Monday, February 15, 2010

Economics of Netflix

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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 TV channels, cable networks and broadcast stations. According to the studios's internal all-source revenue numbers, the six major studio took in $16.2 billion from pay-TV and television licensing of their movies in 2007, which was 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 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. It's in the process of rolling out an Internet service called HBO Go which will allow all HBO subscribers to get, as the executive puts it, "anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation." 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 linenew 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 a 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 still has 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.

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