of gross transactions (GTV) and revenues to quadruple in 2020. 

It is undeniable that Instacart, like Zoom and Peloton, was a COVID winner, but like those companies, it has struggled to build on those winnings and deliver on the resulting unrealistic expectations. The good news for Instacart is that many of the customers who joined its platform at the height of COVID have stayed on, but the bad news is that growth has leveled off in the years since, and especially so leading into the initial public offering.

    As subscribers and grocery sales on the Instacart platform grew between 2019 and 2023, its business model has also been taking form, turning from losses to a measure of profitability in the twelve months leading into the offering:

Instacart Prospectus

Note again, though, that the bulk of the improvement in operating metrics occurred in 2020, and while the numbers have continued to improve since 2020, the change has been marginal. To understand the drivers of Instacart’s profitability over time, let us break down its components:

1. Take Rate: When an grocery order is placed on the Instacart platform, the service fees that Instacart collects represent its revenues from transactions, and the take rate measures these revenues as a percentage of the transaction value. Instacart's take rate has improved over time, doubling from 2.86% in 2019 to 5.70% in 2020, before leveling off in 2021 and 2022, and then increasing again to 7.49% in the last twelve months of 2023.
   
   
   Just to provide a contrast, Airbnb and Doordash, two other companies in the intermediary business have much higher take rates at 14% and 11.79% respectively. Much of that difference, though, is unbridgeable for a simple reason: the grocery business has significantly lower operating margins (at 5%) than the hospitality  (15% in 2022)  or restaurant businesses (16% in 2022). Put simply, Instacart's take rate will be lower, even with full economies of scale at play, than its counterparts in businesses with more profit buffer.
2. Operating expenses: The revenues that Instacart collects, from transactions and advertising, are used to cover its operating expenses, which are broken down into three categories: cost of goods sold, operations and support and G&A:
   
   
   There are economies of scale that kicked in, in 2020, and the good news is that those economies of scales continued to benefit the company in 2021 and 2022, as all three categories of expense decreased, as a percent of sales. 
3. Customer Acquisition and Reinvestment:  Growth comes with reinvestment, and in the case of Instacart, as with many other tech companies, that reinvestment is embedded in its operating expenses (instead of capital expenses), since their two biggest capital expenditures are the costs of acquiring new subscribers (shown as part of sales and marketing) and investments in technology/platform (shown as R&D). 
   
   
   Looking at the customer acquisition (selling) costs alone, there is evidence that these costs, in dollar terms and as a percent of revenues, after the steep drop off in 2020, are rising over time, indicating that there are more competitors for new online grocery shoppers.  If you add to that the same trend in R&D spending, it does look like the company is working harder and spending more to deliver growth after the COVID boost in 2020.
4. Unit Economics: With transaction-based businesses, like Instacart, understanding how the unit economies (on individual orders and platform users) are evolving over time can be useful in forecasting the future. Looking across Instacart's entire history, the typical order size has remained remarkably stable, at around $100, with the spurt in 2020 being the exception.

   

   Instacart Prospectus

   
   On an inflation-adjusted basis, especially in 2021 and 2022, the average order size has decreased over time. That, by itself, may not be a problem, if Instacart customers are ordering more often, especially as they stay on the platform for longer, and to answer this, I look at Instacart's estimates of revenues, by cohort class:

   

   Instacart Prospectus

The good news is that customers who joined the platform in 2017, 2018, 2019 and 2021 spend more on the platform, the longer they are on it. The bad news is that customers in joined in 2020, Instacart's biggest year of growth in users, are spending less on the platform in 2021 and 2022, indicating that some of the COVID gains are slipping away. That should not be surprising, since many customers who used Instacart in 2020 did so only because they had no alternatives, and once the shutdown ended, returned to old habits.

    As the company has struggled, coming off its COVID high, there has been turnover in its management ranks. Apoorva Mehta, who founded the company and oversaw its COVID growth, stepped down as CEO of the company in 2022, and was replaced with Fido Simo, a Facebook executive, with the impetus for the change rumored to have come from Sequoia, the biggest single stockholder in the company. Before you instinctively jump to the defense of founders, like Mr. Mehta, it is worth noting that he owned only 10% of the outstanding shares in the company in 2022. In short, scaling up and high growth often require large capital infusions, and a side cost almost always will be a reduction in founder control of the company. 

The Valuation Story & Intrinsic Value

    With that long lead-in, I have the basis for my Instacart story, and it reflects both the good and bad news in the company's operating history. 

1. Growth: To estimate revenue growth at Instacart, I think it makes sense to break down revenues into transaction revenues and advertising revenues, with the former coming from service fees and subscriptions, and the latter from ads. To estimate transaction revenues, I will assume that gross transaction value on the platform will track growth in online grocery retailing, which seems to have settled into a compounded annual growth rate of about 12%, for the next five years. I will assume that Instacart will maintain its market share of the online grocery market, in the face of competition, but only by cutting its fees and accepting a take rate of 6%, by year 5, down from 7.5% in the trailing 12 months. Advertising revenues, though, are assumed to keep track with gross transactions on the platform.
2. Profitability: Drawing on the company's history of delivering economies of scale on cost of goods sold and operations support, I will assume that the company will be able to improve its operating margins over time to 25%. The tensions between Instacart and its shoppers, as well as push back from grocery stores, will keep a lid on these margins and prevent further improvement.
3. Reinvestment: As user growth levels off, I expect the company to revert to its capital-light origins, and spend far less on customer acquisitions, as well as on acquisitions. This allows me to assume that the company will be able to deliver $3.13 in revenues, for every dollar invested, roughly matching the global industry average.

With these assumptions in place, the value that I get for the company is shown below:

My Instacart Valuation

With my story and inputs, the value per share that I get for Instacart is about $29, close to the offer price being floated of $30 per share. 

    There is, of course, the very real possibility that I could be wrong on my estimates (in either direction) of key inputs: the growth in GTV, the take rate, the operating margin and the cost of capital, and to account for this uncertainty, I fall back on a simulation:

As you can see, at the offer price of $30/share, the company is priced close to its median value, and the distribution of values suggests that there is less upside in this company than in some of the other growth companies I have valued in recent years.

The Offering

    Instacart was expected to hit the market on September 19, and the reception that it gets may tell us as much about the market, as it does about the company. In my posts on the market, starting mid-year last year and extending into this one, I noted that risk capital had retreated o the sidelines, and one of the statistics that I used was the number of IPOs hitting the market. After hitting an all-time high in 2021, the IPO market has frozen, and the ARM, Instacart and Birkenstock IPOs hitting the market in September may be a sign of a thaw. That sign will become stronger, if the offerings are well received and there is a price pop on the offering. 

Pricing versus Investing

    I have long argued that IPOs are priced, not valued, notwithstanding the lip service that everyone involved in the process, including VCs, founders and bankers, pays to valuation, The difference between valuing and pricing is that while the former requires that you grapple with business questions on growth, profitability and reinvestment, the latter is based on how much investors are paying for peer group companies, a subjective judgment, but one made nevertheless. In keeping with this theme, I compared the proposed pricing for Instacart against the pricing of its peer group. That peer group is not other grocery companies, since the Instacart model is very different, but other intermediary companies like Airbnb and Doordash, which like Instacart, take a slice of transaction revenues in the markets they serve, and try to keep costs under control:

While Instacart looks cheap, relative to Doordash and Airbnb, this pricing is an illustration of the limits of the approach.  Instacart trades at a much lower multiple of revenues, because its take rate (as a percent of gross transaction value) is much lower than the slices that Doordash and Airbnb keep. Airbnb keeps 14% of gross transaction value, Doordash keeps more than 11.79%, but Instacart keeps only 7.5%, if advertising revenues are excluded. Instacart and Doordash both trade at lower multiples of revenues than Airbnb, but that is because Airbnb has higher expected growth and higher operating margins in steady state.    

Previewing the Offering

  Since pricing is about mood and momentum, it is worth looking at the ARM IPO offering on September 14, which saw the company's stock price, which was offered at $51, open for trading at $56.10 and close the dat at $63.59. If that mood spills over into this week, I expect Instacart's IPO to pop on its opening day as well, especially given the fact that the offering price seems to reflect a relatively conservative outlook for the company, and the pricing looks favorable. Even if it does not, I don't see much benefit to buying the stock at the offering price, not only because it looks fairly valued, but also because I don't see enough of an upside, even if things work out in the company's favor. 

    The question of what the market will do became moot, even as I was finishing this post, the stock started trading(September 19), and popped to $42 per share, before giving back some of its gains to settle at about $38 per share. At those prices, you would need more upbeat assumptions about online grocery growth and take rates than I am willing to make, but with this market, who knows? The stock may be trading at a discount on value, a week from now. 

The VC Game

    In the last decade, we have raised venture capital to "great investor" status, driven by stories of investments that have paid off in huge returns. In fact, good venture capitalists are often viewed as shrewd assessors of business potential, capable of separating the wheat from the chaff, when it comes to start-ups. That is true for some of them, but I believe that venture capital is a pricing game, with little heed paid to value, and that  the most successful venture capitalists share more traits with great traders, than with great investors. Not only are the best venture capitalists good at pricing the businesses they invest in, honing in on to the traits that are being priced in (users, subscribers, downloads etc.), but are just as good at making sure that these business scale up these traits. Their success comes from timing skills, entering a business at the right time and just as critically, exiting before the momentum shifts.

    Instacart's multiple venture capital rounds illustrates this process well, and you can see the pricing of the company at each round below:

The earliest providers of capital to the company will walk away with substantial profits, even if the company's market cap ends up at $9 - $9.5 billion, as indicated by the offering price. The seed capital providers (Khosla, Canaan and Y Combinator) will have earned at 55% compounded annual return on their investment, at the IPO offering price, well in excess of the S&P 500 annual return of 13.04% over the same period. Every subsequent round earns a lower annual return, and all investments in Instacart made after 2015 have underperformed the S&P 500 significantly, and the NASDAQ by even more.  The biggest losers in this capital game have been those who provided capital in 2020 and 2021, when COVID pushed up both capital needs and company pricing to new highs. The Series I investment in 2021, when the company was priced at $39 billion,will see markdowns in excess of 60%. While there is no redeeming grace for Fidelity and T. Rowe Price, it is true that Sequoia also invested earlier in the company, and will walk away with substantial returns on its total investment. Thus, the write down that Sequoia takes for its $300 million investment in 2021 will be more than offset by the gains it made on the $21 million that it invested in the company in 2013 and 2014. 

   The notion that there is smart money, i.e., that there is an investor group that is somehow wiser, more informed and less likely to act emotionally than the rest of us, and that it earns higher returns than the rest of us, is deeply held. In my view, it is a mirage, since every group that is anointed as smart money ultimately ends up looking average (in terms of behavior and returns), when all is said and done. It happened to mutual fund managers decades ago, and it has happened to hedge funds and private equity over the last two decades. For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns. 

YouTube Video

Instacart files

1. Instacart Prospectus
2. My Instacart Valuation

A Business Upended: Streaming disrupts the Entertainment Business!

It has been an unsettling summer for anyone with a stake in the movie, television and broadcasting businesses.  The strike by screen actors and writers which started in July is now into almost into its third month, with no end in sight, putting at risk the pipeline of movies and shows that were expected to hit theaters and streaming platforms in the next few months. On August 31, Disney pulled its television channels from Spectrum (owned by Charter, the second largest cable company in the US, after Comcast) after a dispute about payments for carrying these channels. Tennis fans, getting ready to watch the US Open on ESPN, were apoplectic, as their televisions went blank in the middle of matches, and Disney, in addition to encouraging them to complain to Spectrum, offered them an option of switching to Hulu+ Live TV, a streaming service alternative to cable. While actors and writers have been on strike before, and contractual disputes between content makers and cable providers is par for the course, the news stories of this summer seem more consequential, perhaps because they reflect longer time shifts in the movie and broadcasting businesses.

Speaking of Disney, a company that has found itself in the crosshairs of political and cultural disputes, the stock hit $80 on September 7, close to a ten-year low. To add to the angst, the threat of artificial intelligence (AI) overhangs almost every aspect of the business, and is one of the contested issues in the strike. The recent troubles in entertainment, though, reflect a longer term disruption that has occurred in the business, with the rise of streaming as an alternative to the traditional platforms for movies and television shows. In this post, I will focus on how streaming has not only changed the way we consume content, but has also modified the way that content gets made. In the process, it has altered the financial characteristics of the companies in the business in ways that the market is still trying to come to terms with, which may explain the market turmoil this year.

A Cautionary Tale: The Music Business and Streaming

    If, as you watch the broadcasting business go through its struggles with streamers, you get a sense of deja vu, it is because the music business in the 1990s found itself similarly challenged, and its upending by streaming may offer lessons for the movie business. In the twentieth century, the music business followed a well-honed script. It was composed of companies which scouted for music talent, signed these musicians to music label contracts and then worked with them in their studios to produce record albums that were sold in music stores across the country. The music companies provided marketing support, seeking out radio stations that would carry their music, and distributional backing to get albums to retailers. In many ways, it was impossible for a musician to break through, without studio backing, and that power imbalance allowed the latter to claim the lion’s share of the revenues. 

    The disruptor who upset the music business was Napster,  a platform that delivered pirated streams of music to its customers, effectively undercutting the need to go into music stores and buy expensive albums. While Napster downloads left much to be desired in terms of audio quality, and the company walked to (and often beyond) the very edge of legality, it exposed the weaknesses in the music business, from how new artists were found and marketed, to how their music was packaged and finally, how that music was sold. When the music companies of the day were able to shut Napster down in 2001, citing digital piracy, they were undoubtedly relieved, but their weaknesses had been exposed. Apple created the iTunes Store in 2001, allowing customers to buy individual songs, rather than entire albums, and the unbundling of the music business began. In the years that followed, music albums and music retailers became rarer, and the advent of the internet allowed musicians to bypass the gatekeepers at the music studios and go directly to customers. As smart phones and personal devices became more plentiful, Spotify and Pandora introduced the music streaming model, and the game was forever changed, and the consequences for the music business have been staggering:

1. The music business shrank and the center of gravity shifted: The entry of streaming companies changed the economics of music, since it largely removed the need to buy music, even in the single-song format. Spotifyand Pandora allowed subscribers access to immense music libraries, with high audio quality, and as they grew, revenues to existing music labels dropped:
   
   
   
   As you can see, music revenues shifted (unsurprisingly) from studios to music streaming, but in a more troubling sign,  the aggregate revenues of the music business dropped by almost 40% between 2000 and 2016. On a more optimistic note, the revenues are now back to pre-2000 levels, albeit not on inflation-adjusted basis, and 65% of all revenues in 2021 came from streaming. It is undeniable that streaming, by removing many of the intermediaries in the old music business model, has shrunk the business.
2. The status quo crumbled: As revenues shrunk, and moved from the studios to the streamers, the companies that represented the status quo imploded. The music studio business, which had a dozen or more active players in the last century, has consolidated into a handful of firms, most of which are small parts of much bigger entertainment companies (Sony. Vivendi), and many of the biggest labels in music (Abbey Roads, Motown) are historical artifacts that have sold their music rights to others. The music retail business was decimated, as music retailers like Tower Records shut down, and as artists looking to replace lost revenues from record sales with live performances and merchandising sales, companies like LiveNation stepped in to fill the need. 
3. The divergence in musician take became larger: As revenues shrunk and partially recovered, not all musicians have shared in the new pie equally. The top one percent of musicians account for ninety percent of all music streams and close to sixty percent of revenues from concerts. A business that has always been top heavy in terms of rewarding success, has become even more so.
4. Personalities became bigger than music labels: The advent of social media has allowed the highest profile performers to break free of most of the intermediaries in the music business. When you are Beyonce, and you have 15.3 million followers on Twitter and 317 million followers in Instagram, you have more reach and persuasive powers than any music company on the face of the earth. While it is true that social media has allowed a few musicians to break through and become successes, I think it is undeniable that social media is exacerbating the differences between big name musicians and unknowns more than it is helping close the gap.

You could see these the last two phenomena at play, this year, in the Taylor Swift Eras Tour, where Taylor has effectively cut out most of the middlemen in the concert business and laid direct claim to the hundreds of millions of dollars in revenues from the tour.

    As movie and broadcast business executives look over their shoulders at what streaming has in store for them, a few of them are undoubtedly looking at the implosion of the music business and wondering whether a similar fate awaits them. The more optimistic among them will point to differences between the music and movie businesses that will make the latter more resilient, but the more pessimistic will note the similarities. To put it in more existential terms, if the movie business resembles the music business in how it responds to streaming, there is a boatload of pain that is coming for the status quo, with the key difference being that a meltdown similar to the one seen in music will wipe out hundreds of billions of dollars in value, rather than the tens of billions in the music business.

Movie and Broadcasting - The Twentieth Century Lead In

    The movie business had its beginnings in the early 1900s, when the first movies were made and Hollywood became the destination of choice for movie makers, at least in the United States. In the years after, the great movie studios had their beginnings, with the precursor to Paramount being created by Cecil B. DeMille and others in 1915, followed soon by Metro Goldwyn Mayer (MGM), RKO, 20th Century Fox and Warner Bros (creating the Big Five), as well as by smaller players (Universal, United, Columbia), . In the golden age (at least for the studios), these five studios controlled almost every aspect of the movies, including content, distribution and exhibition, with movie actors effectively owned and controlled by the studios that discovered them. It took the  US Supreme Court and use of the anti-trust law, in 1948, to first force studios out of the movie theater ownership business, and then to release movie stars from their  bondage, and in the process, it ended the Studio Age.

    Forced to divest themselves of movie theaters and of their control of movie stars, the studios were able to offset the negatives with the positives from new technologies (Technicolor, stereo sound) and an almost unchallenged claim on American leisure time, with close to two-thirds of Americans going to the movies at least once a week in the 1950s. In the 1970s, Hollywood discovered the payoff from blockbuster movies, and the movie business became increasingly dependent on the biggest blockbusters delivering enough revenues and profits to cover a whole host of movies that either lost money or broke even. While Jaws and the first three Star Wars movies (A New Hope, The Empire Strikes Back, The Return of the Jedi) were not the first mega-hits in history, they accelerated the trend towards the blockbuster phenomenon that continues through today. In the 1980s, the birth of video players created ways for studios to supplement revenues at movie theaters with revenues from selling videos and DVDs, while opening the door to illegal copying and piracy. 

     Through this period, the big studios still controlled a large share of the content business, but independent studies, often more daring in choice of topics and settings, took a share. That said, the movie business remained concentrated, with the biggest players dominating each segment of the business.

That movie business was built around box office receipts at movie theaters, split between the movie makers and the theater owners. The latter were capital intensive, since they occupied valuable real estate, owned or leased by the theater companies. Though the theater-owners were nominally independent, studios retained significant bargaining power with these exhibitors and the sharing of supplemental revenues.  

        The broadcasting business lagged the movie business, in terms of development, because televisions did not start making their way into households in sufficient numbers until the 1950s, but it too was built around a system of content-production, distribution and exhibition, but with advertising at the heart of its revenue generation. The dominance of the three big networks (ABC, CBS and NBC) in television viewing meant that television shows had to reach the broadest possible audiences to be successful, and television show success was measured with (Nielsen) ratings, measuring how much they were watched, and an entire business was built around these measurements. That business was disrupted in the 1970s and 1980s with the arrival of cable television, and cable's capacity to carry hundreds of channels, some of which catered to niche markets, shaking the major network hold on viewers and changing content again. At the start of 2010, it was estimated that close to 75% of all US households received their television through a cable or satellite provider, setting the stage for the next big disruption in the business.

Movie and Broadcasting: The Streaming Era

    Netflix, which is now synonymous with the streaming threat to movies, started its life as a video rental company, more of a threat to Blockbuster video, the lead player in that business, than to any of the larger players in the content business. It is worth remembering that Netflix entree into the business was initially on the US postal system, with the innovation being that you could have the videos you wanted to watch mailed to you, instead of going into a video rental store. As the capacity of the internet to send large files improved, Netflix shifted to digital distribution, albeit with angst on the part of some existing customers, but it still relied entirely on rented content (from the traditional studios). It was in response to being squeezed by the studios on payments for this content that Netflix decided to try its hand at original content, with House of Cards and Orange is the new Black representing their first major forays, and set in sequence the events that have led us to where we stand today.

The Netflix Disruption

    The rise of Netflix as a streaming giant has been meteoric, and it can be seen both in the growth in subscribers and revenues at the company, especially in the last decade.

Embedded in these numbers are two other trends worth noting. The first is that the percent of content that Netflix produced (original content) increased from almost nothing in 2011 to close to 50% of content in 2022. The second is that growth in recent years, in subscribers and revenues, has come from outside the US, with US declining from 52% of all subscribers in 2018 to 33.6% of subscribers in 2022. 

    As Netflix has grown, it has drawn competition not only from traditional content makers, with the largest studios offering their own streaming services (Disney -> Disney +, Paramount -> Paramount+ & Showtime, Warner -> (HBO) Max, Universal -:> Peacock, MGM -> MGM+), but also from large technology companies (Apple TV+ and Amazon Prime). While Netflix remains the most watched streaming service, many customers subscribe to multiple streaming services, and as  streaming choices proliferate, more and more US households have started weaning themselves away from cable TV. This cord cutting phenomenon's effects can be seen in  the percent of households that have no cable or satellite TV:

Between 2015 and 2021, about 20 percent of all US households dropped their cable or satellite television subscriptions, with the drop off being dramatic in younger households. In August 2022, for the first time in history, Nielsen reported that more people watched streaming than cable or broadcast TV, and there is every reason to believe that this trend will only get stronger over time. As a final note, there are two reasons why cable and satellite television has not suffered an even steeper fall. The first is that aging households continue to stick with their television watching habits, and relatively few older Americans have cut their cable subscriptions. The second is live sports, especially (American) football, where cable continues to retain a foothold, though even that advantage is under threat, as sports franchises create their own streaming platforms (MLB) or find streaming venues (MLS soccer on Apple TV, the NFL on Amazon Prime). It is in this context that Disney's battle with Charter over ESPN takes on a larger relevance, since ESPN and cable TV have had a symbiotic relationship for more than two decades.

    As streaming has breached the broadcasting business, you may wonder how it is affecting the movie business. In the early years, streaming allowed studios to augment the value of their content by renting it out  to streamers (Netflix, in particular) for substantial revenues. As its subscription base grew, Netflix turned to making original movies, mostly for its own platform, and in 2019, it spent close to $15 billion on original content, rivaling  the spending of large movie makers. 

The COVID shut down of 2020, in particular, changed the dynamic further, as traditional studios, faced with the shuttering of movie theaters, released their movies directly into streaming. That phenomenon has outlasted COVID, and as it develops as a viable alternative for content distribution, it not only strikes at the heart of the traditional movie business but may also be changing consumer behavior.

The Streaming Effect

    As streaming disrupts both the broadcasting and movie businesses, let us look at how it is changing these businesses from the inside, starting with content (types of movies, movie budgets, number of movies), moving on to talent (actor and writer demand and compensation) and then to customers (how much and how we watch content). 

Content

    The growth of streaming platforms has altered content (movies and broadcasting) in significant ways., with the first being an increase in the total volume of content, as streaming platforms try to fill their content libraries. With Netflix leading the way on original content, this has translated into a jump in movies being made, as can be seen in the graph below, from an annual average of 367 movies a year, in the United States, between 2000 and 2012 to 1200 movies a year between 2013 and 2023. 

Source

That increase in demand for content has been accompanied by an increase in costs of movie making, with the average cost for making a movie increasing from $39.5 million between 2000 and 2012 to about $54.5 million between 2013 and 2023.

    If you are wondering why you have not seen an explosion of movies at theaters, it is because fewer of these movies are being made for movie theaters, with big studios, reducing theater movie production by almost 30%, from 108 movies a year, on average from 2000 to 2012, to about 75 movies a year, from 2013 to 2023. While independent studies increased their production over the period, the overall number of movies reaching movie theaters has seen a significant drop off. 

Source

While the 2020 drop can be attributed to the shut down, movie production has not bounced back in the years since.

    Finally, the most interesting effects of streaming may be occurring under the surface in terms of the content that is produced, and they can be traced to the very different economics of making movies for theaters (or shows for broadcasting) as opposed to creating content for streaming services. With the former, the question of whether to make content can be answered by forecasting the revenues that will be generated by that content, either as gate receipts and ancillary revenues (for movies) or in advertising revenues (for broadcasting). With streaming, the end game with new content (movies or shows) is to add new subscribers to the service, and/or induce existing subscribers to renew their subscriptions, and it is difficult to link either directly to individual shows. Even within streaming services, there seems to be no consensus on what strategy best delivers these results, perhaps because success is so difficult to measure. 

• Netflix has chosen what can be best described as the shotgun approach to content, producing vast amounts of content, often in the form of entire seasons, for shows, with the hope that some portion of that content would be a binge-watching hit. That approach has delivered results in terms of higher subscriber count, but at a huge content cost, with content costs growing at the same rate, or higher rates, than subscriber count, until very recently.
• HBO has used a more curated approach to content, making fewer shows, albeit with less divergence in quality, and releasing episodes on a weekly basis, hoping for more viral reach from successful shows (Game of Thrones and Succession qualify as big successes). The plus of this approach is lower content costs, but with much lower subscriber numbers than in the shotgun model.
• Disney Plus started with the premise that a massive library of content would allow the platform to draw and keep subscribers, but early on, the company discovered that to compete with Netflix on subscriber numbers, it needed new content, and much of that content has come from high-profile, expensive shows from its Avengers and Star Wars franchises. If success is measured in subscriber count, Disney Plus has succeeded, but the spending on content has exploded, dragging Disney’s profitability down with it. 
• With Apple TV+ and Amazon Prime, the game is even more difficult to gauge. Both companies spend large amounts in content and clearly lose money on their streaming platforms, but their benefits may come from tying users more closely into their platforms. with benefits showing up other products and services they sell to those in their ecosystems.

Given that all of these approaches have had difficult delivering sustained profitability, it is fair to say that while streaming has succeeded in delivering subscriber growth and changing content watching habits, it has not developed a business model that can delivered sustained profitability.

Talent

  The angst that many actors and writers about the sharing of streaming revenues can be best understood by considering how how they have historically received residual payments on content. Built around a pay structure negotiated in 1960, actors and writers are paid residuals each time a show runs on broadcast or cable TV, or when someone buys a DVD or videotape of the show. With streaming, that old structure has buckled, as the benefits from a show or movie are more difficult to measure, since subscription revenue or subscriber count cannot be directly connected to individual shows. (There are exceptions, where added subscriber numbers can be attributed to a hit show, say Game of Thrones at HBO, or even a high-profile individual, with Lionel Messi pushing up MLS subscriptions on Apple TV+.) To the counter that you can measure how many people watch a show or movie on Netflix or Disney+, note that streaming companies do not make money from viewers, but only from added subscription revenues. With the more diffuse link between viewership and revenues in streaming, the question of how to structure residuals to actors and writers has become a key point of contention, and one of the central elements of the current strike. 

    In 2019, the Screen Actors Guild made an agreement with Netflix that applied to any scripted projects produced and distributed by the platform where residuals were calculated based on the amount that a performer was originally paid and how many subscribers the streaming platform has. That agreement though has yielded wildly divergent payments to actors, with some taking to social media to showcase how little they received, even on widely watched shows, while other bigger name stars are being well compensated. One of the demands from strikers is that streaming services be more transparent about viewership on shows and that they tie compensation more closely to viewership, but this dispute will not be easily resolved. Given the stakes, an agreement will eventually be reached where actors and writers will receive more than what they are receiving now, but to the extent that streaming gets its value from adding and holding on to subscribers, I expect the divergence in pay between the stars of streaming shows and the rest of the content makers to get worse over time, just as it did in the music business.

Consumption

    Has streaming changed the way that we watch movies and broadcasting content? I think so, and here are a few generalizations about those viewing changes:

1. More choice, but less quality control: The fact that Netflix has built its content production around the shotgun approach, and is being copied by other streamers, you and I as consumers will be spending far more time starting and abandoning shows, before finding ones to watch than we used to. Not surprisingly, quite a few us are overwhelmed by that search for watchable content, and choose to go with the familiar (explaining the success of old network shows like The Office, Friends and Suits on Netflix)  or with the herd, often watching what everyone else is watching (the ten most watched shows and movies that Netflix highlights every day create feedback loops that lead them to be watched more).
2. Copycat Productions: The content business have never been shy about imitation and sequels, trying to remake successful content with slight variations or add sequels to hits, but that has notched up with streaming. Thus, the success of a show on Netflix gives rise not only to more seasons of that show, but to a whole host of imitations. If you add to this the reality that streaming platforms track what you watch, and have algorithms that feed you more of the same, you may very well have the misfortune of being caught in a version of Groundhog Day, where you watch the same movie, with mild variations, over and over again for the rest of your life.
3. YouTube and TikTok: As the content on streaming platforms dilutes quality and shifts to reality shows, it should come as no surprise that viewers are spending less time on streaming platforms and more on Twitch, YouTube and TikTok, where you get to watch people put out reality shows of their own, sometimes in real time.

Finally, the early promise of streaming was that it would allow us to save money, by cutting the cable cord, but as with most things that technology has promised us, those financial savings have become a mirage. If you add together the cost of multiple streaming services to the higher price that you paid to get higher-spreed broadband, to watch your streaming shows, I am sure that many of you are paying more on your entertainment budget than you did in pre-streaming days.

The Streaming Effect: Business Models and Profitability

    The effects of streaming on movies and broadcasting content and distribution are showing up in the financial statements of these companies and in the market pricing of these companies. In this section, I will start by looking at how the operating metrics of entertainment companies, with the intent of detecting shifts in growth and profitability, and then turn my attention to how investors are pricing in these changes.

Operating Effects

    For those who are concerned about a music business-like implosion in movie business revenues, I will start with the good news. At least so far, the cumulative revenues across all entertainment companies c has held up to the streaming disruption, as can be seen in the graph below, where I look at the cumulative revenues of all movie and broadcasting related companies from 1998 to 2023:

Note that since companies are classified based upon their core business in this graph, the streaming component of revenues are understated, since the revenues that Disney, Paramount and Warner get from their streaming businesses are counted as movie revenues. As you can, aggregate revenues did see a drop in 2020, because of COVID, but have come back since. If you are wondering why cable company revenues have been resilient in the face of cord cutting and the loss of cable TV subscriptions, it is because cable companies remain the prime providers of broadband, without which there is no streaming business.

    On a less upbeat note, looking at profitability at these companies, the cumulative operating profits have been less reselient, especially in the post-COVID years, with cumulative operating profits in 2022 and 2023 well below operating profits in 2019:

If you bring the revenues and operating numbers together to compute operating margins, you start to get a clearer sense of why movie companies, in particular, are facing a crisis:

The profitability of the movie business has collapsed in the years since COVID, with operating margins dropping below 5% in 2022 and 2023, from more than 15% in the years before COVID.  Streaming seems to be settling into a modicum of profitability, but here again, we may be overstating the profitability of streaming by not bringing into the metric the losses that Disney, Warner Bros and Paramount are facing on their streaming segments.

    In sum, entertainment companies are delivering higher revenues overall, with revenues from streaming and new technologies increasing enough to offset lost revenues in legacy businesses that are being disrupted, but the entertainment business overall is becoming less profitable.

Market Effects

    As streaming has changed the movie and broadcasting businesses, financial markets have struggled to get a handle on how these changes affect the values of companies int these businesses. Looking at the cumulative market capitalization of all entertainment companies, there are two shifts that we can observe over time, one in the decade leading into COVID and one in the years after:

Note the surge in aggregate market capitalization between 2019 and 2021, with Netflix leading the way, and with other entertainment companies partaking, and the drop in value in the last two years.  The trends in cumulative market capitalization of all entertainment companies also masks shifts in value across companies within the group, as can be seen in the graph below, where I look at the diverging fortunes across the last decade of the five largest entertainment firms (in terms of market capitalization) in September 2023:

Between 2013 and September 2023, Netflix gained $174 billion in market capitalization, posting an annual return of 24.5% a year. During the same period, Comcast, Disney and Warner saw their market capitalizations stagnate, in a period when the market was up strongly, effectively translating into a lost decade of returns to shareholders. Live Nation, the fifth largest company in the group in September 2023, barely registered in the rankings in 2013, but has risen 17.19% a year to reach its current standing.

    While the shifts in value from the status quo players to Netflix and Live Nation is buffering the impact of streaming on the cumulative market capitalization of this industry group, the market has become decidedly more negative on one segment of this group - movie theater companies. In the last graph, I look at the cumulative market cap of the four largest movie theater companies in North America - AMC, Cineplex, Cinemark and the Marcus Group. 

While the COVID shut down clearly impacted the 2020 numbers, note that the market decline in these companies started in 2017, and has picked up steam since.

Corporate Governance

    Corporate governance at companies rarely draws attention during the good times, where managerial mistakes are overlooked, and rising revenues and earnings can hide corporate flaws. However, in challenging times, and disruption clearly has created challenges for entertainment companies, it is not surprising that we are seeing more investor angst at these companies.

1. CEO Turnover: There has been drama in the top ranks of Disney in the last few years, as Bob Iger  first turned over the reins in the company to Bob Chapek in 2020, and then reclaimed it two years later. Some of that blowback can be traced to an expensive bet made by the latter on streaming, reorganizing the company around Disney+,  and investing billions into streaming content, trying to attract new customers. While there are factors specific to Disney that can shed light on that company's CEO wars, I expect CEO turnover and turmoil to increase at entertainment companies, as investors look to replace management at companies that are struggling, in a sometimes futile effort to change their fortunes.
2. Activist Presence: It is no surprise that activist investors are drawn to industries in turmoil, pushing companies to spend less on reinventing themselves and returning more cash to shareholders. Here again, the Disney experience is instructive, where Nelson Peltz's opposition to Chapek's plans clearly played a role in the CEO change this year. While Iger has been given some breathing room to fix problems after his return, the clock is ticking before activist investors return to the company. In fact, I expect the companies in the entertainment group to be prime targets for activist investors in the next few years.
3. Spin-offs, Divestitures and Break-ups: In response to streaming challenges, entertainment companies have started exploring whether splitting up or spinning of businesses will improve their chances of survival and success in the streaming age. Warner Bros. was spun off by AT&T and merged with Discovery in 2022, precisely for this reason, and the push for Disney to spin off or divest ESPN is similarly motivated.
4. Bankruptcy: For the companies whose financials have imploded as a result of streaming, and all have debt, you should expect to see dire news stories not just about layoffs and shrinkage, but about potential bankruptcy. In the theater business, this has become reality as Cineworld (owner of Regal, the second largest theater chain in North America) issued a bankruptcy warning in early 2023, and AMC (owner or both the largest theater chain and a streaming service) had to do a  reverse stock split to keep itself from careening towards penny stock status.

There are three final notes that I would like to add to this (long) post. First, I know that this post has been US-centric in its examination of the streaming effects on entertainment, but I do believe that much of it applies to the rest of the world, with a caveat. The status quo may be better protected in other parts of the world, either because of explicit limits on or implicit barriers to entry. Thus, streaming may be less of an immediate threat to Bollywood, India's immense homegrown movie-making business, than it is to Hollywood, but change is coming nevertheless. Second, as I noted before, the line between content made by professionals (movie makers, broadcasting studios) and individuals (on platforms like YouTube and TikTok) is getting fuzzier, and they are all competing for limited viewer minutes. Third, for those in this business who are naive enough to think that artificial intelligence will rescue their companies from oblivion, I would offer the same caution that I did to the active money management business, a few months ago. If everyone has it, no one does, and with AI, content makers may very well find themselves competing with computer power and technology companies, and that is not a fight where they have the upper hand.

What the future holds…

    The consequential and unresolved question is what the movie and broadcasting business will look like a decade from now, since the answer will determine how stakeholders in the business will be affected. To frame the answer, I start by looking at the most malignant and benign ways in which this could play out:

• At one extreme, you may see the movie and broadcasting business follow the music business and see a collapse of revenues, a destruction of the status quo and a resetting of the competitive landscape.  If this happens, some of the biggest names in movies and broadcasting will disappear as independent entities, either absorbed as pieces of much larger companies or cease to exist. The disruptors, including Netflix and Live Nation, will face different challenges, as they now become the status quo, and they will have to figure out how to make their business models profitable and sustainable, even as they themselves will become targets of new disruptors.
• At the other exhibit, you will see entertainment continue to grow as a business, but with status quo players (content makers and exhibitors) bringing their strengths into play to outflank the disruptors. In this scenario, the big names in the movie and broadcasting business will modify how they make and exhibit content, and come back, bigger, stronger and more profitable than they were in the pre-streaming era. 
• There is a middle-ground, where success will require that you draw on the strengths of both the status quo and new technologies. The players in the status quo who are adaptable and willing to change will absorb those players who are not, and there will be a similar shake up among disruptors, with those disruptors who combine entertainment business wisdom with technological knowhow will win at the expense of disruptors who do not. 

As investors in this industry group, your task is simple, if you believe in either extreme. If you believe that disruption will be absolute and upend the movie and broadcasting businesses, you should, at the minimum, avoid the status quo entertainment companies, and if you are more of a risk taker, sell short on these companies. If you believe that after all is said and done, disruption will expand entertainment business revenues, but will leave the status quo on top, you should buy Disney, Warner and perhaps even AMC, and sell short on the highest-flying newcomers in the business. 

    If, like me, you go for the middle ground, your success will depend on how good you are at assessing adaptability in entertainment companies, buying status quo companies with speedy learning curves on streaming and new technologies and disruptors that acquire content-making skills to pair with technological prowess. That would make both Disney and Netflix works-in-progress, with the former still wrestling with the challenge of making its streaming platform a money-maker and the latter working on a content model that is more disciplined and less costly. I took a run at valuing both companies, assuming that they each find their way to a healthy balance (between growth and profits), with Disney's margins settling in below where the 18-20% levels the company delivered in pre-COVID days, and Netflix reducing its content spending (with content costs growing much slower than subscriber growth), going forward:

	Disney	Netflix
Revenues (LTM)	$87,807	$32,465
Operating Income	$7,725	$5,624
Revenue Growth (last year)	8.30%	5.44%
Operating Margin (LTM)	8.80%	17.32%
Expected Revenue Growth (Yrs 1-5)	10.00%	15.00%
Expected Operating Margin	16.00%	20.00%
Sales to Capital	1.46	3.00
Value per share	$87.52	$238.08
Price per share	$80.00	$443.10
Spreadsheet	Download	Download

Put simply, the market seems to be pricing in the presumption that Netflix will continue to get content costs under control, while still delivering growth similar to what it has delivered in the past, while it is pricing Disney for low growth and margins that will fall short of their historic norms. I agree that Disney is a mess, right now, but I do believe that at current pricing, the odds favor me more with Disney than Netflix, but that is just me!

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