Is Netflix Streaming Its Way Towards Disaster?

Netflix, through the simple device of using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now claims 16 million subscribers who pay a monthly flat fee for an unlimited number of rentals. For this mail-in business, Netflix did not need the approval of the studios. It simply buys DVDs, as does anyone else, from retailers such as Wal-Mart then mails them out to subscribers. What makes this form of rental legal is the “first sale doctrine,” which holds that once a person buys a DVD, he can rent it out to others without the permission of the copyright holder. Through that court-approved doctrine , Netflix created its mail-in empire. For a monthly charge of as little as $9 a month, subscribers get any movie they choose on the Netfix website. Whenever a subscriber mails back his DVD in a stamped address envelope provided by Netflix he receives the next DVD he has ordered. There are no late fees.
Rather than backing its trucks up to Wal-Marts, Netflix buys most of its DVDs from wholesalers. Its average price of about $15 per copy. (Some studios also supply lower priced DVDs in return for Netflix delaying its mailing them until a month after they are in video stores.)
Last year, Netflix took in $1.67 billion in subscription fees. For its mailing business, its major expense, other than purchasing the DVDs, is postage and handling. It sends out about 2 million discs a day, which requires maintaining 50 distribution centers and buying over a half billion dollars worth of postage. Because of these expenses, its operating profit was only about 12 percent.
Netflix is now attempting to reduce its vulnerability to postage rate hikes by streaming movies over the Internet. Reed Hastings, the chief executive and co-founder of Netflix, explained that this new strategy is part of his concept that Netflix is not just as a mail-order house but a full-service home entertainment distributor since streaming provides movies in digital form on everything from Ipad, and Iphones, to game console and TV sets. Over the last three years, this streaming experiment has garnered a growing number of subscribers partially because it has been absolutely free to the subscribers of its mail-in service. Next year, however, it plans to charge for its streaming service. If it succeeds in converting its mail subscribers to streaming, it will in effect create a virtual channel that directly competes with the three major Pay-TV channels, HBO, Showtime, and Starz.
The problem here is that while streaming movies is a more efficient way of delivering movies than the mail, it requires a radically different business model. Unlike with mail-in DVDs, the first sales doctrine does not apply to streaming. So Netflix needs to license the electronic rights from the studios, and that is extremely expensive. In the case of new movies, studios license slates of 20 or so titles in so-called output deals for hundreds of millions of dollars. The average cost for a single title in such a deal is about $16 million for a two year license. Where Netflix can buy 10,000 copies of a major title for $150,000 to mail out, it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service either because they prefer DVDs’ higher quality and features or they don’t have the apparatus to receive digital streaming.
For the past 3 years, while building up its streaming service, Netflix found a temporary way around the licensing issue by making a sub-licensing deal with Starz Entertainment, a subsidiary of John Malone’s Liberty Media, which has its own output deal with Disney and Sony. paying Starz only $25 million a year for electronic sub-rights. Disney sued Starz claiming that such a deal violated the output agreement, but Starz held that it could sub-license these rights because Netflix was merely a “content aggregator.” No matter what happens in the litigation, the loophole will certainly be plugged in 2012 when Starz’ output deal expires. Not only will Disney likely demand on a payment for sub-licensing, but Starz itself has recently informed its other licensees that it will no longer discriminate in pricing, which means that Netflix will have to pay what everyone else pays for content.
And Netflix’s renewal problem is not merely with Starz. It also managed to license in 2008 the electronic transmission rights until 2012 for television programs, such as “The Office,” from networks. At that time, syndicators were only interested in the broadcast rights for re-runs of these series, and, as the streaming rights had little value, they licensed them at bargain prices. But the networks now have streaming, and video-on-demand of these programs on their own website, making it highly unlikely they will renew the expiring agreements.
The brutal reality is Netflix’s bargain days for streaming movies and television are coming to an end. As everyone else in the licensing game, Netflix will have to pay real world prices for content. Just the output deal it announced with three of the weakest studios, Paramount, LionsGate and MGM will cost it $200 million a year, a sum that exceeds its operating income last year. And if it wants the kind of output deals the other pay channels have, it will have to pay a great deal more than that.
Netflix, to be sure has brilliantly dominated the DVD mail order business. But, even aside from the immense cost of content, it must overcome three daunting challenges to succeed in the brave new world of cyber space.
First, it will have to compete directly with Pay-TV channels. HBO, which has nearly 40 million subscribers and a yearly cash flow of $1.8 billion, is not about to cede cyberspace to Netflix. It has just launched HBO GO which will stream to HBO subscribers “anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation”, according to Jeffrey Bewkes, the Chairman of HBO’s parent, Time Warner Communication. This includes not only the new titles, it acquires through its $500 billion output deals with Warner Bros, Fox, and Dreamworks but its prize-winning original series.
Second, since there are few barriers to entry to cyberspace, Netflix will also have to compete in pricing Internet savvy companies, including Apple, Amazon, Hulu and Youtube, all of whom can offer similar streaming services.
Third, as Netflix’s streaming consumes more and more of the capacity of broadband carriers such as Comcast, it will have to contend with either restrictions or usage charges that will increase the cost of streaming.
If Netflix fails to meet these challenges, its bold move into streaming might be nothing short of a prescription for financial disaster.

Will Nextflix Be The Next HBO?

Netflix, through the simple device using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now has 11.8 million subscribers who pay a monthly flat fee for an unlimited number of rentals. It gets its DVDS from wholesalers and even retail stores. It can then rent them because of a court-approved "First Sale doctrine," which says that once a person buys a DVD, he can re-sell it or rent it out. Last year Netflix took in $1.67 billion in subscription fees, but because of the high cost of mailing some 2 million discs a day from 50 distribution centers, it only eked out a profit of $115 million.
So it is moving onto the Internet, substituting digital streamed movies for ones that are delivered by the postman. Subscribers get them on their TV via a set top box or game console without any additional charge. This "Watch Instantly" service effectively creates a virtual channel that directly compete with Pay-TV for the wallet and clock of viewers. Such a challenge by Netflix could also result, as Frank Biondi the former head of HBO, terms it, "a terminal career decision if you get it wrong."
The problem is that the First Sale doctrine does not apply to streaming or downloading DVDS so Netflix must buy digital rights, which is exceedingly expensive for new titles. In late 2008, Netflix found a temporary way around this stumbling block by making a deal with Starz Entertainment, a subsidiary of John Malone's Liberty Media, to sub-license the streaming rights of the titles it had obtained from Disney, Sony and smaller studios in output deals. Starz held it could sub-license these rights because Netflix was merely a "content aggregator," but the studios took a dimmer view of this loophole. Disney, according to a top executive involved in the dispute, has warned Starz that it will not renew its output deal (which expires in 2012) unless it either cuts Netflix out or pays Disney a rich premium.
Netflix chief content officer Ted Sarandos portrays the issue as merely a communication glitch, saying, "We have to fight against their fear that we~ll destroy the ecosystem." Despite this well-meaning new-age talk, what is really at stake here is old-fashioned money. The most profitable part of Hollywood's "ecosystem" is the output deals through which studios license movies to Pay TV channels, cable networks and broadcast stations. According to the studios's internal all-source revenue numbers, the six major studio took in $16.2 billion from pay-TV and television licensing of their movies in 2007, which was almost all profit. So the threat of sub-licensing for Internet circulation involves a good more than studio paranoia.
As for HBO, a subsidiary of Time Warner, it is the undisputed leviathan of Pay-TV. It has over 40 million subscribers, $4 billion in revenues, and a cash flow of $1.3 billion. And, unlike Netflix, it owns the digital rights to a large amount of exclusive material, much of which it produced. Over the past decade it invested heavily in original programming, creating such series as The Sopranos (which cost $2 million an episode) to retain subscribers. This made economic sense because cable systems paid it about $6 a month for each subscriber. As a top Time Warner executive who had authorized much of this original production explained to me, the name of the game is subscriber retention.
So HBO is not about to cede cyberspace to Netflix. It's in the process of rolling out an Internet service called HBO Go which will allow all HBO subscribers to get, as the executive puts it, "anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation." Bolstered by its exclusive content, HBO will initially offer some 800 hours a month of programming a month. Its 40 million subscribers can get at no additional charge over the Internet the linenew titles HBO acquires through its output deals with Warner Bros, Fox, and Dreamworks, past and present original series, HBO boxing, and even so-called "late night" fare such as Alien Sex Files.
Netflix, on the other hand, has almost no exclusive content with which to compete with HBO. Back in 2006, it attempted to produce its own original content through a subsidiary called Red Envelope Entertainment, but closed it down in 2008. The brutal reality is that Netflix, with only one-eighth the cash flow of HBO, does not have the scale to produce its own material. Of course, whether or not the Starz deal is renewed, Netflix can exclusively license programming through output deals. But competing in this game, in which the licenses for a slate of two dozen movies can cost in excess of a quarter of a billion dollars, could prove prohibitively expensive. Last year Netflix reportedly spent $100 million on licensing just non-exclusive rights to movies for streaming from Starz and studio libraries. Although this saved postage, Netflix still has to pay the overhead for its distribution centers. Adding hundreds of millions of dollars in output deals to this equation could wipe out much, if not all, of its profits.
Netflix has brilliantly carved out for itself a niche audience who largely enjoy the convenience of receiving older movies, which accounts for about two-thirds of its revenue. It will no doubt continue to satisfy and expand this audience via mailing and streaming. But what it lacks is the wherewithal to do is to replace HBO.
Edward Jay Epstein is the author of 14 books, including two examining the movie business: The Hollywood Economist: The Reality Behind The Movie Business will be published by Melville House later this month, which follows his 2005 book The Big Picture: Money and Power in Hollywood.