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 article. Even 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.