Introduction

The Streaming Video on Demand (SVOD) industry is at an inflection point. Netflix’s recent third quarter earnings report was the last one the company will give before a handful of new video streaming offerings hit the market competing for a slice of your time. The list of new entrants includes Apple with its SVOD service TV+ launching November 1.

It’s clear that Apple is focused on growing services revenue and it’s generally accepted that this is the proper strategic imperative. What isn’t obvious, however, is what strategy Apple should employ to achieve this objective. To date, Apple’s significant app launches in services have been in one of two categories — content (Music, News+, TV+) and financial technology (Apple Pay, Cash, and Card). Given the pending release of TV+, the scope of discussion will be limited to SVOD (a content subsector) and fintech (a financial services subsector). The remainder of this report will do the following:

1) provide context for Apple’s focus on services,

2) evaluate the relative attractiveness of SVOD and fintech by analyzing the market dynamics of each through charts and key insights, and

3) address the question of how Apple should deploy its capital by examining the opportunity cost of entering video streaming.

Context: With revenue stagnant, Apple is looking to services for a boost

Services are the next secular growth story for Apple. Against the backdrop of slowing iPhone sales, CEO Tim Cook directed the focus away from hardware on the third quarter earnings report, leading with “This was our biggest June quarter ever — driven by all-time record revenue from services.”

Third quarter total revenue was up marginally year-over-year and declined year-to-date. However, Apple’s future holds promise when taking a long-term view; hence the earnings report focus on services. While the “Wearables, Home, and Accessories” product category saw almost a 50 percent increase, services represent a higher leverage point because they layer an economy on top of Apple’s substantial base of iPhone users. At the same time, a robust services lineup makes the hardware stickier — it incentivizes current customers to keep their iPhones or to upgrade to the latest model while also potentially luring Android customers into the fold.

Growing revenue by layering services is a narrative that Apple has developed for some time and it recently added another layer. In March of this year, Apple held a press event focused on its services business during which the company announced the upcoming launch of its new video streaming service, Apple TV+. The service will be available worldwide on November 1 for $4.99 per month. Additionally, a 12-month free trial is offered with the purchase of a new Apple device. From a feature standpoint, Apple is attempting to differentiate its offering by serving up a highly curated slate of celebrity-driven originals.

Apple’s go-to-market strategy is to offer TV+ as a loss leader. Investopedia defines a loss leader as “a product or service that is offered at a price that is not profitable, but it is sold to attract new customers or to sell additional products and services to those customers. A loss leader introduces new customers to a service or product in the hope of building a customer base and securing future recurring revenue.” In Apple’s case, the objectives are 1) to drive adoption of its new products through the free trial, 2) to convert free trial users to paid subscribers at the end of the free trial, and 3) to add an additional value point to make buying into and staying within the Apple ecosystem more compelling. The characteristics of the SVOD industry, however, make achieving these objectives challenging at best.

SVOD is a highly capital intensive industry with deteriorating unit economics

The phrase “capital intensive industry” is often used to refer to industries like automobile manufacturing, oil production and refining, steel production, telecommunications, transportation sectors like airlines and railways, and mining. These industries all require a large capital investment to start the business and run it well. Although ratio analysis makes it obvious, Streaming Video on Demand (SVOD) is not considered a capital intensive industry — try searching “streaming capital intensive” and see what Google returns. This is partly because content is not categorized as PP&E and is amortized rather than depreciated. Nevertheless, content acquisition inflates the asset base. This point is illustrated by comparing Netflix (the dominant player in SVOD) to the mining industry (one of the most capital intensive).

One way to gauge the capital intensity of a company or industry is to calculate the dollar value of assets needed to produce a dollar of sales — this is called the Capital Intensity Ratio. As Netflix pivoted its focus to streaming in 2011, its capital intensity doubled, requiring nearly $1 of assets to produce $1 of sales. Since then, this ratio has ballooned to $1.64 of assets for every dollar of sales, surpassing mining.

Capital intensity notwithstanding, the unit economics in the SVOD industry are deteriorating at a rapid rate. On an absolute basis, Netflix’s overall net subscriber acquisition cost is projected to nearly triple over the five year period since 2017 and total marketing spend is projected to more than double over the same period. These are substantial increases, which beg the question what is Netflix getting in return. The answer becomes clear when breaking out domestic and international markets and analyzing acquisition cost per paid net additions as well as marketing return on investment.

Domestic acquisition cost per new subscriber will more than double this year to $68. Given Netflix’s expected monthly ASP, it will take over five months to break even on the cost. Customer acquisition cost is the attempt to isolate the cost of the customer journey through the purchase funnel (point of conversion to a paid user), but let’s also look at total marketing spend — the cost of conversion plus the ongoing cost of content discovery and retention. To do this, I’ll evaluate Customer Lifetime Value (CLV) — the total monthly ASP over the lifespan of a customer discounted to the present — relative to total marketing spend to get a measure of marketing return on investment.

Domestic market Customer Lifetime Value (CLV) could reach $450 by 2021, while marketing return on investment is projected to drop to 34 percent over the same period due to a near doubling of marketing expense from 2018 levels. To calculate CLV, I assume an average subscription length of 36 months. “The average length of subscription among all broadband households is just over 30 months…. The industry average for all services except Netflix is just over 21 months” according to a report by FierceCable. I assume that there’s downward bias on the average OTT subscription lifespan statistic because some new entrants hadn’t been around for 21 months at the time of the study. Also, even though Netflix no longer reports its churn rate, a 2015 report from Parks Associates put Netflix at the low end of the OTT video market noting that roughly 4 percent of US broadband homes cancelled their Netflix subscription over the trailing-twelve-month (TTM) period, representing about 9 percent of Netflix’s subscriber base. Amazon was around 25 percent churn and Hulu came in at 50 percent. Accounting for these two factors, I extended the life of a Netflix subscriber to three years. However, if there is some mean reversion in Netflix’s churn numbers relative to its peers going forward, it will further lower CLV and in turn marketing ROI. For perspective, if the average length of a Netflix subscription were to shorten to 24 months, marketing ROI would drop to zero in 2020 and turn negative thereafter based on JPMorgan analyst estimates of monthly ASP and marketing expense.

Similar to the domestic market, international customer acquisition cost is projected to rise substantially. Nevertheless, the cost is recouped within just the first month of the new subscriber’s lifetime. While the trend is still toward higher cost, it’s clear why Netflix’s primary objective is expansion into relatively less competitive and less saturated territory abroad.

Even though international CLV is around $100 lower than domestic CLV each year, the return on marketing spend is far superior to the domestic market; ROI will almost halve by 2021 and it’s still a great return. The story is not all negative — there are attractive opportunities with respect to international over the near term. However, the overall trend in both domestic and international SVOD markets is deteriorating unit economics as evidenced by increasing time to breakeven per new subscriber and decreasing total marketing ROI over the forecast period.

The outlook for SVOD is a fragmented zero-sum battle ground headed toward painful consolidation

Current competition (Amazon, Hulu, Netflix) notwithstanding, a host of streaming services will launch late this year and early next year alongside Apple TV+ including HBO Max, Disney+, and Peacock (from NBCU). With Netflix already having over 50 percent market share of US broadband households and there being a low ceiling on the number of services to which consumers will subscribe, this will be a zero-sum game in the domestic market. Taking pricing will be challenging, if not impossible going forward.

The share of US households streaming at least one SVOD service has increased dramatically over the past decade and more modestly over the past several years. According to Deloitte’s 12th annual digital media trends survey, the percent of US household subscriptions to a paid SVOD service grew from just 10 percent in 2009 to 55 percent in 2017, a 450 percent increase. The four years through 2018, however, saw a 28 percent increase from 46 to 59 percent penetration, resulting in a compound annual growth rate (CAGR) of 9.5 percent increase in the number of streaming households.

With growth of US streaming households slowing to below single digits and projected to slow further in the coming years, double-digit growth is hard won. Moreover, the top three services are gaining at the expense of other SVOD players but are also benefiting from the trend in consumer bundling. Of SVOD customers who only subscribe to one service, around 40 percent choose Netflix. The vast majority of Amazon and Hulu subscribers consider their services complementary or supplementary. Only 20 percent of Amazon Prime Video subs use it as their sole streaming service; this figure drops to 9 percent for Hulu according to Activate’s 2017 Tech & Media Outlook. Hulu on-demand and live TV benefited from being viewed as complementary and saw growth at a 30 percent CAGR over the four year period. Disney recently announced a $12.99 bundle for Disney+, Hulu, and ESPN+. This bundle will further cement Disney/Hulu as complementary with Netflix. Amazon, because of its similar proposition to Netflix — licensed content and originals — is supplementary. Despite having 100 million low hanging fruit (Prime Members) Amazon’s growth rate was about half of Hulu. Calculations show that the three market leaders’ growth is increasingly eating into “other” SVOD services, the whole of whom experienced negative growth over the period. With no licensed content or live TV, Apple TV+ will surely be a bolt-on subscription.

In a market where Netflix, Amazon, and Hulu have 78, 46, and 31 percent share of streaming households respectively, Apple TV+ will be vying for the third, or even fourth position in consumer bundles. Activate projected that 53 percent of US households would subscribe to at least two bundles in 2018. By 2020, the percentage will reach 62 percent, with 43 percent carrying two subscriptions and 19 percent subscribing to three or more. Given these numbers, Apple’s addressable market for paid SVOD subscriptions in the US is roughly 20 percent of streaming households next year. This works out to about 16 million households — not exactly a compelling market opportunity domestically. Nevertheless, Apple has international aspirations and a distribution platform substantial enough to support some optimism.

Amid ballooning content cost, increased fragmentation could have an overhang effect on the market and originals alone are an incomplete value proposition

Fragmented services not only deteriorate the customer experience, but reduce economies of scale, adding costs to the overall system — costs which are passed to the consumer. Moreover, the total subscription to join just Netflix, Disney/Hulu and Amazon can approach $40 per month depending on subscription level (on top of users’ broadband or mobile bills). On the one hand, this leaves a relatively narrow margin for Apple to convince cord cutters — the most price sensitive segment of the market — of its value proposition. On the other hand, according to a recent Deloitte survey, “43 percent of US households now subscribe to both pay TV and video streaming services” — for these customers it’s easier to cancel a streaming service than it is to part with traditional TV for live news, sports and TV shows.

The myriad SVOD offerings are reminding customers that bundling is still the most efficient means to access content even if they want the bundle to be reimagined. Deloitte found that,

…nearly one-half (47 percent) [of consumers] are frustrated by the growing number of subscriptions and services they need to piece together to watch what they want. Forty-eight percent say it’s harder to find the content they want to watch when it is spread across multiple services. And even a major benefit of having multiple subscriptions — lots of great shows and movies — can be frustrating because consumers have difficulty discovering them.

If not consolidated in a smart way, fragmentation could slow the secular trend of cord cutting and supplementation, hurting all video streaming companies.

Meanwhile, the entrance of numerous players into the SVOD market is creating a content bubble. The nature of competition is such that everyone is bidding (and overbidding) for original programming — the idea being that exclusive content is king because it helps create an economic moat. Nevertheless, while original content is necessary, it is not sufficient. Gaining and/or retaining subscribers still requires access to a legacy media library.

Consider Netflix — Content Chief Ted Sarandos announced last year that around 85 percent of new content spending would be going toward original TV shows, films, and other productions. The problem is that while Netflix has had outstanding success in original content, this success has not decreased the company’s reliance on licensed content. 2/3rd of viewing hours on Netflix still come from licensed content. The reason Netflix is pursuing originals so aggressively is to compensate for the vulnerabilities in its business model. Licensed content is expensive and subject to vindictive price hikes and contract terminations by media companies. The threat from competition is uniquely significant in the SVOD industry because not only is there competition in the traditional sense (increasing alternatives which will ultimately pressure margins), but many of the competitors are incumbent media companies that can fundamentally weaken Netflix’s offering by pulling their content (WarnerMedia pulled Friends, NBCU pulled The Office, Disney pulled content…). To be sure, any upstart in the video streaming space that is not partnered with an incumbent media company will face these same issues, even Apple.

The dual dynamic of slowing domestic addressable market growth and increased competition from new entrants — both upstarts and media incumbents — is creating a content bubble to which even Apple (usually prudent) is not immune. Apple’s budget this year was slated to come in at $1 billion; it ended up being six times that amount… and entirely spent on originals.

While banking solely on originals for its SVOD service, Apple is more diversified in its fintech approach.

An overview of Apple’s current fintech portfolio: Apple Pay, Apple Cash, Apple Card

The enormous potential to disrupt the financial services industry is not lost on Apple. The company has been beefing up the offerings either connected to or inside its digital wallet, touting ease of use and security. So far, Apple has launched three products:

  • Apple Pay. Apple Pay makes digital payments with your iPhone and other Apple devices possible. Once you load your debit and credit cards onto the pre-installed Wallet app, you can make payments online and at retail locations by swiping your iPhone over the Near Field Communication (NFC) terminal. NFC is the technology that allows two devices — like your phone and a payments terminal — to talk to each other when they’re close together. NFC is the technology that enables contactless payments. In January of this year, Apple released that 74 of the top 100 merchants and 65 percent of all retail locations in the US support Apple Pay.
  • Business Model. Card issuers charge retailers around 2 percent for processing payments; these are called interchange fees. Apple leverages access to its user base to extract concessions from card issuing banks (in the form of sharing interchange fees) to participate on Apple Pay. Digital Transactions uncovered a copy of Apple’s original contracts with banks and credit unions in 2014. For credit card transactions, participating issuers would have to pay Apple 15 basis points of the transaction amount. For debit cards, Apple’s share is half a penny for each transaction.
  • Apple Cash. Apple Cash is like Venmo — you can send, receive, and request money from others. The main differentiator is you can do it through iMessage or by calling up virtual assistant Siri. The catch is the sender and recipient both need to have Apple Pay Cash to send money back and forth.
  • Business Model. There’s not much direct monetization around Apple Cash. There’s no fee to send, receive or request money using Apple Cash with normal delivery. For instant transfer, Apple charges a transaction fee of 1 percent of the transferred amount, subject to certain minimums and maximums. The primary purpose of the Cash app is to add to the digital Wallet feature set.
  • Apple Card. Apple Card is the newest app that lives in Apple’s digital wallet. Apple Card is significant because it changes the paradigm — the digital app is primary; the physical card is secondary. It also sheds light on how Apple would approach innovating on traditional banking products. The design ethos is “simplicity, transparency, and privacy”. There are no fees, cash back is available daily, the physical card is numberless, and security technologies like Face ID, Touch ID, and unique transaction codes are built in. It also has a map and budgeting feature that enable you to track where and how you’re spending.
  • Business Model. Similar to other credit cards, the revenue scheme is to collect interest income and interchange fees. The bigger picture, however, is boosting adoption of its other products and services. The relative importance of objectives with respect to Apple Card is evident from the incentive structure: 3 percent daily cash back on everything you buy from Apple and its partners (drives sales of more Apple products and services), 2 percent daily cash back on everything you buy with Apple Pay (drives new users and increases usage per user on Apple Pay), 1 percent on all purchases where you can’t use Apple Pay.

Apple currently prioritizes encouraging product sales through its services’ feature exclusivity over optimizing its services’ utility. One example is that Apple Cash can only send money between iPhone users. Another example is that Apple Card budgeting app doesn’t pull in transaction data from other cards in the Wallet app. If you’re budgeting, you don’t just want to see the transactions you’ve made with Apple Card, you want to see all your card transactions to get a full picture of your spending. Apple will have to balance the line between feature exclusivity and user experience in the future as it moves deeper into fintech.

With respect to features, Apple adding payments to iMessage is a page out of the WeChat playbook. It indicates that Apple is looking at China, and what China has shown is that payments can be made cheaply and easily without banks or credit cards. Extrapolating further, the horizontal integration of Chinese big tech across traditional banking products may soon come stateside.

Relative to SVOD, the fintech industry is bigger, growing faster, and has more advantageous market dynamics for Apple

According to a Citi Digital Disruption Report, the US fintech market will have surpassed $100 billion by 2020. It will double to $200 billion by 2023, at which point it will still only comprise 17 percent of total consumer banking revenue. More directly, $200 billion is only the beginning of a rapidly expanding market opportunity.

Meanwhile, Statista estimates the US SVOD market at $12 billion in 2020. It is projected to grow at a 1.4 percent CAGR over the following 3-year period, reaching $13 billion in 2023. In the US, over the next several years, the fintech market will have grown to 16 times the size of the SVOD market.

The international SVOD opportunity ex-US is more attractive. Subtracting domestic revenue from global results in a 12.6 percent CAGR over the 4-year period from 2019 with the global SVOD market ex-US projected to reach $56 billion by 2023 (still a quarter the size of US fintech, but a significant improvement). The following year, growth is projected to accelerate to 32 percent, with global SVOD ex-US reaching $74 billion in 2024. Combined with the fact that Apple has 1.4 billion devices in use around the world, strong international growth prospects are motivating Apple’s TV+ release in over 100 countries. Nevertheless, convincing users to include TV+ as one of their paid subscriptions will be a costly endeavor whether on an international or domestic front.

Lastly, when analyzing market dynamics more closely (see Industry Comparison Table), it’s evident that Apple benefits from competitive advantages in fintech that it does not in SVOD.

Fintech represents an opportunity to layer services on top of the iPhone user base but also to reach beyond

From a cost-benefit standpoint, there’s a relatively less expensive and more sustainable solution than SVOD for Apple to grow services revenue. Currently, wide disruption is happening across banking horizontals. Banking incumbents like Wells Fargo and JPMorgan Chase are facing competition across their marketplaces. From peer-to-peer lenders disintermediating the banks all together to robo-advisors offering wealth management services at lower cost and lower minimum account requirements than incumbents, fintech startups are either competing with or being integrated by the big banks. The long-term opportunity for Apple in fintech is orders of magnitude larger than SVOD and comparatively inexpensive. With respect to Apple’s current user base, there’s nothing stickier than access to capital. Superior financial solutions layered on the iPhone platform would substantially increase user switching cost. Additionally, acquiring innovative fintech startups represents an international growth opportunity beyond Apple’s iPhone base.

Apple has a substantial user base of 900 million iPhones in use worldwide and a dominant position within the US. Statista estimates that there are 266 million smartphone users in the US. With approximately 120 million domestic users, iPhone market share is around 45 percent.

This is important because a 100+ million user base is exactly the distribution platform that fintech startups need. Often, the big banks can copy and implement the technology of a startup before the startup can reach a critical mass of customers. As Alex Rampell, fintech lead at Andreessen Horowitz, frames it — the issue is whether fintech startups can get distribution before the incumbents get innovation. Apple’s base of iPhone users represents wider distribution than any bank. Empowering fintech startups to leverage this tremendous platform is a powerful strategy to layer relatively low cost, sustainable services revenue.

Big tech companies in China are horizontally integrated to a far greater extent than tech companies in the US. Their structure may provide some insight as to what the future of tech domestically will look like. While I listed some potential acquisition targets for Apple across banking horizontals, I will highlight Branch to illustrate the opportunity set.

Branch — a better model for establishing credit worthiness in a digital age

Overview

According to Statista, there are 3.3 billion smartphone users in the world today. The growth in emerging markets continues to outpace the overall smartphone market — emerging markets alone contribute to ~60% of global smartphone shipments. Most of these people will have access to a digital wallet/bank account, yet there’s no credit card or traditional infrastructure to build out a lending layer on top of that. Moreover, credit cards aren’t going to spread because there’s nowhere to swipe them (hard infrastructure) and no credit bureaus to report credit scores (soft infrastructure). As Branch CEO Matt Flannery puts it, “the credit card of the rest of the world will be an app”. Furthermore, there’s a huge opportunity to use credit to acquire a large user base and subsequently layer other product offerings on top (i.e. payments, remittances, etc). In fact, according to Flannery, Branch’s product roadmap is 1) acquire millions of users through fast credit, 2) become a money transmitter to connect users (e.g. Venmo), and 3) enable point-of-sale payment processing.

Branch is a digital bank for emerging markets that provides access to traditional lending and savings products. Branch makes loans up to $1,000 over a 1–12 month term. The team trains machine learning algorithms on smartphone data to perform the function of a credit bureau and lender at the same time. Basically, the predictive model learns from prior defaulters to make instant credit decisions and improve default rates over time. In terms of scale, Branch already makes 30,000 loans daily — more than Lending Club does in a quarter. Branch’s competitive advantage is that it has a better model for establishing credit worthiness in the digital age.

Flannery refers to Branch as a “full stack” lender. The company handles its own marketing, tech, and financing — it holds the loans on its balance sheet. Currently, Branch takes loans from hedge funds and uses the financing as wholesale debt, lending it out again. This is one example of where Apple could come in and add value. Apple has close to $100 billion in cash and marketable securities on its balance sheet. Financing Branch’s lending would return a higher rate on Apple’s cash while lowering Branch’s cost of capital.

There’s also a social component. Branch is a “do well by doing good” company. It profits by providing access to financial services to regions of the world that would otherwise not have access.

Business model key insight

The genius of Branch is that the team has trained the company’s models on micro lending ($1–2) over short repayment cycles (often same-day repayment). They’re able to build behavioral graphs across entire populations with very little financial risk from any specific default. Moreover, the volume default rate is around 15–20%, but the dollar weighted default rate is ~6% because larger loans are concentrated with lower risk repeat borrowers. The model improves as the volume of data it’s trained on increases, so each customer at this early stage of the business when Value-at-Risk per loan is low has more value to Branch as a data point than from the earned interest. The long game is that Branch is building a credit decision tool trained cheaply in emerging markets, but that can be scaled globally.

Expand into emerging markets beyond the iPhone user base

iOS is dominant in the US, but lags internationally. Especially with respect to emerging markets, iOS is a distant second to Android. This is primarily due to two factors. First, on the hardware side, Apple has rigidly refused to participate at the low end of the smartphone market where most EM customers are buying. Instead, it has committed to a profitability strategy of only selling iPhones into channels that return a healthy margin. Second, Android mobile OS is free for phone manufacturers and users. Manufacturers like Samsung can install Android on its phones at zero cost. iOS is not available to outside phone manufacturers at any cost. This open versus closed system approach has led to a huge disparity between Android and iOS in terms of emerging market penetration.

Android enjoys a dominant position across emerging markets with a median market share of 83 percent and a 2 percent median growth rate with a tightly clustered quartile distribution. In other words, Android has a stable monopoly in emerging markets. Acquiring app companies like Branch is a way for Apple to participate in emerging markets it has largely been locked out of.

Play in a supply-constrained marketplace with near zero acquisition cost instead of a demand-constrained marketplace with high acquisition cost

Due to the high adverse selection risk associated with emerging market lending, there is no shortage of customers, there’s a shortage of competitors. Hence, Branch has zero customer acquisition cost; when people hear they can get access to capital through an app, they want it. The central tests that Branch has passed are 1) whether there’s sufficient prediction value in its algorithms and 2) whether it can establish sufficiently strong relationships with its customers. Both competencies work together to translate into above threshold repayment rates. Because Branch has successfully navigated a market with high adverse selection risk, it opens up a vast set of expansion opportunities. It has overcome the main challenge in its business model by proving that its algorithm can learn to pick the right customers.

We’ve already established that SVOD is a market with high fixed cost (content acquisition) and rapidly increasing variable cost (customer acquisition). This is because video streaming is demand constrained — there are plenty service offerings, but not enough customers to support sustainable growth. Moreover, future growth will come largely at the expense of competing offerings. One caveat is that customers may increase the number of streaming services they are willing to subscribe to, which would expand the market.

Take advantage of post Financial Crisis negative sentiment toward banks

Since the 2008 Financial Crisis, banks have been out of favor with the public. In the US, from The Tea Party on the right to Occupy Wall Street on the left, anti-bank sentiment has spread and has sustained through to the populist movements on both sides of our current politics. Further, according to the World Economic Forum, more than half of the world’s population is under 30 right now. This bodes well for tech companies because millennials are 1) digital natives — the demographic that grew up with technology and views it most favorably and 2) battle scarred — having come of age during the crisis, they are the most anti-bank demographic.

In a recent Bain survey, 54 percent of respondents trust at least one tech company more than banks in general, and 29 percent trust at least one tech company more than their own primary bank. In the US, the proportion of respondents who trust at least one tech company more than banks in general is close to 50 percent. More specifically, a survey by cg42 found that Apple is in a two-way tie with PayPal for second place when it comes to the tech company people would most likely switch to if it offered banking services. First place was Amazon.

Long term, Apple is better positioned relative to the other big tech companies (Amazon, Facebook, and Google) to take fintech market share for three reasons. First, of the four big tech companies, it is the only integrated product-first company and the only one where monetizing user data isn’t the core of its business model. This is an advantage in a market like financial services where privacy-focused solutions are highly valued. Second, Apple is a closed system — its operating systems exclusively run on Apple hardware and are not available to third party device manufacturers. This approach could be valuable as demands from regulators as well as customers push the fintech industry toward higher standardization and security. Finally, Apple has a close relationship to its customers. It has over 270 retail locations in the US that could house customer support for its financial services. It’s also service-oriented in general, emphasizing rapid support for Apple Card through iMessage for example. Amazon, Facebook, and Google all have minimal interaction with their customers and therefore, do not have the deep experience in customer service that Apple has.

Be prepared for regulation updates paving the way for domestic OTT credit markets

Hampered by post-Financial Crisis regulation and legacy infrastructure, the banks have not innovated. This void has already paved the way for fintech startups and indeed, big tech. But there’s another wave of regulatory change on the horizon that will open the marketplace further. Over-the-top (OTT) credit apps will bypass the credit bureaus to make better, faster, and cheaper credit decisions for consumers. The main hurdle is 1970s era regulation governing credit practices that needs to be updated to handle advances in technology. Specifically, The Equal Credit Opportunity Act of 1974 (ECOA) must be rethought for lenders to use Artificial Intelligence (AI) and Machine Learning (ML) algorithms to make credit decisions in the US.

ECOA was established to prevent discriminatory lending practices like redlining — a term originating from the practice of government mortgage providers using the provision of mortgages to segregate neighborhoods by race. There are a series of protected classes under ECOA such as race, sex, and age, in addition to less obvious factors like whether the individual receives public assistance. ECOA is comprised of two standards: disparate treatment and disparate impact. Disparate treatment is simple. The Consumer Financial Protection Bureau (CFPB) states that “disparate treatment occurs when a creditor treats an applicant differently based on a prohibited basis such as race or national origin.” The second standard is more nuanced. CFPB states “disparate impact occurs when a creditor employs facially neutral policies or practices that have an adverse effect or impact on a member of a protected class unless it meets a legitimate business need that cannot reasonably be achieved by means that are less disparate in their impact.”

The disparate impact standard is where potential problems arise. An FDIC working paper titled “On the Rise of the FinTechs — Credit Scoring using Digital Footprints” showed that just five digital footprint variables could outperform the traditional credit score model in predicting who would pay back a loan. According to the Brookings Institute, “The five digital footprint variables are simple, available immediately, and at no cost to the lender, as opposed to say, pulling your credit score, which [is] the traditional method used to determine who [gets] a loan and at what rate”. The variables are:

  • Borrower type of computer (Mac or PC)
  • Type of device (phone, tablet, PC)
  • Time of day you applied for credit (borrowing at 3am is not a good sign)
  • Your email domain (Gmail is a better risk than Hotmail)
  • Is your name part of your email (names are a good sign)

This seems straight forward enough, however, each of the variables in the working paper is correlated with one or more protected classes. As Brookings points out, “it would probably be illegal for a bank to consider using any of these in the U.S, or if not clearly illegal, then certainly in a gray area.” For example, is it unethical for the algorithm to bias toward Mac users if it happens to be the case that a disproportionate percentage of Mac users are male? These are hard questions that will have to be worked out.

In the meantime, innovation in digital credit is happening outside of the US. Fintech startups like Branch can operate unencumbered by domestic regulations. This head start is important because ML algorithms must be “trained” for them to be effective at prediction. The model needs to know the outcome of each prediction (e.g. default or paid-in-full). The algorithm is then able to look at the predictions it got wrong, identify the similarities between the other wrong predictions as well as the differences between the group of incorrect predictions and the correct predictions. This allows it to adjust itself to make better future predictions. Even after regulatory updates, Apple will have to start from scratch training its credit decision algorithm. According to Finder, average personal loan size in the US is around $8,000, so training data won’t be cheap. By acquiring Branch, Apple would gain a trained algorithm and credit industry specialized data scientists.

Conclusion: a discussion of Apple’s strategic objectives and opportunity costs

It’s clear that the economics, industry growth, and competitive advantages are more favorable for Apple in fintech rather than video streaming, which begs the question why enter streaming in the first place. The following is a discussion of three strategic objectives and the likelihood that Apple is pursuing and/or will accomplish each:

  • Profitability. Apple is likely not looking for TV+ to be directly profitable. First, it’s offering a complimentary year of TV+ as a loss leader to encourage new purchases of iPhone, iPad, iPod touch, Mac, or Apple TV. Second, the monthly subscription is only $4.99. At this pricing, it would need over 100 million subscribers to break even on its annual content cost (assuming content cost will at least stay at the current level of $6 billion, which is probable given the stiff competition).
  • Differentiation. One of Apple’s salient competitive advantages is design. While it’s likely that TV+ will provide one of the best user experiences, it’s unlikely to be a game changing improvement over the best available options. New research from Parks Associates claims that the quality of the user interface (UI) is most important when it comes to SVOD subscriber satisfaction. Further, users’ assessment of the UI and ease of finding content impacts their willingness to recommend the service to others. However, the same study found that “70% of US broadband households with a major video service consider its user interface to be good, with 48% rating it ‘very good’….Netflix, Hulu, and Amazon — the big three in OTT streaming — have largely set the standard for content navigation and ease of use.” Based on consumer expectations, great UI is more a necessary feature than it is a major differentiating feature when it comes to competing with the big three.
  • Halo Effect. Apple unveiled TV+ in March amid much celebrity fanfare. Oprah Winfrey and Stephen Spielberg were among many celebrities touting their upcoming shows exclusively on TV+. While the actual content library on TV+ pales in comparison to the top three SVOD competitors, cachet is valuable. Having A-list star power touting Apple’s platform is like displaying the red sports car on the dealership floor — not many car shoppers will buy it, but the positive association with the shiny sports car makes the consumer see the other vehicle options on the floor more favorably. In psychology, this is called the Halo Effect.

From the discussion above, we can assume that Apple’s product positioning is not geared toward optimizing for profitability but rather cost leadership and that Apple TV+ will likely be seen by consumers as having great UI (competitive with Netflix, Amazon, and Disney/Hulu) but not substantially differentiated. Therefore, the scope of Apple’s strategy must reach beyond the TV+ service itself. Moreover, Apple’s primary business is selling hardware. The wider strategic view is to layer service offerings in order to sell more hardware. This holiday season, Apple will sell over 70 million iPhones and millions more iPads, Apple TVs, and Mac computers. All of these will come with a TV+ 12-month free trial. Serving up this content for free initially will allow Apple to build up its content over time, while testing its programming with its substantial base. Excluding services revenue, Apple made over $228 billion from product sales in 2018. But the real leverage is with its iPhone business — sales came in at $167 billion in 2018, 73 percent of all product revenue. For every 1 percent Apple manages to grow iPhone sales going forward, it will add nearly $2 billion to revenue.

While acquiring exclusive video content is a valid objective and certainly high profile, what’s the real cost? Of course, there’s the direct cost of acquiring the content and operating the business (which is unpacked in the above sections), but there’s also the indirect cost of foregone opportunities.

Apple spent $6 billion on content for TV+ this year alone and content budgets tend to go up, not down. Moreover, Apple could have potentially made strategic acquisitions across banking horizontals to bolster its Wallet app. The post-money valuations chart is illustrative of the real opportunity costs that Apple faces when prioritizing its strategic initiatives. From a finance theory perspective, future cash flows should be discounted to the present at a rate that reflects the opportunity cost of capital. That is, the discount rate should take into account the lost return from the foregone opportunity. In Apple’s case, it’s making a strategic investment in one of two industries. Apple’s strategy team probably used financial modeling to help evaluate potential outcomes for allocating capital to either SVOD or fintech.

I propose that perhaps the discount rate used for allocating capital to TV+ may be too low. More directly, if Apple were just able to keep pace with the overall fintech market growth rate on its projects over the next three years, it could see a 25 percent annual return. If the internal rate of return (IRR) of its SVOD projects is below 25 percent, it suggests that fintech should be the higher priority focus. After all, what’s the rush to enter video streaming — an industry with heavy competition where margin is being competed away (as evidenced by Apple’s loss leader market strategy) and even international SVOD revenue growth is not expected to increase to fintech levels until 2023? Perhaps it’s more prudent to wait out the painful consolidation. If the SVOD industry is in a content bubble, it will inevitably burst. At which point, Apple could come in and buy assets cheaply.

Another form of opportunity cost is not fully pursuing an alternate strategy within SVOD. Amid the hype over TV+, the revamp and launch of Apple’s TV app was relatively quiet. When TV+ rolls out, it will live in the TV app. The TV app is meant to be your central hub for movie and TV show content. It shows content from iTunes, your library, connected streaming services, and now (importantly) subscription Channels.

Apple TV Channels allow you to subscribe with various services from within the app. According to Apple, you can subscribe to just the channels you want without downloading any apps. You can watch content included with your subscription right inside the Apple TV app — on demand and across all your devices. The key feature of Channels is integration. Channels reduce the friction of discovering and watching content. For example, if you’re subscribed to HBO, you can go to the HBO channel within the TV app, navigate to “Game of Thrones”, and immediately start playing it right within the TV app — no extra app required, no bouncing around, no signing in. You can also download content from any channel for offline viewing. Additionally, channels support all the normal Apple TV controls — you can scrub (which works better on Apple TV than any other device), you can call up Siri to “skip ahead 10 minutes” within a show or say “find all horror movies” to filter through the catalogue.

Currently Amazon Prime Video, Hulu, and Netflix are not channels. When you select content from these services, you’re bounced to their app. Additionally, Apple TV app is coming pre-installed in new Samsung and other smart TVs. While most of the functionality is identical to how the TV app functions on Apple devices, Amazon Prime Video, Hulu, and Netflix are not even available within the app. For instance, you have to jump out to Samsung’s app tray to navigate to the respective apps — this creates friction.

With the TV app, Apple is showing a roadmap for consolidation of the fragmented user experience, but it’s going to have to get buy-in from the big three SVOD services. Entering SVOD as a competitor content provider, reduces the likelihood of cooperation. More directly, entering video streaming is not worth the opportunity cost of becoming a dominant platform by successfully reimagining the TV bundle. Simply put, TV+ is not solving a consumer pain point, while TV app is attempting to solve the biggest consumer pain point right now — fragmentation and the disjointed, sub-optimal user experience that comes with it.

As the streaming industry matures, fragmentation will ultimately give way to consolidation. Currently, the industry is on a path toward consolidation through competition. This will be an ugly, painful process of aggressive price wars (lowing revenue) and outspending (inflating costs). Apple can avoid this by leveraging its strengths to become a platform for all streaming content. Instead of a streaming -as-a-service strategy, Apple should pursue a platform-as-a-service strategy to create new, dynamic bundles that consolidate content and improve the user experience. It should also give serious consideration to potential fintech acquisitions across banking horizontals.

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