• by Diane Mermigas , May 31, 2011

The explosive shifting and creation of value in the emerging interactive market is especially intriguing to watch in the case of Netflix and HBO.

Even as Netflix continues to spur its video competitors, incumbent HBO is poised to reinvent itself yet again. Netflix's meteoric growth into a $14 billion company with a record-high $260-plus share stock has created new value in a mobile-connected market, while siphoning existing business from rivals.

How much of the new market economics HBO can attract and how much of its core business it can retain or grow is a matter of response and timing. It reflects the quandary confronting so many other legacy companies caught in the shifting gears of digital technology.

The Time Warner on-demand movie service has pulled its feet out of the fire before, with hallmark original series such as "The Sopranos" and "Game of Thrones." (HBO supplies a disproportionate amount of authenticated content because it services more than one-third of all U.S. pay TV homes.) More recently, HBO Go has provided its pay TV subscribers -- through existing cable, satellite and telephone distributors -- access to HBO programming on their connected mobile devices. It is primarily a defensive move to keep subscribers from defecting to streaming video services such as Netflix.

HBO On Demand reduced core subscriber churn by an estimated 15%, and HBO GO is expected to cut churn by another 10%, according to Credit Suisse analyst Spencer Wang. More importantly, HBO GO is expected to create $2.2 billion to HBO's estimated $15 billion value, which also will be accretive to Time Warner.

The key to creating new value is authentication, which allows consumers with a pay TV subscription to access TV content online. Although Time Warner and partner Comcast are perhaps best known for their TV Everywhere initiative, nearly 90% of all pay TV subscribers will have access to some form of authenticated content by year's end.

But the fight to stay alive is becoming more complicated. HBO needs to secure the support of digital affiliates such as Amazon, Apple and Google to alternatively distribute its content. Ultimately, HBO may need to take its service direct-to-consumers -- another risky strategy with inherently greater upside potential.

For now, HBO is embedded in Time Warner's cable networks and Turner's basic cable channels, which provide a gateway to the service that charges an additional $15 per month for its premium content to nearly 30 million subscribers. HBO generated $1.4 billion in earnings on $4.3 billion in revenues last year, which represents nearly one-third of Turner's overall cable economics and nearly one-fourth of Time Warner's overall revenues and earnings.

Clearly, an erosion of HBO's value could have a dramatic impact on Time Warner's bottom line. The bears argue that HBO's subscriber base is being cannibalized by Netflix (which, like Comcast, claims 22.8 million subscribers) and other over-the-top services. The result: a fall off in subscribers and subscription revenues and a rise in content costs in order to remain competitive. Indeed, Netflix recently moved the bar higher by paying big bucks to acquire first rerun rights to "Mad Men" and to commission original programming. The move by Netflix and other over-the-top video players to acquire content directly from studios could potentially marginalize pay TV services such as HBO as well as cable networks.

Netflix's aggressive advancement is not the only threat to HBO's value proposition. Amazon is moving quickly to provide affordable and plentiful content access and storage. Not to be outdone, Comcast is reaching beyond its own Xfinity TV online brand. Comcast is working with MIT to test the delivery of live television content over its own Internet protocol. The more players in the streaming pond, the more marginalized even a rock star service like HBO becomes.

Wang isn't buying it, and argues that HBO's best days are ahead, primarily because it will be leveraging its strengths. Foremost among them is that HBO is already an a la carte service with clear digital content rights to distinctive original fare. HBO is also positioned to continue competing with vastly underestimated older library content.

"Not only is HBO not overly at risk, but also may have the greatest opportunity to reposition its business model, improve its economics and, ultimately, extract incremental value from digital technology," Wang observes in a new report, in which he refers to HBO as media's "most under-monetized asset."

Of course, that is key for all legacy businesses these days, no matter how progressive -- to remain sensitive to a consumer's discretionary spending. While the monthly cost of pay TV subscriptions has increased 29% over the past five years, consumers' real incomes have fallen precipitously -- one reason why pay TV penetration is now declining, Bernstein analyst Craig Moffett points out in a new report.

So the tug-of-war between HBO and Netflix may have more to do with economics than with content procurement or delivery. Netflix may be a cheaper, faster answer for video-hungry consumers than an HBO embedded inside cable's costly infrastructure.