The increasingly risky business of digital video distribution

Summary:

In this high level review of today’s legal digital video distribution business I discuss the issues with the current value chain, problems with content licensing, and why these will not support desperately needed long-term growth for the industry. Evidence is provided to support this view and, unless there are some significant changes in the industry, digital video distribution will be limited to a short-term upside for only certain market players. Confronted with the flawed download-to-own model, currently in crisis, digital players are also struggling with the rental model and they are negotiating themselves into major losses. Content owners are reaping the bulk of the benefits today, but this way of doing business is ultimately unsustainable for the entire value chain and it is only a matter of time before studios see their digital content revenues suffer. The current success of services such as Netflix can be deceiving, for many reasons highlighted in this post, and belief that such services will continue to prosper under current commercials ultimately sets flawed precedents for the market and puts its true potential at risk.

Main Post:

Through evidence collected from the market, and from personal experience, I will formulate a high level position on the state of today’s digital video distribution industry. In short, it is not looking very healthy for numerous reasons, but before discussing in more depth, let’s define some terminology. We can split premium digital video distribution into two main segments: Ownership (aka Electronic Sell Through, EST, or Download to Own, DTO) and Rental or Video On Demand (VoD). Globally, the EST business has been a disaster while the VoD segment has shown some promise. It is easy to view Netflix’s impressive growth, the “Hulu For Sale” sign and related asking price, and the numerous digital content deals being signed for hundreds of millions of dollars, as a sign of a healthy and growing industry; however, by looking at these companies and deals in more detail, piecing together the facts, and crunching some numbers, it quickly becomes apparent that there are some clear symptoms of a struggling industry.

Below are two excerpts from a Morgan Stanley Home Entertainment Industry paper dated July 16, 2009 (2 years ago). Although only addressing the US market, the below trends can be considered as relatively analogue in many developed European markets. These two “Debates” address both the sell-through and the rental businesses.

With perhaps a few exceptions, I believe it is safe to conclude that the EST model has been an overall disappointment so I will not provide much detail or specific evidence in this post. Morgan Stanley’s own assessment on the Sell-Through market, in my view, is still relatively on target, as-at 2011:

The continued increase of illegal “digital” sources (piracy), the inflexibility of legal copy DRM formats, and the higher than acceptable pricing points are all killing the digital sell-through business.  A recent article from the Financial Times does an excellent job of painting the picture of today’s EST market and the challenges facing Studios and distributors…but as Mitch Singer, President of the DECE consortium, states:  “EST isn’t dead … we just haven’t offered consumers something they want to collect yet…” and perhaps he is right, and a standardized and flexible solution such as Ultraviolet is the answer, but it is not so much a problem of technology as it is of attitude and outlook – and here is where I believe most of the changes are needed. Since much of these issues also relate to the VoD business, I will provide more detail further on in this post.

In another key debate, Morgan Stanley suggested that the rental model, including VoD, would essentially be Home Entertainment’s saviour. They took a Bearish view (as opposed to a Bullish one) on predicting the growth and impact of digital (both digital & VoD in the below exhibit) on the overall video rental market:

Morgan Stanley’s take on this is can be considered as a very “short-term” view. Yes, digital rental is beneficial for the content owners and this will remain the case short-term, but a healthy market depends also on the success of other value chain players, principally the distributors. And for the distributor, the short-term has already proven difficult in most cases and long-term is looking even worse. Although digital rental has shown more promise than digital ownership, it still has not met expectations. Excluding the US market, digital movie revenues in 2010 were $243 million according to Screen Digest. This is only a small fraction of the revenues generated today by both rental and retail of physical disks and assuming that this figure is reported by distributors (i.e., their revenues), my key question is this: Has the reported $243m covered the Minimum Revenue Guarantees (MRGs) often required by content owners (and paid in advance)? Even if it has, by what margin? These are delicate questions for distributors to answer and most likely they would never give a straight answer. So what does all this mean to the overall health of the digital distribution business? All players – not just distributors – should be concerned. Today’s pure (i.e., non subsidized by other services) digital premium content distribution business model is not making much “business” sense.

The significant growth and success of Subscription VoD (SVoD) services (e.g., Netflix), where individual title buy-rates are not applicable, has created an additional false sense of overall industry security. Granted, SVoD runs on a different business model than Transactional VoD (TVoD), and it can be considered as the future of VoD consumption bringing a real sense of “value for money” to the end-consumer (more details on this view here); however, what is often not considered is the fact that most SVoD services not only have similar content costs to TVoD businesses but, unlike most TVoD services, they have the added issue of no “higher margin” revenue streams, such as PayTV, internet, mobile, and fixed line subscriptions, to bundle with – Despite the rapid growth in SVoD subscriber numbers, most of these services still rely on their physical distribution business to remain profitable.

Something is clearly not right with today’s digital distribution value chain, and if you do some research, there is an overwhelming amount of evidence out there that suggests an imminent collapse of the business; unless the DNA of the business model and its value chain is revolutionize, that is. Below are some symptoms I’ve managed to identify of an unhealthy industry:

Netflix is setting itself up for trouble, primarily due to increased competition and rising content costs:

A recent in-depth financial analysis of Netflix provides numerous warning signs of a business that could very well fail long term. I believe that Netflix’s rising cost of content will not be supported by future subscription revenues. An analyst at Wedbush Securities, Michael Pachter, predicts Netflix’s streaming content licensing costs will rise from $180 million in 2010 to a whopping $1.98 billion in 2012 – Full article. Most likely, the quality of Service (and the end-consumer) will ultimately pay the price: Netflix’s current content deals probably have subscriber caps (limits) and once these are reached, Netflix will be forced to remove content from its service (unless it pays much more in content licensing fees). This ongoing business model issue is already impacting the Netflix customer, as they learned the hard way when hundreds of Sony Pictures movies vanished from their “Watch Now” menus in June of this year. Add an aging list of library titles on offer and the fact that there has been a high level of insider stock trading amongst Netflix Execs, and the signs rippling through the investor community are not positive.

Other similar SVoD (and Advertised-funded premium VoD) Services will follow suit:

Although the Googles and Amazons of the industry have much larger wallets to invest in content and higher margin businesses to lean on, they will quickly run into similar issues as those facing Netflix today. And the ultimate question will haunt them as well: Will future subscriber revenues be able to support the rising costs of running such services?

Amazon will soon be seeing its content costs soar. The recent CBS deal is a carbon copy of the Neflix deal and another deal with NBC Universal will cost them an additional fortune in licensing fees.

Once Hulu leaves the cushy womb of the content rich triad (ABC-Disney / NBC-Universal / News Corp.), it too will need to put up the cash currently demanded by major premium content owners to cover MRGs and it too will need to accept steep commercial conditions where over 50% (often 70%) of content revenues go back to the Licensors. Why else has Yahoo! stated that it will not consider buying Hulu, at its owners’ asking price, unless the Hollywood triad guarantees 4 to 5 years of exclusivity for its content? Full articleEven one of the most cash rich giants, Microsoft, has said no to a potential Hulu deal.

The high cost of content is not the only issue facing these services, as so clearly stated in a recent New York Times article on the fate of Hulu: Every legal digital video distribution service is “bound by contractual handcuffs that hamper prospective viewers…Viewers want more shows on more screens. But Hulu’s partners — the big networks — want steady profits.  And, for the moment, the networks seem to have the upper hand.” Full article And it is this exact conflict of interest between the distributor (who wants to provide the end consumer the best service possible, while still making “some” money) and the content owner (who wants to offset its dying physical format business with big revenues from digital) that is stunting the growth and true potential of the digital video distribution industry. It also promotes the use of illegal substitutes. “For all the innovation that Hulu represents, the site also lays bare the gulf between what online viewers want and what TV companies are willing to give them…CONVOLUTED and often outdated contracts for the rights to shows and channels are the single greatest impediment to the growth of TV on the Web, on Hulu and elsewhere.” Read my in-depth post on the real issues behind Piracy for more insights.

Most TVoD services aren’t achieving profitability or even breaking even:

Of the numerous TVoD businesses out there (Online, ADSL, Cable, ect.), I would bet that 95% of them never achieve breakeven or profitability. Studio imposed pricing levels are often too high to stimulate enough sales to make business cases work, not to mention the upfront revenue guarantees required to even get the content. Content ingestion costs and DRM restrictions are unnecessarily high. Digital versions of the same DVD or Blu-ray copy are inferior products, often with no subtitles and with limited language support, and the list of issues goes on…

Apple’s iTunes service is an exception, but it runs on a very different business model:  A) their business plan was never approved to make profit off content sales…content distribution is considered a marginal business to drive device sales so their business model favors the Licensors’ quest for the biggest piece of the revenue pie, B) they virtually guarantee Licensors high sales volumes (iTunes is one of the biggest digital content stores in terms of subscribers in the world), and C) I would bet that they don’t owe the content companies a single dollar in MRGs because Apple simply refuses to accept them. Similarly, a Telco often accepts to run a money losing TVoD element of their larger triple/quadruple play offer. They would view the cost of VoD content as a “necessary evil” to reduce the risk of churn and to ensure that their customers don’t seek this content through competition. Unfortunately, this sets a dangerously expensive standard and gives an inaccurate impression of the business. The TVoD business is viewed as a success story to numerous external constituents, including journalists and the general media. Every Digital TV service now has an extensive library of VoD titles for renting, and to the delight of content owners, acquiring VoD content rights has become a must have commodity. But the distributors’ actual business case performance, in most cases, tells a dismal story. With VoD buy rates not growing as expected, Telcos often find themselves constantly trying to renegotiate 3 to 5 year deals with content owners in a desperate attempt to reduce losses.

Up to now, the digital business has been good to content owners and this will probably remain the case in the short term. Unfortunately, their long term upside (if I were to predict one) is not good. And this is exactly where the problem lies. Currently, each player in the value chain is taking too short-term a view on their digital business: Content owners want to offset decreasing Home Entertainment and TV licensing revenues as quickly as possible; they want to maximize revenues upfront and lock key partners into getting use to paying a high price for their content. Distributors want to beat out competition with “first to market” services and innovations, easily giving into content owner demands. But this behaviour creates unsustainable game play conditions, which will ultimately impact the end-consumer.  Articles such as The Sale of Hulu is good news for the content business stimulate unhealthy presidents for the digital distribution business and they harbour short sighted strategies. This Modus Operandi has inflated the real market value of digital content rights, where the cost of this content is higher than the end consumer’s willingness to pay, and where distributors are often cushioning the true cost of content.

I predict that the laws of economics will eventually win, long term, and that the true value of digital rights will decrease significantly. With the long list of easy and cheaper alternatives to legal digital copies, including $1.50 Blu-ray New Release rentals from Redbox.com and the growing number of sophisticated illegal high quality digital sources, consumers will ultimately determine the success of digital video services. The sooner that distributors and content owners work harder together to improve the value chain into a mutually beneficial business, and the sooner a network of innovative, low cost, and 100% DRM flexible distribution services immerges, then the sooner they will save the entire business from failing. This, in my view, is what it will take for Digital Entertainment to achieve its true potential.

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12 Responses

  1. Many interesting data points arranged to maximize “doom and gloom” conclusions. I find it a cobweb of logical fallacies that can be swept aside with little trouble. For example, EST has yet to be fully agreed and implemented by all the major Hollywood studios; to declare this a “disaster” is just downright wrong. Let’s see how this looks in 3-5 years please! As for TVOD, yes take rates have been historically disappointing — but that’s mostly due to the simple fact that the studios were making money hand over fist from DVD sales with vastly better margins. Now that the DVD market has all but collapsed (except for BluRay), we may see the light bulb come on in Hollywood and they start putting the resources to make this successful. As for Netflix “troubles”, I’ll take those any day of the week. They leveraged an incredibly great (low cost) license deal with Starz and made a billion tons of money. Yes they will now have to pay roughly the same content fees as Comcast or TWC — but last time I looked those companies were doing quite well from their multichannel video businesses, thank you very much. Netflix’s EBIT will take a hit — but the main result of that should be to bring their insanely high P/E back in line with reality. Final thought for now is that I don’t have the foggiest notion about what the author is proposing in the way of “solutions” or “fixes” to the fundamental problems he (incorrectly/inaccurately) identifies: Apparently at some time in the future in a parallel universe, “…distributors and content owners work harder together to improve the value chain into a mutually beneficial business, and the sooner a network of innovative, low cost, and 100% DRM flexible distribution services immerges…”. And, presto: They are saved from their own greedy methods and small-minded goals of maximizing profits for their respective companies. Yes, all we need is for Fox (et.al.) and Comcast (et.al) hold hands, look into the souls of their counterparts, and agree to “improve the value chain.” Such a touching “cumbaya” scenario brings tears to my eyes. Let’s give it a try by all means! If this works, we can use the same model to get the Israeli’s and Palestinians to make peace!

    • @Steve – Thanks for your “animated” contribution. I will have to disagree with how you believe to be sweeping aside my “fallacies” and with pretty much everything you have stated; with the exception of the “collapsing” DVD business (even though it is important to distinguish between rental and retail). Here is why & how I disagree with your points:

      1. “EST has yet to be fully agreed and implemented by all the major Hollywood studios”. This is not correct since all major Hollywood Studios license out EST rights. Some do this as separate deals to VoD rights whilst others include EST within VoD deals. The problem with EST is that there are no “good for the consumer” DRM solutions approved by all the majors. Oddly enough, only pirated copies provide this full viewing flexibility, since they are DRM free. DivX showed promise, but the 6 device limit and the fact that only 3 majors approved the DRM solution has caused issues. Apple’s solution is great, but you can’t view the content without an Apple device. Windows’ 10.1 isn’t even worth mentioning. So perhaps Ultraviolet will be the best solution? Maybe, but the pricing point and restrictive windowing (due to TV rights, for example) will continue to stunt the true potential of digital.

      2. “Let’s see how this looks in 3-5 years please”. Exactly…read what the analysts and investment banks are predicting and the 3-5 year view on EST is dismal. I suggest that you get your hands on some market research from companies such as ScreenDigest, Informa, and even the Morgan Stanley report that I have quoted in my blog post. But I’m not relying only on market research…I’ve done EST deals myself, licensing Sony Pictures content to MediaMarkt’s first ever EST service, and know firsthand that this business will never grow unless the price point reduces significantly, and unless such services have very flexible DRM that does not impede the consumer. And, one of the main points of my post is exactly this.

      3. VoD buy-rates have been disappointing “mostly due to the simple fact that the studios were making money hand over fist from DVD sales with vastly better margins.” First of all, poor VoD buy rates are not determined by gauging them against physical Home Ent. performance figures, as you are suggesting. Poorly performing VoD buy rates are the result of actuals being way off budgeted “business case” numbers (and those projected by market analysts), which in turn are suppose to determine what MRGs distributors pay content owners. So, MRGs are too high, and these businesses are under performing to their budgets. Secondly, the physical disk business has LOWER margins than the digital copy business, not “better” margins as you also suggest. This is mostly due to higher distribution and production costs in physical; with digital copies, this disappears and they even make the distributor pay for the master file and any encoding / transcoding. So, the digital business is “supposed” to be more profitable for the studios…

      4. “we may see the light bulb come on in Hollywood and they start putting the resources to make successful” Hollywood has been working on its digital revenue strategy for longer than you think, so the “light bulb” has been on for some time…I can personally attest to this. Did you know that Paramount Pictures has recently significantly reduced their digital division’s resources”? Also, did you know that Sony Picture’s digital rights business management has moved from a separate “Digital” division to the Television group, and now it is mostly managed by their Home Ent. Division? So, it’s not a matter of dedicating resources to make the digital business a success, it is a matter of doing it the right way…with a long term “sustainable” vision, something all studios have struggled with.

      5. “They leveraged an incredibly great (low cost) license deal with Starz and made a billion tons of money.” Wow…”a billion tons of money”? What has driven Netflix’s “digital” success has not been so much the cost of their content deals, granted the Starz deal worked well for them, but much more so their reliance on their physical rental business, where they already had a massive user base. It is easy to convert an already paying customer onto digital (in particular if you don’t increase the subscription fee!). This was the real secret to their success…not the Starz deal (which currently accounts for only 8% of their consumer viewership)…and just announced recently, Starz has decided to drop a renewed deal with Netflix in order to mitigate risks to their more traditional revenue streams.

      6. “Comcast or TWC — but last time I looked those companies were doing quite well from their multichannel video businesses, thank you very much.” Exactly…the key in your point is “multichannel” businesses, not just PayTV, but also their internet business. This is what I am stating in my post: TVoD can make sense in this context because these companies can afford to take losses in TVoD due to the much higher margins they make off their other businesses …SVoD or TVoD only businesses cannot.

      7. “Yes, all we need is for Fox (et.al.) and Comcast (et.al) hold hands, look into the souls of their counterparts, and agree to “improve the value chain.” I like your metaphor here 🙂 but it doesn’t describe what I have discussed in my post. If you understood my post, it would become apparent to you that more than 50% (often 70%) of the value chain is in the control of the content owners…so, it is in their power to actually make the difference. Distributors, such as Comcast, are relatively powerless; even though Comcast now owns Universal, there are 4 to 5 other majors to contend with. The Apple model does not work outside of the Apple universe because non Device centric content distributors need better margins in order to grow the content distribution business. The recent Netflix / Starz breakup is an excellent example of the current issues in the value chain. Netflix clearly rejected Starz’s proposal of a new deal because it cost way too much and Starz decided it was not worth risking a deal with Netflix without ensuring Pay TV type licensing revenues. This is a clear set-back to the development of digital distribution as a viable business…

  2. Great info…..

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  5. Further developments on Netflix’s challenges in the market and an excellent example of how content owners choose to protect existing “more traditional” revenue streams (e.g., Pay TV licensing fees) instead of defining the future (and true potential) of new media:

    http://latimesblogs.latimes.com/entertainmentnewsbuzz/2011/09/netflix-to-lose-starz-its-most-valuable-source-of-new-movies.html

  6. Claudio — You are quite articulate and certainly welcome to your own opinion on these matters. We clearly live in parallel universes since my experiences and yours don’t sync up very much.

    One data point will suffice, the Starz/Netflix break-up. Starz made a crazy deal with Netflix that averaged to about $.25/sub/month. Comcast, TWC, et.al. are paying Starz about $2/sub/month. Are you really arguing that the digital distribution business has to rely on crazy one-off deals that are ridiculously out of the market norm in order to survive?

    Distributors generally pay on average 35% to 45% of every dollar of OpEx to license content. Netflix got a one-time windfall that swelled its treasury. Maybe they can’t pay what Comcast & Co. must pay for quality content…their biz models are certainly not the same, with Netflix having an ARPU that’s 10%(or less) of a CATV, IPTV, or DBS Operator’s gross which comes not only from television services but also their ISP and VoIP products. It’s a tough market out there, and it will be interesting to see how Netflix (and others yet to come in SVOD) fare in a cold, cruel world.

    • You are right on that point, Steve – It is a tough market out there. I wouldn’t use content license costs as %age of overall OPEX in this particular discussion, but rather content costs as a %age of revenues from the content itself. And this is where it becomes a major problem, under today’s conditions…margins for the distributor are too low for the business to make much sense. And this is why today’s pure VoD based content services (which don’t have other high margin revenue streams to lean on) are struggling. Thanks again for your insights!

  7. Netflix’s share price comes crashing back to earth: http://articles.businessinsider.com/2011-09-15/tech/30159120_1_netflix-stock-dvd-plans-charge-users

    • Duh. P/E is still nuts. I’m a Netflix subscriber and grazing their library these days is like night and day from even 2 months ago. Most of the asset are C and D…real crap. And all this is happening as they launch a dozen or more international markets which will seriously increase OpEx. My prediction is that the share price drops much much further.

  8. Adding this analogue write-up on the failed economics of the digital music streaming business: http://gigaom.com/2011/12/11/why-spotify-can-never-be-profitable-the-secret-demands-of-record-labels/

    Most of these “secret” contractual caveats are also present in many digital video distribution deals.

  9. […] by the same organizations that hold movie and TV Series content rights. And as stated in a previous blog post, content owners demand such a large cut of the value chain that running digital content […]

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