Add in the burgeoning popularity of free, ad-supported online streaming video and Web-enabled portable devices--conventional distributors, it's time to worry.
The concern comes when pay TV, DVD sales and even conventional broadcast television are strained. Even film studios' high-margin economics are being squeezed by rising piracy and the loss of $10 million in profit from every unsold DVD (which triggered a 64% decline in Disney's studio operating income last quarter).
Domestic pay TV growth is expected to slow to 5% in 2009 from 11% last year. U.S. consumer home entertainment--boosted last year by video games--is expected to decline 7% each of the next three years, Bernstein Research estimates. Cash-strapped consumers are more selective and unpredictable.
Still, more than 20% of Netflix's 9.4 million subscribers (and 1 million Microsoft Xbox LIVE Gold members) have already signed onto its new streaming service even before the complete rollout of supporting multifunction devices from LG Electronics, Samsung, and TiVo. Despite competition from Amazon streaming movie rentals to Roku set-top boxes, download services like iTunes and Web video sites like Hulu, Netflix founder Reed Hastings says this latest reinvention of his company delivers better, cheaper entertainment in a weak economy. The 82% of U.S. Internet households and 57% of all domestic homes equipped for broadband are a click away from all-you-can-stream home movies for $10 a month.
Netflix is changing the home-video delivery model the same way Amazon continues to reinvent bookselling. The new option--to download a digital version of Jeff Jarvis' book, "What Would Google Do?"--will alter the publishing model. Both are evolving personalized on-demand, subscription-based business models that are upending license fees, advertising and everything about the status quo.
The surge of free and on-demand content online that is devastating ad-supported broadcast television and DVD sales will erode cable's subscription business. Time Warner Cable CEO Glenn Britt told investors on Feb. 5 that he is beginning to see "cord cutting" by younger broadband consumers "who will choose not to buy subscription video when they can get the same stuff for free...the cable network business will suffer mightily if this trend continues."
Time Warner is exacerbating matters by proposing metered charge for broadband consumption. Cable providers' shocking underutilization of the Internet bypass has been limited to launching an addressable Project Canoe to grab more national and local advertising. Although only one-fifth of its video revenues are considered discretionary, Comcast is broadening its appeal beyond core pay cable, data and phone with social Web services, such as Fancast, Fandango, Vehix and Plaxo.
Cable's general reliance on retransmission fee tussles with TV networks and pricey retention marketing are only good as long as the pipeline is dominant. The top six cable companies have 35 million broadband subscribers, compared with Google's 149 million domestic unique users. Google's YouTube accounted for half of the 13% increase in monthly online video viewing in December, to a record 14.3 billion. And they aren't all kids. The Pew Internet and American Life Project reports that the age gap is closing on Internet and wireless video.
For now, Netflix must continue mail delivery of the newest film releases because of cost-prohibitive licensing fees, but it has boldly shifted to a new IP-based business model that is destined to become the industry standard. It is making the intrepid digital transition that other companies must make to survive. It is also responding to consumers' desire to do more with what they have rather than buy new electronic gadgets--evident from the record losses at Sony and Toshiba.
Interactive consumers are turning to "active" in-home family entertainment like Wii over "passive" movies, according to Goldman Sachs--suggesting that Netflix and pay TV operators will add heavy doses of games. But consumers are driven mostly by value--getting the most for their money. Although cable has grown its share of TV audience the past decade while lowering its cost relative to other entertainment forms (the cost of one hour of cable has declined by an inflation-adjusted 26%), it still faces disintermediation by wireless broadband, according to Bernstein analyst Craig Moffett. The delay in digital TV conversion may only compound the problem as the ill-equipped 5 million U.S. households look beyond pay TV operators for easy, less costly alternatives.
Citigroup expects average cable company capital expenditures (on expensive set-top boxes) to decline to 15% of revenues, even as they strive for 100% digital conversion. The unknown is how much of their pay TV business will be siphoned by IP-based interactive services. Meanwhile, all cable operators are demonstrating vulnerability to economic downturn and changing consumer behavior. Time Warner Cable reported marked declines in net subscriber growth in all major areas, especially video, last quarter.
Trading at just 5-times 2008 trailing earnings (2009 will be worse), Time Warner Cable's valuation is "materially lower" than the telcos, despite having revenues and earnings growth rates twice as large--debt and dividends notwithstanding, Moffett said. Goldman Sachs analyst Ingrid Chung expects "deteriorating fundamentals given increasing program costs, a dramatic slowdown in subscriber trends, a mid-teens decline in ad revenues, and contracting margins."
There is new evidence cable is "ceding" its broadband share gains to Verizon and AT&T, which explains why Microsoft has pulled its $1 billion investment from Comcast. Cable's failure to fully extend its bundled services to wireless broadband outside the home will prove fatal. "It's hard to believe traditional video distributors are keeping pace with the capabilities of the Internet," observes Pali Capital analyst Richard Greenfield, who now has a "sell" rating on Time Warner Cable. "Will cable simply become a dumb data pipe over time?"
Maverick Mark Cuban cautions that Internet streaming video, however cheap and pervasive, will never match TV's mass reach. He says "the great Internet video lie" is that the Internet competes with conventional distribution--although it can only render the same mass reach combining a half dozen online content delivery networks.
For now, Netflix is skillfully maneuvering the rapidly shifting broadband terrain, using its wireless wits to conquer a corner of the new digital market--one consumer at a time.