Cable Operators

The Netflix Niche

1/31/2011 12:01 AM Eastern

Netflix helped drive Blockbuster
to its doom. Is the pay television
industry next?

The short answer is “probably
not.”

The rapid rise of Netflix is
undeniably astounding. The
company added 3.1 million
subscribers in the last three months of 2010
to stand at just over 20 million at year-end,
blowing past analyst forecasts. For the full
year, it added 7.7 million net subscribers, up
63% from 12.3 million at the end of 2009.

Cover_Story_Image_1/31For many, Netflix represents the potential
end of the traditional cable-TV model by
delivering a cheaper, more user-friendly entertainment
package across more than 200
different devices. Its streaming-only package
currently sells for $7.99 per month —
less than two video-on-demand movies from
most major pay TV providers and as little as
half what HBO costs per month.

Indeed, Netflix’s eye-popping growth and
cut-rate plans have prompted pay TV operators
to respond with new marketing tactics
and services, such as “TV Everywhere” authenticated
content, to fight off the insurgent.

“Netflix’s low-cost, subscription streaming
service (with improving content) is our biggest
worry and could become ‘good enough’
for consumers with moderate income and TV
usage to use as a substitute for pay TV,” Credit
Suisse analyst Spencer Wang and his team
wrote in a September 2010 report downgrading
their rating on the U.S. media sector. A
Credit Suisse survey found 17% of Netflix users
already have cut the cord.

Netflix makes more than 20,000 titles
available for instant streaming and is continually
ramping up that library. Roughly half of
subscribers’ online viewing is made up of TV
shows and the other half are movies.

Despite all its growth and ambition,
though, Netflix’s offerings are too narrow
to shake the foundations of the cable, satellite
and telco TV business. Netflix, which
CEO Reed Hastings describes as a technology
company, doesn’t offer live sports, news
or current primetime TV hits. And its business
model — an attractively priced alternative
to bricks-and-mortar video-rental stores
— wouldn’t allow it to pay top dollar for that
content anyway.

Moreover, Netflix doesn’t offer a better selection
of on-demand content than TV providers,
according to Jeffrey Binder, general
partner with venture-capital firm Genovation
Capital. It has simply done a better job of
marketing and giving customers tools to find
and manage their entertainment, he said.

“Netflix gives the appearance of having a
much deeper and broader library than your
service provider, because the operators have
done a poor job of expressing what’s there
and making it available to consume across
multiple screens,” said Binder, who was the
founder of VOD startup Broadbus Technologies
(now part of Motorola).

And in the case of TV shows, Netflix typically
offers only episodes of past seasons.
“They don’t have the revenue to buy fresher
content,” said a media executive whose company
licenses some post-syndication shows
to Netflix. “If they go that route, they’re going
to compete with DirecTV, Verizon and
Comcast.”

Netflix itself disavows any intent to deliver
a lineup fully comparable to cable TV.

“Netflix values completeness over current
content,” vice president of corporate communications
Steve Swasey said. “We don’t a put
a premium on live.”

Added Swasey: “People like to watch the
Oscars in real time. You don’t get that from
Netflix.”

Hastings, on the company’s earnings call
last week, said that while Netflix’s streaming
service spurs demand for higher-speed
broadband tiers, cable companies aren’t
thrilled about the Netflix incursion.

“We’re not a big threat [to TV operators’
video business], but it’s hard to see why it
makes sense for them to help us grow,” he
said.

PLAYING DEFENSE

Still, operators are moving to protect VOD
specifically and, more broadly, their video
subscription businesses.

AT&T, for one, this month relabeled its
transactional video-on-demand service
U-verse Movies, emphasizing the availability
of new releases to fight rental competitors
like Netflix.

The telco, which had previously marketed
the service as U-verse On Demand,
is touting that it
offers t it les up
to 28 days before
Netflix and
that customers
can watch many
titles on TV, as
well as online,
on mobile devices
and with a Microsoft
Xbox 360.

“We know our
customers have
lots of ways to get
movies,” AT&T executive
director of
U-verse marketing
John Blinkiewicz
said. “Our competition
has changed
in the on-demand
space, from the
cable space, and
shifted more toward the Netflixes and Redboxes
of the world.”

Similarly, the cable industry last fall reprised
its VOD campaign, “The Video Store
Just Moved In,” with a four-week run, in part
to try to blunt the Netflix message.

And Comcast, Verizon and Dish Network,
among other operators, have stepped
up the TV Everywhere push to deliver on-demand
content — including HBO original
series — across PCs, tablets and smart
phones.

What’s prompted the reaction is that, besides
adding subscribers like crazy, over
the past year, Netflix has been stockpiling a
growing amount of TV shows and movies for
streaming.

The company recently inked an expanded
deal with Disney-ABC Television
Group, reportedly worth $200 million,
which included shows from Disney Channel
and ABC Family. Last summer Netflix,
struck a deal with Epix, the joint movie
venture of Paramount Pictures, Metro-
Goldwyn-Mayer and Lionsgate, worth
around $1 billion over five years to provide
movies 90 days after they premiere
on linear TV.

“Our interest in television shows is
high,” Hastings, together with newly appointed
chief financial officer David
Wells, wrote in a letter to shareholders
last week.

As its subscriber base has swelled, Netflix
has become a target for critics complaining
that it is devaluing TV content.

‘200-POUND CHIMP’

Earlier this month, Turner Broadcasting System
chairman and CEO Phil Kent warned studios
and other content producers that if they
make shows available through Netflix, Turner
would probably pay less for them or even pass
on them altogether. Time Warner Inc. CEO Jeff
Bewkes, in an interview with CNBC at the International
Consumer Electronics Show, dismissed
Netflix as “a 200-pound chimp — it’s
not an 800-pound gorilla.”

“Some consternation about Netflix success
is natural,” Hastings and Wells said, comparing
the rise of Netflix to the arrival of the Fox
broadcast network 20 years ago.

“A new entrant bids up the price of content,
and the incumbent aggregators are not
pleased,” the executives wrote in their 2010
shareholder letter. “Netflix is good for consumers,
good for content producers, and is
one more competitor for existing aggregators.”

But a backlash in the media business could
starve Netflix and its ilk of high-value programming.
“We aren’t saying that Netflix or
other [over-the-top] providers will never get
premium subscription content again, but our
channel checks indicate that willingness to
license such content, especially for any real
length of time, is decreasing dramatically,”
RBC Capital Markets analyst David Bank
wrote in a Jan. 21 research note.

On the other hand, money talks, and
Netflix has bragged about its willingness
to “write very large checks,” in the words of
chief content officer Ted Sarandos.

For example, Netflix expects to bid against
HBO for the rights to the pay-TV window
from Warner Bros. when that deal is up in
2014. “We’re a nearly $100 million a year customer
for Warner Bros., and both of us would
like to expand that, if it makes sense to,”
Hastings told analysts last week.

In the nearer term, Netflix is focused on
renewing with Starz Entertainment. Their
previous agreement, struck in 2008 for a reported
$30 million over three years, will expire
in the middle of the first quarter of 2012.
“[C]arrying Starz is one of our most important
deals,” Hastings and Wells wrote last week.

Netflix has tried to point out that it augments
the content ecosystem, rather than
cannibalizing it.

Since it began streaming Starz Play content
in October 2008, the number of Starz
subscribers through traditional pay TV distributors has grown, as HBO’s rolls have declined
over that time. “In other words, the evidence
is pretty clear that content that is also
licensed to Netflix generates more money for
its owners than content that is withheld from
Netflix,” Hastings and Wells said.

Netflix’s move to streaming is not only
about customer convenience. Just as significantly,
the costs of Internet video delivery
are mere pennies versus approximately $1
for each DVD mailed and returned.

Netflix last year paid more than $500 million
to the U.S. Postal Service to deliver DVDs
by mail. “If we were paying a studio that much,
we’d be their biggest customer,” Swasey said.

LAST-MILE ECONOMICS

Given Netflix’s shift toward Internet delivery,
there’s a battle brewing with broadband
providers over the costs of delivering
massive quantities of content.

For cable operators or telcos to charge
Netflix or its content delivery network
partners “to let in the bits their customers
have requested from us… is inappropriate,”
Hastings and Wells wrote last week.

That’s a reference to the standoff over network-
interconnection fees between Comcast
and Level 3 Communications, which landed a
contract to be one of Netflix’s primary CDNs in
November 2010. The MSO said Level 3 should
pay in order to deliver more than double the
traffic to Comcast’s network, while Level 3 asserted
that any fees for delivering content to
a broadband provider constitute a toll that is
barred under the Federal Communications
Commission’s network neutrality rules (see
“Level 3 May Test ‘Open Net’ Rules,” Jan. 17).

However that spat plays out, to Binder,
Netflix will always be unable to compete
with facilities-based providers on efficiently
delivering high-quality content.

“The providers have the last-mile advantage
— it’s the economics of moving content
over a public backbone versus over a private
network,” he said. “The question is how long
it takes [service providers] to effectively marginalize
Netflix.”

NETFLIX: BY THE NUMBERS

20 million: No. of subscribers as of Dec. 31, 2010, up 63% from 12.3 million a year earlier

$2.16 billion: Revenue for full-year 2010

$1 billion: Amount Netflix will pay Epix over five years for movie streaming rights


More than 200:
No. of devices able to access Netflix instant streaming

$4.01: Average monthly gross profit per customer in Q4 2010, versus $4.96 in Q4 2009

$1: Approximate postage and handling cost per DVD for Netflix, versus “pennies” per movie
streamed over the Internet

$7.99: Monthly price of the streaming-only (non-DVD) tier in the U.S.

$1.18 billion: Value of commitments related to streaming content license agreements, as
of Sept. 30, 2010

Sources: Company reports, Multichannel News research

September