The
Hollywood Economist
The numbers behind the industry.
Netflix, through the simple device using the post office
to bypass video stores, has become one of the great success
stories of the new entertainment economy. It now has 11.8
million subscribers who pay a monthly flat fee for an unlimited
number of rentals. It gets its DVDS from wholesalers and
even retail stores. It can then rent them because of a court-approved
"First Sale doctrine,” which says that once a
person buys a DVD, he can re-sell it or rent it out. Last
year Netflix took in $1.67 billion in subscription fees,
but because of the high cost of mailing some 2 million discs
a day from 50 distribution centers, it only eked out a profit
of $115 million. So it is moving onto the Internet, substituting
digital streamed movies for ones that are delivered by the
post man.. Subscribers get them on their TV via a set top
box or game console without any additional charge. This
“Watch Instantly”service effectively creates
a virtual channel that directly compete with Pay-TV for
the wallet and clock of viewers. Such a challenge by Netflix
could also result, as Frank Biondi, the former head of HBO,
terms it, “In a terminal career decision if you get
it wrong.” The problem is that the First Sale doctrine
does not apply to streaming or downloading DVDS so Netflix
must buy digital rights, which is exceedingly expensive
for new titles. In late 2008, Netflix found a temporary
way around this stumbling block by making a deal with Starz
Entertainment, a subsidiary of John Malone’s Liberty
Media, to sub-license the streaming rights of the titles
it had obtained from Disney, Sony and smaller studios in
output deals. Starz held it could sub-license these rights
because Netflix was merely a “content aggregator,”
but the studios took a dimmer view of this loophole. Disney,
according to a top executive involved in the dispute, has
warned Starz that it will not renew its output deal (which
expires in 2012) unless it either cuts Netflix out or pays
Disney a rich premium.
Netflix’ chief content officer Ted Sarandos portrays
the issue as merely a communication glitch, saying, “We
have to fight against their fear that we’ll destroy
the ecosystem.” Despite this well-meaning new-age
talk, what is really at stake here is old-fashioned money.
The most profitable part of Hollywood’s “ecosystem”
is the output deals through which studios license movies
to Pay channels, cable networks and TV stations. According
to the studios’s internal all-source revenue numbers,
the 6 major studio took in $16.2 billion from pay-TV and
television licensing of their movies, which is almost all
profit. So the threat of sub-licensing for Internet circulation
involves a good more than studio paranoia.
As for HBO, a subsidiary of Time Warner, it is the undisputed
leviathan of Pay-TV. It has over 40 million subscribers,
$4 billion in revenues, and a cash flow of $1.3 billion.
And, unlike Netflix, it owns the digital rights to a large
amount of exclusive material, much of which it produced.
Over the past decade it invested heavily in original programming,
creating such series as“The Sopranos” (which
cost $2 million an episode) to retain subscribers. This
made economic sense because cable systems paid it about
$6 a head a month for each subscriber. As a top Time Warner
executive, who had authorized much of this original production,
explained to me the name of the game is subscriber retention.
So HBO is not about to cede cyberspace to Netflix. In the
next few weeks, it will roll out an Internet service called
“HBO Go” which will allow all HB subscribers
to get“ anything they want to see, anytime, anywhere,
over their laptop, Iphone, tablet, Play station”,
, as the executive put it. Bolstered by its exclusive content,
HBO will initially offer some 800 hours a month of programming
a month. Its 40 million subscribers can get at no additional
charge over the Internet the new titles HBO acquires through
its output deals with Warner Bros, Fox, and Dreamworks,
past and present original series, HBO boxing, and even so-called“late
night” fare (such as “Alien Sex Files.”)
Netflix, on the other hand, has almost no exclusive content
with which to compete with HBO. Back in 2006, it attempted
to produce its own original content through a subsidiary
called Red Envelope Entertainment, but closed it down in
2008. The brutal reality is that Netflix, with only one-eighth
the cash flow of HBO, does not have the scale to produce
its own material. Of course, whether or not the Starz deal
is renewed, Netflix can exclusively license programming
through output deals. But competing in this game, in which
the licenses for slate of two dozen movies can cost in excess
of a quarter of a billion dollars, could prove prohibitively
expensive. Last year Netflix reportedly spent $100 million
on licensing just non-exclusive rights to movies for streaming
from Starz and studio libraries. Although this saved postage,
Netflix had to pay the overhead for its distribution centers.
Adding hundreds of millions of dollars in output deals to
this equation could wipe out much, if not all, of its profits.
Netflix has brilliantly carved out for itself a niche audience
who largely enjoy the convenience of receiving older movies,
which accounts for about two-thirds of its revenue. It will
no doubt continue to satisfy and expand this audience via
mailing and streaming. But it lacks the wherewithal to do
is to replace HBO. So when media guru Randall Rothenberg
asks “Who will be the HBO of the 21st century, the
answer is... HBO.
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