Video Killed the Radio Star 

Internet Video to Your Television: A Few Steps Closer to a Mass Market 

By Charles B. Slocum and Ellen Stutzman 

Internet video is a few steps closer to reaching television sets in mass numbers, thanks to unforced errors by the market leader, an astute move by a stealth competitor, and a rare, tantalizing, hint of what is next for the most inscrutable video provider. The move from the PC to the TV is a key development in breaking the cable cartel and it’s closer – but less predictable – than ever.

The leader in delivering video content to television sets has long been Netflix, which astutely entered the DVD-by-mail business when most business strategists thought the DVD business was long settled and soon to decline. Netflix knew, by all accounts, that they had to bide their time until streaming content to viewers got cheaper than mailing it, until high-speed Internet subscriptions were common enough in the U.S. to make subscriptions in high numbers possible, and until devices existed that could deliver the content to TV sets. Netflix entered the streaming business long after some of its competitors, but at precisely the right time, and pursued a strategy of ubiquity, even getting inside the tightly controlled world of the Apple TV.

Netflix succeeded in the DVD-by-mail space by being a one-stop shop. If a DVD exists, you can probably find it on Netflix. The relatively low monthly fee was fixed, with no late fees (though there is an implicit late fee if you keep those same two DVDs on the coffee table for weeks and weeks). Netflix’s stated goal was to do the same by streaming buffet-style “anything you want” and “all you can eat” for a fixed low price.

Hollywood had already seen Netflix and Redbox devalue the DVD and thus trim DVD revenues. The industry did not want streaming to perpetuate lower prices. Because Hollywood controls the licensing, the industry could say “no” to the plans – and did so. Netflix found itself without content; no content meant no strategy.

Then, in March, Netflix stunned Hollywood by outbidding HBO for the series House of Cards, a remake of a popular British political TV series. This signaled a new strategy: Netflix would be the HBO of the Internet. The company also licensed the pay TV window for films from Relativity and Dreamworks Animation. Starz realized Netflix was more of a competitor than an ally and did not renew its sub-license. Without all-inclusive content, Netflix had to buy a small portfolio of marquee content to satisfy pockets of constituencies and patch together a smaller, but more loyal, subscriber base. Netflix already had 20 million subscribers to HBO’s 28 million. Many analysts compared Netflix to Comcast, but the astute ones compared it to HBO.

But the best analogy for Netflix might be Tiger Woods—once invincible, now humbled and injured. The problem, it appears, is that Netflix itself was not convinced of its new course.

Miscommunication

By all outward appearances, Netflix was courted as a buyer for House of Cards as a stalking horse, a source of negotiating leverage for the producer against HBO. Just as the $100 million license was approved within Netflix, senior executives were simultaneously proclaiming publicly that Netflix was not entering the original-content business. Had they missed the memo about the strategy change? More likely there was no memo. Netflix’s next two moves demonstrated a huge gap between the apparent deep understanding Netflix had of its customers and the reality of its complete lack of understanding of what its customers loved about the company. They raised prices as much as 60 percent for the very same services that customers were already receiving, then announced that they would split the DVD service apart from Netflix under a different brand name Qwikster.

The split specifically meant that customers could no longer search for desired films and add them to either a DVD queue or streaming queue, depending upon availability. Users would now have to search separately. The combined search had been a significant convenience. With pricing and searching no longer cross-collateralized, viewers protested and a significant number cancelled their accounts. Investors were spooked and the stock, which had reached a stratospheric $300, tumbled to less than $100. Netflix retreated on the split operations, but not the pricing, and the subscriptions and stock price did not rebound. With its shares worth one-third of what they had been worth, Netflix faces a tough fundraising challenge, essential for a growing company.

Had Netflix never understood its customers? Had they lost sight of their customers in a funk over a changed strategy? Likely the latter. When the all-inclusive/low-cost streaming strategy was rejected by Hollywood, Netflix cast about for a new strategy. It found two new elements and made mistakes because of each. The first was original content. The House of Cards deal had been a stroke of luck and an ideal choice. Netflix made headlines and found what would likely be a successful alternative strategy. Yet, they appear to have reacted with panic to the economics of high-priced content with a move to raise prices. The company that tested each operating change in its website intensively to gauge customer acceptance seems to have made a gut call and badly misjudged customer reaction.

The Anti-Social Network

The second element of a new strategy for Netflix involved Facebook. Among the less noticed of Facebook’s recent moves to add direct links to video within the site is Facebook’s integration with Netflix. What your friends are streaming through Netflix can be recommended to you via Facebook.

However, a law exists prohibiting video distributors from revealing a customer’s rentals. By recommending to you what your friends are streaming, Netflix and Facebook could be violating this law. It’s not clear that the law applies to streaming videos (or even to Netflix’s rentals-by-mail operation), but disassociating the streaming activity from DVD rental activity would make the separation clearer. Thus, the separate queue management and separate brand name for the DVD service. All the better, also, to position the DVD service to be sold off at an appropriate time.

The problem is that customers didn’t appreciate either of those advantages. By responding to its own corporate needs, and not those of its customers, Netflix stumbled. It’s a precarious place to be, sitting atop a stock price that is 80 times earnings. And Netflix fell from grace to about 20 times earnings (still high) amid subscriber defections and doubts that it knows what it is doing.

A Stroke of Luck

Into this strategic opportunity steps the Dish network satellite service. Satellites are elegantly low-cost as a video distribution technology – adding a customer adds exactly zero cost on the transmitting side of the operation. Yet, this one-beam-hits-all infrastructure has a major disadvantage: It’s a one-way technology. There is no on-demand utility. Satellite service gets close with hybrid techniques, but there is always a limit that cable can beat. What cable calls “TV Everywhere,” Dish (and DirecTV) can’t offer anywhere.

To counter this limitation, Dish bought the remnants of Blockbuster in April. The online service that Blockbuster created failed as a standalone business, but perfectly complements Dish’s satellite service as an on-demand offering. The DVD-by-mail aspect offers the greater value that Netflix demonstrated is so important to customers. And, the brick-and-mortar stores that Blockbuster and everyone else has written off as obsolete, can serve as the unified retail outlet network that Dish could never previously afford.

Possibly the only buyer who could find an upside in Blockbuster’s failed leap to the future, Dish got a bargain on its incremental move. Then, Netflix tripped and suddenly Dish’s “plan B” turned into an opportunity to craft a new “plan A.” Dish has the triple threat of linear channels, DVDs, and streaming on demand.

Stimulating this competitive landscape is Amazon, which, in February, turned millions of subscribers of its free shipping program into online video subscribers. It’s an illogical but elegant move that gives Amazon a streaming video service with millions of subscribers on day one. And, Amazon offers the portable devices for subscribers to view the content on. Their set-top integration, however, lags.

Another major player in online video is Hulu, which the potential buyers concluded was an incomplete business as packaged for sale. Its TV network owners committed a few years of programming rights to their online baby as they put it up for adoption, but the buyers saw through that ruse. They either offered a price too low for the owners to sell at, or required a greater commitment of programming rights than the owners were willing to commit, especially for current series. This is true even with the inclusion of Hulu+, which offers a wider selection of content for a subscription price similar to that of Netflix. So for now, Hulu remains the red-haired stepchild living above the garage of the networks’ TV-built estates.

More Stealth Bombers

The other stealth players in Internet streaming are the incumbent cable TV operators. Eager to protect their cartel, they used their economic power to limit suppliers from selling to new competitors who might be seeking to compete with cable over the Internet. This gave rise to the concept of TV Everywhere, which provides cable TV content via the Internet, but only through the subscription you have with your cable company. As this Internet access blends together with cable-based on-demand content, and as portable devices become more frequently used for TV Everywhere, at what point will a cable TV company simply offer an Internet-based subscription? The answer is that AT&T already does – its U-verse service is all Internet technology, though still limited by its physical wires. If Dish attracts more than a few new subscribers, cable operators will grow eager to offer service outside their wired footprints. Already, cable operators (Comcast and Verizon Fios, so far) are cooperating with third-party boxes such as the Xbox from Microsoft to blend its TV Everywhere offering with other Internet-linked content. In the past, with TiVo as the sole active player in that space, the cable operators only cooperated as much as the FCC required them to.

Other companies are also poised to move into the online streaming business. Their moves remain as yet unmade, but potentially strong. Wal-Mart bought the Vudu streaming service. Best Buy bought the CinemaNow streaming service. Google bought the Sage TV software company to beef up its Google TV product.

And then there is Apple. Apple is perennially rumored to have both a TV and a streaming video service in development. An unusual hint came in the biography of Steve Jobs by Walter Isaacson, published shortly after Jobs’ death. Jobs is quoted by Isaacson as saying that he had been pursuing the reinvention of the television, integrating a wide variety of sources of content into a simple user interface, and that he had “finally cracked it.” The most common Internet speculation is that Jobs was referring to integrating Siri, the voice-controlled artificially intelligent software program newly offered on the iPhone 4S, into a television. It seems likely that a touch interface, using an iPhone and/or iPad also is a part of the breakthrough. And, beyond that, Jobs’ surely was also referring to getting around the poorly performing technology currently required by cable companies for third-party set-top boxes. This “cable-card” technology is the technology that Google acquired with its Sage TV acquisition and which TiVo has long had as a strategic advantage. Neither of those solutions, as successful as they are at coping with the limitations of the current infrastructure, seem anywhere close to something Jobs would allow Apple to release. It’s safe to say that Jobs has sought to leverage the iCloud infrastructure that currently makes all your iTunes music available on any iOS device for his reinvention of the television. This must, of course, include linear television channels, rumored to be something Jobs had sought to license, but could not. With Jobs telling Isaacson that he “cracked” the interface and with the iCloud technology in place, licensing content seems to be the only obstacle to the rumored 2013 release of an Apple TV.

As Wal-Mart dominated video sell-through, Netflix was starting to dominate rentals and threatening to dominate streaming. The Hollywood production cartel has a “love/hate” relationship with the cable TV/Internet cartel and really doesn’t like the near-monopolies of Wal-Mart and Netflix. By content-owners withholding licensing, and with the unforced stumbles of Netflix, a near-monopoly in streaming is now much less likely. Netflix will likely survive its missteps, though perhaps through a shotgun marriage with a deeper-pocketed partner. And subscribing to Netflix will become a nonexclusive proposition, like subscribing to both HBO and Showtime is now.

But in the near future, a combination of Dish/Blockbuster, Wal-Mart/Vudu, Best Buy/CinemaNow, Google TV, and Apple will likely also share in the streaming market. This would create a more seller-friendly market. A key development to look out for is HBO offering its Internet-based HBO Go outside of a cable TV subscription. This would mark a major step in the disempowering of the cable cartel.

Also, smaller bundles, or outright a la carte cable TV, would also indicate actual competition, rather than the cartel activity prevalent in cable TV today.

Where do these strategic churnings leave content owners, and writers who receive residuals from them? Happy. Consumers would have more choice. Content sellers would have more leverage and thus receive higher license fees. Writers then receive more residuals. These are all signs of a healthy capitalism and a healthy Hollywood.