M.A.D. - Mutually Assured Destruction or the Cold War axiom that kept the US and Soviets from ever launching a first strike. I’m sure MAD has been examined at length by historians, psychologists, sociologists, political strategists and more. It’s also been and being explored by comics (illustrated, not stand-up) and comic filmmakers (action, not funny haha). Alan Moore’s “Watchmen” explores the risk of nuclear war, geopolitical strategy for weapons accumulation and the fate of human society. The asymmetry in US/Soviet arsenals caused by Dr. Manhattan made nuclear war a near certainty, despite disastrous consequences. The upcoming film, “X-Men: First Class” inserts the mutant heroes into the middle of (and I believe to steady) the Cuban Missle crisis. Mutants using super powers to prevent global thermo-nuclear war…if only! The truth is, MAD and human understanding of its tenets, prevented both sides from ever taking a decision that would set off an unreversible chain of events leading to ultimate destruction. Why bring this up (other than my inner teenage nerd’s excitement to reference comic books)?
The US Pay TV business is mired in its own Cold War that risks imploding the current distribution and revenue ecosystem; a model that generates significant profits and cash for nearly all incumbent players. Of late, there has been escalating rhetoric surrounding affiliate/retransmission consent fees paid by the distributors to the content owners for the right to broadcast/deliver television networks. With each successive stand-off/signal pull/consumer complaint, buzz about a la carte and/or over-the-top (OTT) programming permeates the marketplace and clouds investor sentiment (and better judgment). Both sides play off this dynamic. Content owners threaten to go directly to the consumer, either via emerging distribution platforms (hulu, hulu+, YouTube/iTunes/Amazon rentals) or directly (HBO Go, Crackle). Distributors threaten to drop or price-tier lesser watched channels (Scripps’ Cooking Channel, News Corp’s Fuse, etc.) depriving content owners of the revenue/EBITDA benefits of “full” distribution. Time Warner Cable launched a “TV Essentials” tier last fall that excluded “expensive” networks like ESPN. Both sides are employing the same strategy: try to capture marginal new customers, without encouraging downgrades or disconnects, while gaining leverage over the other side by threatening to weaken/break the traditional TV bundle.
Under the surface, both sides know this would be a disastrous outcome…for everyone. It’s a new form of M.A.D. - Mutually Assured Disconnection. Any medium or large disruption and rapid unwinding of the current PayTV linear distribution model would have wide reaching implications; mostly negative.
Loss of Scale: For a content owner, there may be no better business model than the one currently in place in the US. Network affiliate fees are paid on a per subscriber basis, regardless of ratings. The per subscriber fee is negotiated based on demand for the network and its programming and, somewhat, by its parent company’s other networks. However, if ratings fall off a cliff the day after an affiliate fee deal is signed, the network owner is still paid that fixed, per subscriber fee. Put simply, its a recurring, high margin and growing revenue stream. With ~100mm Pay TV households in the US, these numbers add up fast. Subscription revenues for the major media companies (Viacom, Disney, Time Warner, Scripps and Discovery (News Corp doesn’t break it out in filings) top $21b last year. This isn’t entirely domestic revenue, but the US is the most advanced Pay TV markets and its distributors pay the highest affiliate fees. The networks, in turn, reinvest these affiliate revenues back into programming with the hope of sparking a virtuous cycle. Time Warner recently struck a deal with the NCAA and CBS to share coverage of March Madness. Turner has been investing heavily to grow its nascent sports brand (Sports Illustrated is well known, TNT/TBS less so).
The math is pretty simple. Let’s say TBS gets $1/sub•m from 100mm homes. That’s $1.2b in annual revenues. Lose 50% of the distribution to a la carte programming and Turner needs a 100% increase in the affiliate rate to maintain revenues. That’s before the incremental distribution and marketing expenses related to direct to consumer business. Maybe TBS can get $2/sub retail, or more, but will subscribers also pay up for TruTV, HLN, CNN, TNT, Cartoon Network, TCM and more? More importantly, will enough consumers pay more than current affiliate rates just to make up the revenue difference under the current model? I don’t watch HLN and I already have too much Nancy Grace in my life. The revenue and EBITDA lost from lack of full distribution will be difficult to replace. And this is just affiliate revenue. Full distribution also allows the networks to charge higher advertising CPMs.Popping of TV Advertising Bubble: I think many investors were unwilling to believe the strength of the TV advertising recovery until we were nearly 18 months into it (pretty much right now). I think it’s partly a function of underestimating the depth of the trough in October 2008 when the auto, real estate and financials INDUSTRIES were basically all in meltdown. To a larger extent, however, I think investors believed that TV was an antiquated and undesirably broad medium that would rapidly lose share to the likes of online/mobile search and display. Fear of cord cutting and a shift to OTT video consumption (with hulu pounding its chest about its CPMs) only added to the negative sentiment. While advertising dollars have shifted rapidly online (not just to search and display, but to group buying and other emerging channels), they have also shifted to TV. Yes, TV is actually still gaining share. But now that this is reasonably well understood (at least as reflected in share prices), it’s important to reflect on why TV advertising has been strong and why it will keep cable networks from going OTT: advertisers want broad audiences. While advertising CPMs are nominally driven by network/show ratings, in reality they are the sum of a complex equation with many factors, not least of which is perceived network brand and reach. Cable networks that have spent years chasing broadcast CPMs can now claim to offer the same scale, but with growing ratings (a nice multiplier). Break up the current packaged network distribution model and the audience begins to fragment. Advertisers in search of fragmented (ie targeted) audiences will do much better with online campaigns.Ramp in Expense/Red Tape: There are benefits and drawbacks to selling wholesale, as is the current cable network model. Sure, certain channels earn less in per subscriber affiliate fees than they might if they sold direct to customer; though how much less is unclear. As mentioned, I think this is offset by the greatest benefit: getting paid whether the consumer wants the channel or not. That dynamic disappears immediately in an a la carte world. With its beautiful new HBO Go product showing up on handsets, tablets and (very soon) TVs, HBO has a chance to go direct to consumer with a compelling OTT product. This would allow HBO (and its parent Time Warner) to recapture 50% of the retail price they share with distributors and potentially charge a higher retail price (to protect traditional distribution and to account for HBO Go’s flexibility/mobility). For now, however, they are opting to leave HBO Go as an authentication-based product. If HBO, a network for which the customer is used to paying a premium price within their Pay TV bundle, is staying committed to packaging, what does that mean for traditional cable channels? Would a consumer with no interest in animals pay $1/m for Animal Planet? $0.50/m? It’s unclear. The customer has never had to answer the questions, “Do I want to pay for Animal Planet and how much?” For Discovery to even reach that customer, they would need to build out a direct to consumer salesforce and a full customer support system (yikes). Major and mid-tier content owners have not been directly responsible for answering consumer concerns (outside of the occasional American Idol voting scandal) in a long time. Unsatisfied moviegoers complain to the theater. Angry cable customers (even subscribers having issues with the likes of HBO) call their service providers.
What about under a transactional OTT model (a la iTunes)? Well, let’s ignore the big questions (finding new shows, show/channel churn, etc.) and make some rosy assumptions. Each episode of “River Monsters” sells for $2. This year’s season premiere had 1.7mm viewers, so let’s assume everyone would have downloaded the episode instead, that’s $3.4mm in revenue. Now lets take this rosy estimate to its exponential end: every one of the 300hrs of announced original programming has the same download success (no repeats, off-season, etc.). That’s $1b in annual revenues. Whoops, we forgot iTunes’ 30% cut, so make that $700mm in revenues. Animal Planet is Discovery’s third most important network behind TLC and Discovery Channel, so $700mm looks good compared to current domestic affiliate revenues of $1.8b. Is every hour of original content going to be downloaded/viewed as often as the most popular episode of the top rated show on the network? Unlikely. The customer isn’t contractually obligated to download every episode like the distributor is contractually obligated to the affiliate fee. How does a network or studio budget for new product with almost zero visibility into their main revenue stream? Lots more hits and misses, generally lower quality content and write-downs like the movie business. This distribution model also likely eliminates advertising revenues, as customers don’t want to pay for pieces of content and still have to watch ads.Increased Customer Churn: Customer churn characteristics can be complicated. It’s hard to ever really get an apples-to-apples comparison because of promotional timing, variable competitive dynamics, subscriber/service plan tiers, diverse geographic footprints and more. Unfortunately, with Pay TV reaching practically full penetration in the US, gross adds are increasingly difficult to acquire, making churn an even more important performance metric. There is one nearly guaranteed (and thus aggressively marketed (and highlighted on investor calls)) driver of churn reduction: bundling. Customers that take more than one service from any single provider are significantly less likely to churn from that service provider than single service customers. Triple play customers are even less likely to churn than double play subscribes. It’s still early days in quad bundles (though handset aspirations and multiple lines often make the mobile service decision separate), but the service providers are nonetheless excited. While cable operators could continue to experiment with smaller and smaller tiers (a la “TV Essentials”), they risk disrupting the consumer’s price/value perception of the TV package. What is the value of a $40/m bare bones TV package measured against free broadcast TV, $8/m for Netflix and another $8/m for hulu plus? Especially with those OTT services built into most current generation Internet-enabled TVs. Even priced within a promotional double-or-triple play bundle, the value proposition is weak. Once the subscriber exits the triple play bundle, we know they are more likely to churn. I’d expect double play voice/data to be priced very aggressively by incumbent telecom companies, even inside VDSL and fiber footprints, to win share from cable companies rapidly losing video subscribers. They could even offer free months of OTT services as part of a promotion.
This also ties in with the question as to why content owners would make their products so readily available to emerging distributors, who in turn, sell it at a highly commoditized and discounted price. I’ll get to that in the last bullet.Lost Video Revenues: While Video is the lowest margin of the three main cable subscription businesses, it still accounts for well over 50% of revenues (nearly 100% for DBS providers) and accounts for the largest percentage of revenue generating units (RGUs). Comcast has 22.8mm video subs, 17.5mm HSD subs and 8.9mm VoIP subs. Time Warner Cable has 12.3mm video subs, 9.5mm HSD subs and 4.4mm VoIP subs. Cable operators are focused on driving higher penetration of the latter two services through bundling, they are not interested in destroying the base of which they build. Video is also the highest ARPU product by a considerable margin: standalone video ARPU for Time Warner Cable is 80% higher than HSD ARPU. In the Pay TV ecosystem, higher video revenues are reinvested in programming, meaning a rapid decline for the service provider would directly negatively impact affiliate revenue for the cable network owner.Squeezes the Highest Quality Video Service Provider: DirecTV has the highest video ARPU in the industry. This is unsurprising considering its reputation for offering the highest quality video product (plus the NFL Sunday Ticket). DirecTV places a high value on the content it acquires and charges a premium to access it. DBS is the most efficient form of delivery for a linear TV feed. They are often the only video competitor to an incumbent cable company in certain markets, also making them an ally of the content owners in many recent affiliate/retrans fee negotiations. It makes sense that it is in the content owners’ interest to ensure the DBS providers (and by that I mainly mean DirecTV) are on strong competitive standing. OTT video distribution would have the exact opposite effect. Yes, DirecTV recently launched a new VOD service and has been aggressively rolling out Internet connected STBs. The interface is extremely well thought out and intuitive and the VOD content is mostly on par with the cable offerings. The problem is DirecTV does not own an HSD pipe. Because the US has no Wholesale Broadband Access (WBA) regulatory burdens on incumbent network operators, it would be extremely expensive for DirecTV to build their own nationwide broadband infrastructure (and I personally think we are a long way from wireless as a high QoS alternative).
DirecTV has a resale agreement with many incumbent Telco/DSL operators (CenturyLink, Frontier, AT&T/Verizon outside of IPTV footprint), which drives bundled subscriptions. The customer relationship stays with the telco. The vast majority of their Internet connected STBs are connected to DSL service. The bulk of DirecTV’s subscribers and new net additions come from direct sales, with the customer bringing his own HSD service. Historically, the quality of DirecTV’s video product was enough to drive customers to decline/exit bundled services from cable operators. A smooth transition in video consumption over 3 to 5 years would allow DTV to use its massive cash flow generation and technology advantage to adapt and augment its platform and marketing strategy. In a scenario with a dramatic shift to OTT services, customers will migrate to the highest quality broadband offering, leaving DSL for cable and fiber, likely leaving the premium video-only service behind.Further Commoditization of Content: Netflix writes the big checks, for sure, paying upwards of $100k per episode/film over 2 to 3 years for “library” content. It’s hard to say no to those checks in the face of plummeting DVD sales and non-existent EST business. Making content available digitally, and on a number of different platforms, also helps to mitigate piracy. As long as the content owners and distributors maintain the health of the linear TV package, I think that Pay TV packages at $60/m and library content from Netflix at $8/m, hulu+ at $8/m or Amazon Prime at $79/yr can co-exist; the services are still very much complimentary. This equilibrium is quickly disrupted in a shift to a la carte distribution. Does a consumer want to pay $6/m (or more) for TNT, TBS and USA or $8/m for Netflix, which comes with 11 seasons of Law & Order:SVU, 6 seasons of LOST, 9 seasons of Scubs and more? Turner has not licensed much original content, but there are plenty of SyFy, USA, Bravo, Comedy Central, MTV and other network originals available on streaming. Even premium services like Epix, Showtime and Starz have made content available to Netflix, with content from the first two displayed removing the network brand entirely. All of that for $8/m!
Short and medium term contract lengths would keep Netflix streaming well supplied with content during a sudden disruption to the legacy Pay TV business. The content owners argue that if this type of commoditization led to a gradual increase in subscriber disconnects, they would pull back from licensing their content (or charge more for it). I think that to a certain extent, they could have success. TV watchers still very much rely on network brands and channel surfing to discover new content. As long as streaming services remain complimentary, the content owners are free to take Netflix, Youtube and Amazon’s money while experimenting on emerging platforms in concert with their current distribution partners (Xfinity, TWC iPad App, etc.). Both content owners and distributors will rely on these same products to slowly transition revenue, business and subscription models as distribution and consumption habits evolve. There is no benefit to accelerating this process.
These are just some of the reasons
I’ve come to believe and have stated before, that traditional Pay TV isn’t going anywhere for another 3 or 4 years. The risks are simply too great. The threat of damage to all members of the ecosystem from any one brash move should keep all of the major (and probably mid-tier) players in line. I think the most likely outcome is a continuation of the
status quo, coupled with some cautious experimentation. Broadcasters will extract ever more retransmission fees from distributors. Cable affiliate rates will grow at fixed contract escalation rates and new deals will be negotiated. Distributors will continue to raise prices modestly for TV packages, to pass on some of these increasing programming costs. Content owners will reinvest higher affiliate fees into more original, event and sports programming, growing the value of the linear package. In parallel, distributors will push hard on HSD (and to a lesser extent VoIP) penetration through bundling and short term service quality increases. Both the content owners and the distributors (or one-and-the-same in the case of Comcast) will experiment with direct to consumer, OTT solutions based on different platforms, revenue models and modes of consumption. This will empower some new entrants, but content owners will be
careful to keep Pandora (Greek myth, not music service)
in the box (and off the iPad).
Everyone should learn to stop worrying and learn to love linear Pay TV. While MAD should protect the industry from the existential threat of OTT/a la carte, they have to be extremely careful of a considerably more real threat: pricing customers out of the service. Continued consumer price hikes risks pulling forward what should be a 3 to 5 year transition in content delivery and consumption. For the moment, Pay TV still offers great price-value for its intended purpose (curing boredom) and these price hikes can be allocated to other essential services (HSD). At a certain point, however, the average consumer will but up against an expense ceiling. Once the perceived price-value of the TV package falls below what’s available at a considerably cheaper price tag (Netflix at $7.99, Hulu+ at $7.99, Broadcast TV at $0), disconnects will begin to accelerate. Cable networks have invested heavily in sports, event programming and original content to continually increase the value side of the equation, but there will come a point when the numerator is just too big. In the not too distant future (or for a younger generation, the future is now), when the consumer is forced to choose between HSD and TV, they will now choose the former. And once they are gone, they aren’t coming back.
