Internet TV: Extreme Make Over – Industry Edition

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Paul Sagawa

203.901.1633

sagawa@sector-sovereign.com

August 12, 2010

Internet TV: Extreme Make Over – Industry Edition

  • The media industry has undergone several wrenching technology driven changes in its history – e.g. motion pictures, radio, television, video tape, cable, etc. – and in each case, the industry value chain was drastically reordered. Existing industry categories shrank or transfigured, while entirely new businesses emerged – the birth and death of video rental stores during most of our lifetimes is an exemplar of the phenomenon. We believe that the inevitable, but long, transition of video to digital, a la carte distribution, nearly complete in the related field of recorded music, will be relentless and may prove to be the most transformative of all
  • The current television value chain is a $130B business in the U.S., of which 83% flows through as revenues for physical distributors – e.g. cable MSOs, satellite providers, broadcast affiliates, etc. – which generate roughly 35% in operating profit and pass 40% of their revenue to content aggregators. Aggregation – e.g broadcast networks, cable networks, pay-per-view, – generates $52.2B in fees, subscriptions and advertising, yielding a 30% operating margin, with 50% for content production and acquisition. Video content production is a $53.1B annual business, of which 60% comes from channelized distribution – first run and syndication. Production generates average operating margins of 7%, likely depressed by artificially low transfer fees at integrated network owners, with 40% going to talent and rights fees
  • Distribution and aggregation face significant threats. The Internet allows content owners to bypass channelized video, weakening the negotiating power of traditional distribution, and opening an opportunity for new players to aggregate and market content, enable search/navigation, and manage advertising and subscribers. To the extent that these players can rely on self-produced content and contractually lock in exclusive rights to other high value content, channelized distributors and aggregators may forestall the churn of users to on-line alternatives, buying time to establish their own brand value on the Internet. Nonetheless, we expect competition for content rights and advertising revenue to pressure both sales and margins for channelized players
  • As new content flourishes in on-line venues, as content owners not under complete control by channelized aggregators test the Internet waters more aggressively, and as technology and regulation enable easy living room viewing of on-line TV, the diaspora of eyeballs and ad dollars onto the Internet will accelerate, thus attracting more and better content, and then more eyes and dollars. This cycle of positive reinforcement will advance opportunities for new players – e.g. Netflix, Hulu, Apple, Google, etc. – to aggregate, market and monetize content on-line
  • Producers of content will obviously benefit from the emergence of an alternative to network/cable distribution. However, dramatically lower barriers to entry on the Internet are attracting new producers, and eroding the value of business relationships between producers and traditional distributors. Bidding for high value properties, such as sports, will grow increasingly fierce, with rights owners exploring opportunities to forward integrate into self distribution. The rise of team-owned and league-owned production and distribution channels, such as the New York based YES or the NFL network, is evidence of this phenomenon. Movie studios have also been aggressive in pursuing alternative distribution, first through their own dedicated cable networks – e.g. Epix, Starz, etc. – then through comprehensive on-line deals with new aggregators like Netflix
  • Content producers that are integrated with channelized aggregation and/or distribution face a difficult transition. If programming exclusivity is used to prolong the value of a network, it may erode the value of the content, while maximizing the value of content could hasten the deterioration of the network. Most video content owners have moved to embrace the on-line medium – NBC-Universal, Fox and ABC co-founded Hulu and make most of their network content available to subscribers of that service
  • The painful experience of the recorded music industry is a powerful reminder for media players – failure to act decisively in the face of piracy fears allowed Apple to gain critical mass with its proprietary iTunes solution that has greatly diminished the industry’s collective negotiating power. As such, the video market is evolving with open technical standards across multiple aggregators and an implicit acceptance that digital piracy can only be discouraged, not eliminated. This likely hastens the transition
  • In our scenario, companies that are disproportionately tied to traditional channelized distribution and aggregation –cable operators (e.g. Comcast, TimeWarner Cable, Cablevision) and cable network operators (e.g. Discovery, Scripps) – appear to be the losers. On-line aggregators (e.g. Netflix, Google, Apple) are advantaged, as are owners and producers of high value content (e.g. Lions Gate, Dreamworks). Big integrated media players (e.g. Disney, News Corp, Viacom, CBS, Time Warner) face a mixed bag of opportunity and threat where success will be determined by the relative exposure to channelized aggregation vs. production and their ability to transition their channelized properties into effective on-line aggregation and marketing franchises

In Da Club

The path from an idea for a show to the nation’s living room television sets has been well worn. Talent brings ideas to agents who pitch to production companies (producers), who fund pilots and in turn pitch the networks and cable channels (aggregators), which select, schedule and market shows to viewers and advertisers, and negotiate with cable and satellite operators (distributors) to carry their channels and pay a fee (Exhibit 1a and 1b). Today, aggregators and distributors are capturing a disproportionate amount of the profit produced by the chain, recognition for their gatekeeping role in determining which programs find their way to the consumer. In this system, potential new entrants are squeezed – track record and relationships are a bigger determinant of which programs get produced and scheduled than the quality of the idea itself, and channels are added to cable system line-ups as a part of negotiations over a full slate of networks between huge media conglomerates. Bad shows are routinely added to the weekly grid because of relationships between producers and aggregators – often part of the same larger media company – and bad channels stick on cable systems because they are bundled with other popular properties.

The Internet End Run

New content is now finding its way to eyeballs. YouTube is visited by 145M unique visitors per month and streams 3.5B videos per week with the average viewer consuming 1 hour of online content per week (Exhibit 2). Netflix has more than 15M subscribers accessing video content over the internet. 20% of US households have Internet connected game consoles with access to on-line video content. 25% of new TVs sold now accept direct Internet connections. Moreover, all of these statistics are trending strongly upward.

Of course, there are obstacles. Most Americans do not connect their living room TVs to the Internet and the cable industry provided set top boxes are not designed to make it easy to do so. The advertising industry has been cautious in shifting its spending to on-line video. The cable industry is fighting back with expanded video-on-demand services. Network brands are well established, with established audiences that enable cross-promotion of new programming. Some of the most attractive programming is contractually tied to the channelized model for years.

None of this is insurmountable. Most of these hurdles were also cited as obstacles for fledgling cable networks as they challenged the broadcast networks, yet the spread of cable and the emergence of attractive programming off of the traditional networks attracted viewers and advertisers. The same will be true of on-line content. Home electronics manufacturers are adding Internet connectivity and navigation tools to bring on-line content into the living room around the set top box and the FCC is pressing a plan to force the cable industry to offer an open interface to its services that will work without a proprietary set top box. Advertisers may be cautious, but they are not blind to changing consumer viewer patterns and will almost certainly follow the audience shift to on-line as it grows more significant. Cable on-demand services and network operated aggregation channels on the web will certainly compete for leadership on-line, but the advantages of incumbency will be greatly mitigated on the fiercely democratic Internet. Finally, contracts aren’t forever, and many content owners have been savvy enough to retain rights to on-line distribution.

While it will almost certainly be years before more than a smattering of households turn off their channelized video connections – cable or satellite – to rely entirely on Internet TV, we believe that the flow of viewership and advertising from one to the other will be relentless and irreversible. At some point, perhaps a decade from now give or take, the exodus will reach critical mass and businesses that remain overly dependent on channelized television will begin to fail. This scenario brings opportunity to many, but catastrophe to some.

Distribution Dissolution

Cable bulls either do not take the threat of an on-line video dominated future very seriously, or they believe that cable MSOs can parlay current dominance in wired broadband service into business sufficiently lucrative that the deterioration of the traditional channelized video service will not be painful. We believe both perspectives are flawed. The movement of consumers toward on-line content has begun in earnest, as we outlined above. Moreover, the trajectory of technology advances will allow for reliable and nearly instantaneous access of a nearly limitless pool of high definition video content by nearly every household AND wireless mobile device within the next 10-15 years, with the added potential for an integrated interactive dimension that has yet to be reasonably explored, much less exploited. The channelized paradigm does not offer this future.

As for future cable domination of broadband, this presupposes that regulators would allow MSOs carte blanche in maximizing cash flow from wired broadband, AND that wireless technologies will not offer a viable competitive alternative in the future. We believe that this is unrealistic on both counts, and have written about the issue in detail, most recently in our April 20, 2010 piece “A Thousand Paper Cuts, the Future of Cable TV”.

Aggregation Complication

Cable and broadcast networks – companies that select, schedule and market video programming that is broadcast over dedicated channels – take the largest share of profits in the television value chain. Simplified, these aggregators typically operate several thematically distinct channels, buying programming, then monetizing it via advertising, fees negotiated with distributors, and in some cases, subscription fees charged to viewers (Exhibit 3).

In our on-line dominated scenario for the future, the aggregation business will change dramatically. Traditionally, aggregation has been dominated by a relatively small number of media conglomerates, each bundling multiple channels in negotiations with distributors. While haggling over fees has created the biggest headlines – rancorous negotiations between Disney/ABC and Cablevision resulted in a blackout of the Oscars for many NY viewers – aggregators have also used their clout to induce system operators to take on new or less popular channels as part of a package, resulting in a raft of infrequently watched channels clogging the middle of the lineup based on a hope that they can be promoted into economically viable properties (Exhibit 4). Obviously, this element of the business is eliminated in an online model, not just the fees, but also the ability to push less proven or popular programming into distribution.

Maintaining the value of an on-line brand will be crucial, else content producers will have ample incentive to spread their programming indiscriminately or to bypass aggregators entirely. That value will derive from an ability to attract and retain viewers, and generate advertising and subscription revenue. Without prime positioning on a cable channel line-up, a successful on-line aggregator must establish itself as a first stop for finding desirable programming, a role that demands a comprehensive choice of content, powerful tools for navigating the ocean of choices, and a delivery infrastructure able to maintain market leading service quality. Against this, NBC, ABC and FOX partnered to launch Hulu, which collects programming from all of their networks. CBS’s TV.Com takes a different tack, acting as “meta-aggregator” by facilitating choice, then linking users to desired content resident on other sites (Exhibit 5).

Of course, there are others with their eye on the aggregator role for on-line video. Google offers a ubiquitous search brand, a core competency in advertising, YouTube, and a matchless physical infrastructure for delivering video content. Apple can leverage its dominant iTunes music distribution service and its gold-plated brand reputation. Netflix has 15 million paying subscribers and a strong growth trajectory based on its on-line film rental and download business. These well financed and net savvy competitors can be expected to challenge incumbent channelized aggregators for leadership in the brave new world, and like almost everything else on the Internet, scale and first mover advantage will likely be the biggest determinants of success.

Production Fragmentation

For the biggest media players, production and aggregation go hand and hand. Production companies are largely tied to aggregation networks, with a minority of programming bought in from independent producers. Disney, Viacom, News Corp, Time Warner, GE’s NBC-Universal and CBS control roughly 80% of television production and 90% of aggregation(Exhibits 6 and 7). A scenario by which aggregation becomes less dominated by vertically integrated producers would very likely be more hospitable to independent producers against a wider continuum of production values. The popularity of lower cost, reality-based programming, and of low quality user generated video, suggests a potential explosion of new content from new sources.

However, in a vast sea of programming all seeking an audience, marketing in its many varied forms will be crucial. Traditional high production value series will require aggressive advertising campaigns to attract and sustain the audience necessary to justify their cost (Exhibit 8). Syndication, historically hugely important in the economics of scripted television production, could be badly effected in an Internet dominated world. First, the proliferation of new programs could crowd out catalogue content, and second, the scourge of piracy will likely make it difficult to demand more than cursory payment. On-demand viewing will eliminate the audience lead-in effect inherent in time-slot scheduling, so programs will be left to generate their own viewer loyalty without the halo effect of a popular scheduling partner. This will favor companies that can establish major hits – a la American Idol, or CSI – and producers that can keep costs very low – e.g. Funny or Die, CampusHumor.com, etc.

In this environment, live programming will gain special prominence. Viewers cannot fast-forward advertising during a live show and pirates cannot steal it in real time, so event-driven programming like American Idol and other contest type shows could be immensely valuable in the on-line world. Another obvious example is televised sports, which attract sizeable and desirable audiences at pre-scheduled intervals, but we are skeptical as to their value to independent aggregators. Conferences, leagues and teams will be able bypass traditional network aggregators and broadcast to viewers directly. Team and league owned networks, such as The NFL Network, YES, NESN, and others, demonstrate the risk to traditional aggregators.

It is likely that the big production studios will suffer in our scenario due to the influx of new competitors, the disruption of traditional distribution relationships, and the increased leverage of creative talent.

Talent Rises to the Top

The real winners in the shift away from the traditional channelized model are likely the creative talent. The layers of gatekeepers that filtered the programming for public consumption are being bypassed, making personalities and creators that are able to attract and retain an audience more valuable. Conan O’Brien’s recent 9 figure contract with Time Warner’s TBS reportedly gives him ownership of the show’s content for future use. We expect future negotiations with other proven audience favorites to move in the same direction

Winners and Losers

Many of the winners in this extreme make-over are privately held – fledgling content producers, technology start-ups with ideas for video search or targeted ad insertion, viral marketing geniuses, etc. However, we believe several Internet savvy firms – Google, Apple, Netflix, Rovi, etc. – may play important roles in enabling would-be viewers to find desirable programming and watch it on-line. There is also a short list of independent content producers – Lion’s Gate, Dream Works, CKX Entertainment, Gaylord Entertainment – that are publicly traded. To the extent that these players can deliver reliable streams of attractive programming, they may also be winners (Exhibit 9).

The losers are straightforward. Cable and Satellite TV operators – Comcast, Time Warner Cable, Cablevision, DirecTV, Dish Network, etc. – and cable network aggregators – Discovery, Scripps – will likely suffer as the channelized model contracts.

The biggest media players – Disney, Time Warner, News Corp, CBS, Viacom, and NBC-Universal – will also face serious pressures in their aggregation businesses, and new competition from independent content producers that have been disadvantaged by the current industry structure. Success for these players will be dependent on how well they handle the transition to the new model. In an Internet world where first mover advantage and scale mean everything, hesitation could be death.

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