Interview

«Everything in the Way We Watch Television Is Going to Change»

Michael Pachter, veteran tech analyst at Wedbush Securities, talks about the latest trends in the streaming sector, Netflix's difficult balancing act and the fundamental upheaval in Hollywood caused by the market entry of tech giants like Amazon and Apple.

Christoph Gisiger
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Michael Pachter, veteran tech analyst at Wedbush Securities, speaks about the latest developments in the streaming sector, Netflix's prospects and the fundamental upheaval in Hollywood caused by the market entry of tech giants like Amazon and Apple.

The tensions are clearly noticeable. On Tuesday evening, the S&P 500 closed weaker again. It’s now already 27 trading days since U.S. stocks made their last all-time high.

One of the few exceptions that has been able to escape the downward trend in recent weeks is Netflix. The streaming pioneer from Silicon Valley is currently generating a lot of buzz with the success of the Korean TV show «Squid Game».

Since the low of mid-August, the shares have surged more than 22% and are hovering just below last week's all-time high. A decisive driver for the next direction of the stock is expected next Tuesday after the market close, when Netflix presents its quarterly earnings results.

The Market/NZZ therefore talked to Michael Pachter. The industry veteran works at Wedbush Securities in Los Angeles and is one of the most respected analysts in the Internet and entertainment sector. On Wall Street, he is known for being one of the rare Netflix bears.

In this in-depth interview, which has been edited and condensed for clarity, Mr. Pachter speaks about the latest trends in the streaming sector, Netflix's difficult balancing act and the fundamental upheaval in Hollywood caused by the market entry of tech giants like Amazon and Apple. He also tells which stocks promise the most potential.

Mr. Pachter, the pandemic has changed many things in Hollywood. Because movie theaters were closed in many places, the major film studios released their productions directly on streaming services such as Disney+, HBO Max or Amazon's Prime Video. What's the industry going to do now?

When it makes more sense economically to release a movie in theatres only, the studios will do that. At the end of last year, AT&T panicked. Yet, their mistake wasn’t releasing new movies day-to-day on HBO Max, but committing to that for an entire year. Starting on January 1st, they won’t do that anymore. Disney already announced that all of their films will have a minimum run of 45 days in theaters before streaming. The real test case was probably the release of «Black Widow» on Disney+ which was the most pirated movie in history. Disney learned that lesson on a premium video-on-demand movie for $30: The minute a movie hits a streaming service, copies are available on myriad websites because it’s very easy to copy. So I guess everybody goes back to normal.

So are retail investors right to speculate on meme stocks like AMC?

AMC doesn’t make sense. The guys who bought the stock up don’t actually know what the company can earn. It’s trading at a close to $20 billion, but AMC doesn't generate enough cash to be traded at that level. They would need to make about $2 billion EBITDA a year, and in 2023 they might make $1 billion if they’re truly lucky. But it doesn’t matter: Stocks like GameStop and AMC trade at such high values because they were heavily shorted. The guys who were buying them think that the shorts will keep coming back and they can squeeze them out of their positions - and so far, they have been right.

Can this game really go on forever?

Eventually, the shorts will just think that this isn’t worth it. I mean, that’s really the reason Netflix has gone up so high: The shorts have gone out of the way. If people were short Netflix at $200, they definitely don’t think its stock is worth more than $600. But they let it go. It’s like Tesla. Tesla was a short at $200, so why wouldn’t it be a short at $800? At some point, the shorts just decided that they are not going to fight the tape, so they let it go.

Netflix even reached a new record high of $639.10 last week, although the stock markets are generally weaker.

Which is really dumb because competition is getting worse, not better. There will be further consolidation among entertainment companies, and that suggests that less content will be available to Netflix going forward. I understand the theory that everybody is going to stream all their content all the time, and that we’re all going to stop subscribing to cable TV. The same theory is that we are all going to drive electric cars which I also believe. But here’s the question: With established car companies like General Motors, Toyota or Porsche, why am I going to buy a Tesla? These companies ultimately make perfect cars. There is no way Tesla can win. I feel the same way about Netflix: If we stop subscribing to cable, what are we going to watch? We are going to watch content, not service. It’s whoever has the best content; and that’s names like Disney and Warner Bros, not Netflix. To me, it’s so naive that you reward a distributor of other people’s content. That makes no sense at all.

Then again, Netflix was perceived as the big winner at this year’s Emmy Awards.

But look closely at what they won: It’s mostly technical Emmys, they barely won any on the creative side. It was basically the same three shows that won everything. For example, «The Queen’s Gambit» won eleven Emmys. Walter Tevis, the guy who wrote it, also wrote the 1961 movie «The Hustler» with Paul Newman and «The Color of Money» with Tom Cruise and Paul Newman. Then he published «The Queen’s Gambit» in 1983 and died one year later. So is there a sequel coming to «The Queen’s Gambit»? Netflix will try, but it won’t be very good. So who cares?

But with «Squid Game,» Netflix has just landed another big hit.

Most people say it’s really a weird show. The fact that it’s number one is only because Netflix promotes it so heavily. You can’t log on to Netflix without running into it. Last month, it was «Clickbait», and the month before they had another show. It was «Tiger King» last year for a time. In a month, we won’t be talking about «Squid Game» anymore. The point is: We will be talking about a show like «Ted Lasso» because we want season three, and then we will be talking about «Ted Lasso» season four next year. I think people genuinely like that show because it’s a genuinely good show. That’s why it won the Emmy award for Outstanding Comedy Series. Do you think «Squid Game» is going to win anything?

With «Ted Lasso,» Apple's new streaming service has achieved its first significant popular success. What does it mean for the industry when tech companies like Apple and Amazon make inroads into Hollywood?

Everybody is going to outspend Netflix. Netflix’ problem now is that they just have way too much to keep going. They have to re-create everything every year. In other words: If they went from ten good shows to fifty to hundred, they would have to make a hundred shows next year. They’re costs are never going down, but people don’t get that.

Last year, however, Netflix generated positive free cash flow. In July, Red Hastings also confirmed that his company would not have to take on any more debt to finance its day-to-day business.

Yes, but they didn’t spend any money during Covid. They got lucky and licensed a lot of content. That’s why «Squid Game» is here: They couldn’t make shows in the US but in Korea where they had super low infections. So Netflix got lucky because they didn’t have to spend any money and subscribers didn’t quit. Their cash flow is fine for a year, but they’re not going to keep every subscriber forever. At $280 billion, the valuation makes no sense at all. But analysts are not very honorable. Whatever the share price is, if they have a «Buy» rating on the stock, it has to be 20% higher.

What does this mean for Netflix in the medium to long term?

Netflix faces a difficult balancing act. The company is at a stage in its business lifecycle where it should be in the position to dramatically improve profitability. So burning cash at this level is unsustainable. Basically, Netflix is faced with a choice of being a fast growing, cash burning enterprise or a slow growing, immensely profitable enterprise. I think it will choose the latter path, and my price target of $342 is based on a more realistic valuation of the enterprise as a slow growth company. It’s the same thing with Tesla: People think Tesla is going to be immensely profitable and sell 100% of the cars in the world. But you can’t do both. If you want to sell 100% of the cars, you have to give them away. That’s the only way. And the only way Netflix can get all the eyeballs is that they have all the content, but they are never going to get all the content.

However, so far Wall Street seems to disagree.

Here’s what investors are missing: Only people above medium income can afford three or four streaming services, and if you cut the cord, you can afford five or six. So the reason you are going to see Netflix’ growth slow and stay slow is that they are already the first service everybody subscribes to. The next ones are Disney+, Hulu, Amazon and HBO Max. Even Disney just told us their growth is slowing. And, if Disney’s growth is slowing, Netflix has to be really slow. Therefore, I expect that they are going to miss this quarter. They guided to a low number of new subscribers, but I expect it’s going to be a really low number.

Now Netflix is entering the video game market. What do you think of this strategy?

That’s actually smart, but I don’t think they are going to get into gaming quickly because it’s hard. Amazon has been trying for years, and they just finally launched a game that’s doing ok. I’m sure Mike Verdu, the video-game executive Netflix hired, is fine, but the studio they just bought is tiny. They’ve never had a big hit, so they’re not going to make a big hit for Netflix. If Netflix is really serious about gaming, they would either buy a gaming company or something like Warner Bros. Interactive Entertainment.

Who do you think has the best chance in the streaming wars?

No one is talking about this, but the guy you should watch is Amazon. They have a product called IMDbTV, a free ad-supported streaming service. They don’t have much content, so Amazon is buying MGM. A lot of people think they’re buying MGM because they want it to produce movies for Amazon Prime and for the James Bond franchise which is actually controlled by the Broccoli family. But MGM has 4000 movies and 17’000 hours of TV shows in its library. So as soon as that deal closes, Amazon can take IMDbTV and make it a big deal: offer it on every Roku System, on every original equipment TV maker, and pay to have it promoted.

And how does that fit in with Amazon's overall strategy?

The interesting thing is that they can advertise Amazon on IMDbTV. The service already sells ads, but going forward they can advertise things like Amazon’s product of the month. Also, every third or fourth ad can say: «Are you tired of ads? Sign up for Amazon Prime and we will give you all this content for free.» Today, there are about 200 million households with Amazon Prime, and there are about 1.5 to 2 billion households on the planet. That means they only have 15% of them, and they want 80%. Sure, a lot of people are poor, but a lot of people aren’t. There are at least 700 million households that aren’t poor, and Amazon wants them all.

What role does technology play here?

Here’s an idea: If you have a special TV remote control and a screen that has a meta tag built in, then whatever you’re pointing at with your remote will show up on your phone. For instance, if you point at an Alienware PC in the show «24», it will pop right up on your Amazon app. So Amazon can meta tag anything in any shown on IMDbTV, and instantly you have the ability to click and buy it. What’s more, they can sell space in their shows for product placement without worrying about whether people are recognizing a brand or not. That’s a huge competitive advantage. That’s why I expect that we are going to see Amazon do that - and when they do, everything in the way we watch television and how we consume programming is going to change.

Is this what the brave new world of the entertainment industry looks like?

I actually think the future of streaming TV is ad supported streaming. With Netflix at 200 million subscribers, just about everybody who wants to pay for streaming already does. Sure, there is room for maybe another 100 million, but they’re not going to get 500 million more. There are 1.5 billion households who watch television globally. As long as they all have internet, and at least 1 billion of them do, why aren't they going to watch ad supported streaming TV? Streaming supported by ads and not by subscription fees is the way to expand the market. That’s the next big frontier, and Amazon owns it.

But isn't that basically the same approach as traditional cable television?

Yes, but here’s the difference: When you’re watching MSNBC on cable TV, the advertisers conclude you probably must be over 50, so they will do a bunch of pharmaceutical ads for you. I watch MSNBC, and they advertise drugs for Arthritis, Aids and Women contraception. But it’s not that one person needs all that stuff. They’re still segmenting the audience into little niches, and each commercial might appeal to only 5% of the audience. But Amazon knows exactly what you ordered, what your purchase behavior is. So the ads can be specifically targeted at the person based on that data.

What does all this mean for investors?

I think that you are going to get a merging of big tech, streaming and advertising. Facebook worked for the last ten years because fewer and fewer people watch commercial broadcast television and switch to streaming. So advertisers had to find a place to spend those dollars, and Facebook gave them that place. As Facebook and Google worked, advertisers thought that they needed to branch out and advertise on Twitter, Snapchat or TikTok, and that worked. Now, they’re looking at video games, and they’re also finally figuring out advertising with video on demand. So if you watch advertisers, you have a better feel for where eyeballs are going than anything.

Why are videogames interesting for advertising?

We know that free-to-play games work. People don’t want to pay $60 for a game without knowing if they like it. But they might spend $1000 once they’ve tried it. The market for $60 games peaked at $22 billion in 2011. Today, the free-to-play market is over $100 billion by itself. How is that possible? Because they’ve expanded the market to everybody. The only cost of playing a free-to-play game is having a phone or a PC. The same is going to happen with television: You have to deliver for everybody for free. And the way you are going to make the money is advertising-based video on demand. That’s really the future of advertising and the future of streaming: everybody has to have access to it.

Which stocks promise the most potential against that background?

I like Amazon, because they have a finger in all of that. I don’t cover social media companies anymore, but they will do ok. But the video game companies are going to kill it. Right now, they’re the only entertainment medium that gives their content away, but they shouldn't. Anybody with mobile gaming revenue should be advertising. For instance, Zynga is going to get close to 25% of their revenue from ads, for Activision it’s under 20% but over 15%, and for EA it’s 10%. So they all have room to go up a lot. That’s why I think the game companies are the best opportunity.

How can you imagine advertising in videogames in concrete terms?

A couple of years ago, Fortnite had a Tom Brady New England Patriots jersey available as a skin in the game. I don’t remember how many they’ve sold, but it was a lot. They paid the Patriots for the rights to that jersey, and they probably paid Tom Brady, too. And, they made money on the jersey. So why don’t they have Nike shoes in there, for example? They could tell Nike to create shoes in Fortnite and everybody can customize them: It’s $1 for a pair of white sneakers, and one extra dollar to customize them, for example make purple shoes with pink stripes. How many people do you think would customize them? All of them! In that case, Epic Games can say to Nike: «We only collect 12% of that revenue, you can have 88%.» Or how about customers paying for a new pair of Nikes and getting those shoes in the Fortnite game? So if you bought them you can show off that you actually have them in real life. How fun would that be? That’s why I think the video games business is really just on the verge of exploding and being giant.

Michael Pachter

Michael Pachter is an equity research analyst at Wedbush Securities, providing coverage of the Entertainment Software, Entertainment Retail, Social Internet, E-Commerce, and Movies & Entertainment sectors for the last 20 years. He also hosts one of the most significant and highly-regarded industry events during the annual E3 conference. He's also hosting an internet TV show called «Pachter Factor» about video games. Previously, Mr. Pachter spent two years as the Director of Research at Wedbush Securities. Before joining Wedbush Securities, he served as the Director at Management Resource Center, a middle-market investment bank. Before that, Mr. Pachter spent 15 years in various financial and management positions at Atlantic Richfield Company, most recently as Director of Strategic Planning. He has been recognized as StarMine’s Top Earnings Estimator year after year and Best on the Street by the Wall Street Journal. Mr. Pachter holds an M.B.A. from the Anderson School at the University of California at Los Angeles, a Juris Doctor from Pepperdine University, an LL.M. in Taxation from the University of Florida, and a bachelor’s in Political Science.
Michael Pachter is an equity research analyst at Wedbush Securities, providing coverage of the Entertainment Software, Entertainment Retail, Social Internet, E-Commerce, and Movies & Entertainment sectors for the last 20 years. He also hosts one of the most significant and highly-regarded industry events during the annual E3 conference. He's also hosting an internet TV show called «Pachter Factor» about video games. Previously, Mr. Pachter spent two years as the Director of Research at Wedbush Securities. Before joining Wedbush Securities, he served as the Director at Management Resource Center, a middle-market investment bank. Before that, Mr. Pachter spent 15 years in various financial and management positions at Atlantic Richfield Company, most recently as Director of Strategic Planning. He has been recognized as StarMine’s Top Earnings Estimator year after year and Best on the Street by the Wall Street Journal. Mr. Pachter holds an M.B.A. from the Anderson School at the University of California at Los Angeles, a Juris Doctor from Pepperdine University, an LL.M. in Taxation from the University of Florida, and a bachelor’s in Political Science.