The first window opens: Enter Netflix

The first window opens: Enter Netflix

The Delta Perspective
A recent flurry of announcements has hailed the arrival of original programming from OTT video providers. Netflix, the multi-device SVOD service platform, released House of Cards in February, Hemlock Grove in April and Arrested Development this weekend. Also lined up are Turbo F.A.S.T. (December) and Sense8 (2014). Amazon announced it was piloting 14 shows for their Prime service subscribers, with the goal of commissioning a full series for the best-ranked pilots.
Of particular note is that both companies behind these announcements are not traditionally known for original programming. Rather, both Netflix and Amazon began operating in the middle of the media value chain (retailers or content packagers) but – enabled and emboldened by the digital OTT delivery channel – they are now able to extend upstream.
 

What exactly is driving the OTT players?

Content production is a risky business as it relies on consumers’ subjective preferences. There is a strong possibility that millions of dollars invested in a production will result in a commercial flop. So, why are these companies going into territory traditionally dominated by Hollywood incumbents?
 
1. There was probably no other option
For decades video content was developed and delivered in a closed ecosystem. Hollywood studios invested in producing a slate of show pilots or were commissioned by TV channels that slotted the shows into 24 x 7 schedules and marketed them to the audience. TV channels generated revenue through advertising, fees from pay-tv providers or both. The system worked well for all stakeholders as studios started to own TV channels and in some cases, pay-tv platforms. However, it also became bloated as all sorts of bundles (of shows, channels and services) were pushed into the market. As a result, the gap between the number of available and watched TV channels widened considerably.
 
In contrast, OTT-based services are either bundle-free or significantly cheaper-priced than legacy bundles, resulting in a disruptive threat to the current ecosystem. Until now, studios were playing along with this eco-system because:
  • They / their holding companies received significant revenue from downstream TV channels and pay-tv operators, and;
  • OTT players didn’t have pockets deep enough to pay for premium Hollywood content
     
Being the last window, by the time content came to OTT platforms, it was either a hit and hence priced at a premium, or a failure which nobody wanted to carry.
The “Netflixes” of this world were essentially left with two options: either bid higher or accept later release windows or sub-par content. This was the bitter lesson from the negotiation between Netflix and Starz where the two parties could not reach a renewal agreement because of a significant price increase.
 
2.    Original programming lends exclusivity and flexibility and creates further growth opportunities
Because of rapid adoption (Netflix has ~36 million subscriptions) and innovative pricing (e.g. Amazon Prime subscribers get free access to Amazon Prime Instant Video), OTT providers are now able to control their programming by investing in own production and thereby claiming the first window for their digital platforms.
 
Content ownership also results in opportunities beyond first release. Most OTT providers aspire to build international scale with Netflix having already launched in Latin America (2011), UK, Ireland and the Nordics (2012) and planning to go deeper into Europe in 2013. However, negotiating international rights is a lengthy, expensive and burdensome process. Netflix’s life becomes much less complicated when it decides to launch its own content in multiple territories.
 
Early exclusivity is a strong differentiator, not only from the old TV guild, but also from OTT peers. Being non-facility based, OTTs’ barriers to entry are low, and hence their ability to sustain market leadership requires strong brands built on differentiation and exclusivity. Netflix knows how powerful  a weapon this can be and factors it into the equation from day one.
 
Content ownership also results in incremental revenue stream opportunities through licensing (windows/territories that don’t erode its competitive advantage) or merchandising (which generates credible revenues for HBO today). Granted, licensing revenues will not materialise today, given Netflix’s current focus, but are definitely not ruled out in the future. It must be highlighted here that Netflix only paid part of the production costs for House of Cards, securing the SVOD rights, but does not have rights for physical DVD distribution. However, if this experiment succeeds, we would not be surprised to see Netflix placing bigger bets, hoping to recover them from revenue streams beyond VOD.
 
3.    Customer data allows OTT players to make more efficient content bets
Finally, the digital players (unlike TV channels) have access to an increasing amount of data on how subscribers respond to the content. Each title is tagged with multiple pieces of meta-data which are crossed with usage statistics – when you watch, when you abandon, how you rate it, etc. Armed with so much information Netflix has a more accurate view of what works and what doesn’t - a great advantage when it comes to developing its next show - thereby softening the inherent risks in content production.
 
You will hear opposing opinions on this topic though. It is true that so far the digital platforms have been successful in leveraging big data to fine-tune and personalise their value proposition, and they hope to do the same with original content production.
 
However, pundits argue that customer data is not so important. Firstly, it informs you about the past but limits creative exploration. Secondly, creating good television sometimes simply requires solid execution of a well-known formula – take a proven story (House of Cards adapted from the 1990s UK success), a good director (David Fincher), a compelling writer (Beau Willimon) and well-loved cast (Kevin Spacey) – and voila you have it. No data – big or small, can beat that.
 
Hence, the jury is still out on this one.

 

What does the future hold?
In the media value chain, content production was the key missing link for OTT players. They had already reached the customer over the internet with their robust platforms, packaging capabilities and strong brands. With original content however, digital players have effectively closed the loop.
 
So, how much should traditional players worry? So far, House of Cards has been positively received. Unfortunately Netflix has not released viewership numbers but the show has received critical and audience acclaim and even generated Emmy buzz. Are we witnessing the evolution of the first digital media conglomerate? Traditional players clearly feel threatened and, in response, have stepped up their own efforts to offer similar consumer experiences.
 
The big-seven pay-tv operators in the U.S. now all offer a TV Everywhere (TVE) service (e.g. TWC’s TV Everywhere, Dish’s Anywhere, Comcast’s AnyPlay, etc.) which allow an authenticated pay-tv subscriber to view pay-tv programming in live and catch-up modes on multiple devices. However, consumer adoption continues to be slow because of:
 
  • Poor marketing
  • Lack of measurement
  • Limited content
  • Hesitant studios (since TVE potentially dilutes the increasingly attractive SVOD window)
  • Lack of consistent consumer experience
     
A recent poll from Ad Age discovered that only 20% of pay TV customers are even aware they have access to TV Everywhere.
 
Incumbents have also started to deploy their own versions of OTT-based VOD offerings: Verizon’s Flexview product, its partnership with Netflix competitor RedBox Instant, Dish Networks’s acquisition of Blockbuster to push its @Home service or Sky’s NowTV service are all examples. These robust OTT offerings were launched by pay-tv operators 
recently, either to combat the Netflix threat or to extract value from the shifting consumer preferences. Pay TV operators in emerging countries need to follow suit and deploy similar TVE and OTT offerings before a Netflix or a Netflix-like player gains scale in their respective markets.
 
On the flip side, Netflix will also need to justify to its shareholders the need for expensive content (reported to be $100 million for two seasons of House of Cards) if penetration doesn’t continue to grow rapidly. Even if penetration grows, it is always challenging to precisely map content investment with revenue gains in a subscription model. Incumbents will react to Netflix’s success by making content access even more difficult (e.g. HBO’s recent ten-year exclusive deal with Universal; WB, MGM and Universal not renewing a recently-expired deal with Netflix, choosing instead to build their own OTT platform; losing exclusivity to EPIX content, etc.). And needless to say, while House of Cards appears to be an audience hit, Netflix will also encounter duds along the way.
 
As a final note, we are cautiously monitoring the proliferation of video content and should emphasise that this needs to happen in a controlled manner, else it risks collapsing under its own weight. Recently, original content productions were announced by companies including Condé Nast, The Wall Street Journal, YouTube, AOL, Microsoft and Yahoo. As these content offerings boom, many risk being remembered either as unsuccessful experiments or for fragmenting the audience into tiny, unmonetisable niches.
 
This overcrowding happens in any market where entry barriers are low. In the case of app stores, for example, hundreds of thousands of apps are published but only a handful become a hit. Consequently, consumer backlash is a tangible risk and it wouldn’t be completely surprising if overwhelmed TV audiences seek sanity by sticking to the well-packaged TV channels curated by honed programming executives.

Sources:
1.    Netflix website (www.netflix.com)
2.    Netflix SEC filings, Feb 2013 (www.sec.gov)
3.    BBC News (www.bbc.co.uk)
4.    The Hollywood Reporter (www.hollywoodreporter.com)
5.    Netflix Long Term View (ir.netflix.com)
6.    Investment Analyst Reports Q1 2013 (BAML, JPMorgan)
7.    AllthingD (www.allthingsD.com)
8.    TV Dimensions
9.    Nielsen
10.    Credit Suisse
 

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Delta Partners - TMD Advisory and Investment