DIS - Paramount: It's Not Quite Showtime Yet

2023-09-28 13:56:15 ET

Summary

• Paramount has made it a strategic priority to improve its DTC segment economics significantly by next year.
• This includes increasing Paramount+ ARPU by 20%, while also penetrating further in growing opportunities in digital advertising and improving operating leverage by leaning-in on existing assets.
• However, management's ambitions have not sufficiently de-risked for rapidly evolving competitive dynamics and company-specific weaknesses in its DTC foray, in our opinion.

Like its peers, Paramount ([[PARA]] / [[PARAA]] / [[PARAP]]) has made it a priority to narrow losses from its direct-to-consumer ("DTC") business over the next 12 months. While relevant efforts have yet to result in a net positive impact in overcoming the accelerating pace of secular declines in linear TV, which remains a core driver of Paramount's earnings and cash flows, the company's near-term roadmap is a step in the right direction. Specifically, management has highlighted three key focus areas in driving significant improvements to DTC economics next year - 1) improve ARPU by 20% through enhancing DTC engagement and subscriptions; 2) improve DTC ad dollar retention and penetration; and 3) realize greater cost efficiencies through measured content and marketing spend, while restructuring existing assets to drive greater scale and operating leverage.

The following analysis will gauge the implications of each strategic focus, and determine their potential impact on the stock's near-term performance. We believe that the combination of secular declines in linear TV, ongoing (albeit narrowing) losses in DTC amid intensifying competition, and Paramount's highly levered balance sheet remain significant overhangs on the stock. Not only is there limited respite to the challenges over the near-term, we believe Paramount also faces idiosyncratic weaknesses that could put its DTC financial targets at risk. While the stock continues to trade at a discount to both its historical levels and Paramount's media and entertainment peers with a similar growth profile, we remain cautious of further volatility ahead as the underlying business fundamentals remain a weak link.

1. DTC ARPU Expansion

Management has guided 20%+ ARPU growth for Paramount+ in 2024, which is on the higher end of what's been observed at key rivals such as Disney+ ( DIS ), Max ( WBD ), and Netflix ( NFLX ). The double-digit ARPU expansion is expected to be driven by a combination of efforts, primarily 1) subscription growth, with a higher mix from higher ARPU regions like Western Europe, Canada and Australia; 2) the full year impact from price increases implemented earlier this year; and 3) the introduction of new subscription tiers to better address different consumer preferences and gain market share through price discrimination. However, we think there is still limited visibility on the extent of which Paramount+ can maintain more than 20% ARPU growth in 2024, which could inadvertently impact the extent of DTC margin improvements heading into the new year.

Subscription Growth - Paramount+ has seen a significant deceleration in subscriber net adds during the second quarter. The company had 0.7 million net paid additions, falling from +4.1 million during the first quarter. While management has attributed the deceleration to "seasonal softness [and] a strategic shift of content releases to better align with the launch of Paramount+ with Showtime", with subscriber growth to reaccelerate in 2H23, we find it difficult to match the extent of net adds observed in Q1.

Specifically, we see intensifying competition in the streaming business, alongside a weakening consumer spending backdrop as key headwinds to driving subscription growth. American households are already subscribed to 3.7 streaming services on average, fuelled primarily by a combination of cord-cutting dollars moving online and the increasing availability of different platforms to choose from. Recent industry checks have highlighted content, price and ads as three key considerations among consumers when choosing a streaming service.

While Paramount+ boasts one of the cheapest monthly subscription rates relative to its comparable peers, its content slate remains a "competitive disadvantage to peers", especially after rival Warner Bros. Discovery's blockbuster merger last year. This will essentially increase Paramount+'s exposure to seasonality risks on subscription growth, which is already observed in soft Q2 net adds due to the shift in content release timing. The observation also diverges from management's optimism that seasonality-driven sign-ups - such as sports viewers - can ultimately become mainstays on the platform too if they could just engage with "one or two additional titles". Paramount+'s content disadvantage to peers is likely to challenge its ongoing efforts in creating a differentiated value proposition against intensifying competition, which could hamper management's intentions to drive ARPU growth for the platform through greater subscriber acquisition, especially in the domestic market.

Instead, further penetration into international regions such as Western Europe, Canada and Australia could drive more meaningful contributions toward Paramount+ ARPU growth. Despite heavy competition, entering into a new region is likely to be accretive for Paramount+'s global subscription growth, and less challenging than fighting for incremental share in the maturing domestic market.

Price Increase - Recall that Paramount+ had increased the price for its premium with Showtime package by $2 to $11.99 per month, and its Essential basic package by $1 to $5.99 per month earlier this year. And the platform has so far experienced a net benefit with lower-than-expected churn, which is corroborated by the outsized growth in DTC subscription revenue (+47% y/y; +10% q/q) relative to the nominal increase (+1% q/q) in net subscriber adds. Management expects Paramount+ ARPU in 2024 to benefit further form the full year impact of said price increases, and views this as a critical driver to the 20% growth target.

However, we are wary of the tough y/y set-up heading into the new year, which could net out the price increase benefit in 1H24. Specifically, the price increases were announced in February and implemented in late June when the newly introduced Paramount+ with Showtime bundle went online. The favourable impact on revenue observed in Q2 is expected to last through 2H23, especially with the upcoming fall sports season and new episodes on popular titles encouraging new sign-ups.

But considering the lapping headwinds going into the second half of next year, maintaining ARPU growth of 20% for full year 2024 would rely heavily on ad revenues (discussed further in later sections), and become a more difficult endeavour. This is in line with relatively modest ARPU expansion trends observed at peers like Max, Disney+ and Netflix, which have all increased prices in recent quarters. Specifically, DTC streaming leader Netflix has warned of flat to slight declines in its average price per member ("ARM") heading into Q3, as it expects a tougher PY comp set-up from lapping price increase tailwinds in early 2022.

Introducing New Tiers - Management regards the continued rollout of new Paramount+ tiers - such as the recent Paramount+ with Showtime offering - as key to attracting new subscribers, especially in higher-ARPU international markets. We think the addition of new tiers might be the best of the three strategies in maintaining ARPU expansion for Paramount+.

Specifically, expanding availability of ad-supported Paramount+ to more international regions could extend the platform's reach, and improve its appeal to ad dollars needed to make up for the lower ARPU subscriptions. Paramount's diverse portfolio of content - spanning sports to scripted and unscripted titles - would also aid the introduction of new tiers critical to maintaining market share and expanding ARPU over the longer-term. This would enable the platform to better address different consumer preferences, while also being able to better price discriminate and drive improved operating economics for Paramount+ over the longer-term. And we already see this benefit happening in the newly introduced Paramount+ and Showtime bundle, which has garnered a 40% higher content consumption rate relative to the Essential package. This highlights the new tier's value proposition to certain customers, while allowing Paramount+ to better monetize from this cohort.

Doubling Down on DTC Advertising

The second strategy to improving DTC economics is by capitalizing on growing AVOD opportunities. Digital advertising currently accounts for more than two-thirds of global ad spending. And AVOD platforms are poised to benefit from the transition away from linear ad spending as viewers in "the 18-49 segment [move] online". In addition to being a replacement for linear TV ad formats over the longer-term, Paramount also views DTC streaming as a viable alternative to ad dollars previously limited to digital formats such as "social media and short-form video advertising". However, we remain conservative about Paramount's prospects in disrupting social media and short-form video ad formats with its DTC platforms. Specifically, the company's DTC platforms such as Paramount+ still has a far lower audience reach relative to social media and short-form video advertising giants in the industry. It also lacks the proprietary targeting technologies that the social media and short-form video ad giants have built their success on.

But DTC ad growth remains a critical driver for ARPU expansion at Paramount+, nonetheless. Based on recent industry checks, more than a fifth of streaming users "prefer ads to subscriptions on an absolute basis", with more than half of the cohort citing pricing sensitivity for their choice. Age plays a larger role in determining ad tolerance, with users above the age of 44 "more willing to choose ads". The appeal of AVOD platforms to consumers is further corroborated by robust take-rates observed at peers like WBD, which had previously indicated that about half of its subscribers are hooked on the ad-supported tier.

While most of Paramount's rivals, including Paramount itself, does not disclose the breakdown of subscribers by tier, recent industry observations of ARPU for ad-supported subscriptions surpassing that of ad-free subscriptions also suggest strong consumer take-rates for AVOD. We see DTC ad demand and ad-supported subscriptions as complementary - without robust consumer demand for ad-supported tiers, there simply isn't sufficient reach to incentivize DTC ad demand; hence, strong AVOD ARPU expansion is a key gauge for consumer reception on AVOD offerings, in our opinion.

However, competition is another fierce headwind for Paramount as it looks to better capitalize on streaming ad opportunities, which is critical to the economics of its DTC segment. While AVOD ad sales are expected to increase by more than 11% this year, outpacing the broader ad industry's recovery, the ensuing impact for streaming platform operators is likely to be much more tempered. This is due to the increasing injection of new ad inventory as a result of continued expansion of ad-supported tiers launched by Paramount and its peers in recent quarters, which will weigh on placement prices and temper the impact of resulting ad revenue contributions to DTC ARPU.

While Paramount+'s lower audience reach relative to its rivals will inadvertently dampens some of the platform's appeal to advertisers, we view the company's EyeQ digital advertising format as a key differentiator amid growing industry competition. Specifically, by simplifying the process in ad deployment and ensuring adequate reach to Paramount's audience base, EyeQ effectively improves important performance metrics, such as return on ad spend and cost per mille, for advertisers. This is especially critical for advertisers given the inherently macro-sensitive industry, which incentivizes them to better optimize every ad dollar spent.

Taken together, Paramount is well-positioned to benefit from DTC ad sales growth on the back of longer-term secular tailwinds. However, the combination of intensifying competition and ballooning AVOD ad placement inventory, paired with Paramount+'s disadvantage in having a weaker subscriber base could potentially temper the impact on ARPU expansion. This is another execution risk factor that could derail management's financial target for the DTC segment next year.

Improving Operating Leverage and Unlocking New Synergies

The significant reduction of DTC losses that management intends to achieve next year will also be driven by the ongoing practice of disciplined spend management - including measured content investments and marketing spend. The company is also seeking to improve operating leverage by restructuring existing assets to drive greater synergies.

And an example of this is the recent rollout of Paramount+ with Showtime, which expands content availability to consumers under an ad-free format while also commanding a greater subscription premium to drive improvements in DTC economics. This is similar to the recent rebrand of WBD's Max offering earlier this year, which combines the platform's predecessor, HBO Max, with additional content from discovery+. By consolidating assets, media and entertainment giants are looking to better manage the economics of a capital-intensive transition from linear TV to streaming. This is corroborated by cost synergies that Paramount expects to realize with the combination of Paramount+ with Showtime - this includes a reduction in the ratio of "services content expense relative to Paramount+ revenue" by optimizing the joint programming strategy. The combined platform is also expected to consolidate marketing spend and help the broader DTC segment realize better margins over the longer-term.

In addition to the integration of Showtime into Paramount+, the company is also looking to leverage its sports advantage to drive better overall economics for the DTC segment. Specifically, Paramount owns some of the most highly coveted sports broadcasting and streaming rights in the industry, including Big 10, March Madness, PGA, UEFA and NFL. This has allowed it to integrate certain live sporting events into Paramount+, which has been a key to driving subscription and ARPU growth (though most remain seasonal as discussed in the earlier section).

With sports being one of the only critical links left in holding linear TV demand together, many players within the broader media and entertainment industry are starting to recognize the tremendous value of integrating sports into streaming. This is in line with WBD's recent confirmation that it will be introducing a new Max tier with live sports streaming within the foreseeable future to better monetize on its coverage of the NHL and NBA games, among other events. We also see resilience and pent-up opportunities for Disney's ESPN network and ESPN+ streaming platform. We believe Paramount's competitive portfolio of sports streaming and broadcasting rights will not only be favourable to improving growth at Paramount+, but also effective in enabling increased operating leverage for the broader DTC segment by consolidating costs and realizing their joint marketing synergies.

The Bottom Line

Of the three strategies analyzed, we view the internal restructuring of different platform assets to unlock new synergies, alongside the additional implementation of cost-saving initiatives, will make a more meaningful impact on DTC margin expansion over the near-term. While ARPU expansion realized through the recent price increase, alongside ongoing efforts in driving DTC subscription and advertising growth are steps in the right direction in improving the segment's economics, rapidly evolving competitive dynamics and consumer preferences in the market could potentially thwart management's aggressive target.

Specifically, by eyeing 20% ARPU expansion in 2024, we don't think Paramount has sufficiently de-risked for the concoction of competitive, macroeconomic, and company-specific challenges it faces. This could potentially dull the market's reception of any favourable progress that falls short of the target, and unlock further volatility in the stock's near-term performance.

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