August 12, 2010 – Internet TV: Extreme Make Over – Industry Edition

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The media industry has undergone several wrenching technology driven changes in its history – e.g. motion pictures, radio, television, video tape, cable, etc. – and in each case, the industry value chain was drastically reordered.  Existing industry categories shrank or transfigured, while entirely new businesses emerged – the birth and death of video rental stores during most of our lifetimes is an exemplar of the phenomenon.  We believe that the inevitable, but long, transition of video to digital, a la carte distribution, nearly complete in the related field of recorded music, will be relentless and may prove to be the most transformative of all

The current television value chain is a $130B business in the U.S., of which 83% flows through as revenues for physical distributors – e.g. cable MSOs, satellite providers, broadcast affiliates, etc. – which generate roughly 35% in operating profit and pass 40% of their revenue to content aggregators.  Aggregation – e.g broadcast networks, cable networks, pay-per-view, – generates $52.2B in fees, subscriptions and advertising, yielding a 30% operating margin, with 50% for content production and acquisition.  Video content production is a $53.1B annual business, of which 60% comes from channelized distribution – first run and syndication.  Production generates average operating margins of 7%, likely depressed by artificially low transfer fees at integrated network owners, with 40% going to talent and rights fees

Distribution and aggregation face significant threats.  The Internet allows content owners to bypass channelized video, weakening the negotiating power of traditional distribution, and opening an opportunity for new players to aggregate and market content, enable search/navigation, and manage advertising and subscribers.  To the extent that these players can rely on self-produced content and contractually lock in exclusive rights to other high value content, channelized distributors and aggregators may forestall the churn of users to on-line alternatives, buying time to establish their own brand value on the Internet.  Nonetheless, we expect competition for content rights and advertising revenue to pressure both sales and margins for channelized players

As new content flourishes in on-line venues, as content owners not under complete control by channelized aggregators test the Internet waters more aggressively, and as technology and regulation enable easy living room viewing of on-line TV, the diaspora of eyeballs and ad dollars onto the Internet will accelerate, thus attracting more and better content, and then more eyes and dollars.  This cycle of positive reinforcement will advance opportunities for new players – e.g. Netflix, Hulu, Apple, Google, etc. – to aggregate, market and monetize content on-line

Producers of content will obviously benefit from the emergence of an alternative to network/cable distribution.  However, dramatically lower barriers to entry on the Internet are attracting new producers, and eroding the value of business relationships between producers and traditional distributors.  Bidding for high value properties, such as sports, will grow increasingly fierce, with rights owners exploring opportunities to forward integrate into self distribution.  The rise of team-owned and league-owned production and distribution channels, such as the New York based YES or the NFL network, is evidence of this phenomenon.  Movie studios have also been aggressive in pursuing alternative distribution, first through their own dedicated cable networks – e.g. Epix, Starz, etc. – then through comprehensive on-line deals with new aggregators like Netflix

Content producers that are integrated with channelized aggregation and/or distribution face a difficult transition.  If programming exclusivity is used to prolong the value of a network, it may erode the value of the content, while maximizing the value of content could hasten the deterioration of the network.  Most video content owners have moved to embrace the on-line medium – NBC-Universal, Fox and ABC co-founded Hulu and make most of their network content available to subscribers of that service

The painful experience of the recorded music industry is a powerful reminder for media players – failure to act decisively in the face of piracy fears allowed Apple to gain critical mass with its proprietary iTunes solution that has greatly diminished the industry’s collective negotiating power.  As such, the video market is evolving with open technical standards across multiple aggregators and an implicit acceptance that digital piracy can only be discouraged, not eliminated.  This likely hastens the transition

In our scenario, companies that are disproportionately tied to traditional channelized distribution and aggregation –cable operators (e.g. Comcast, TimeWarner Cable, Cablevision) and cable network operators (e.g. Discovery, Scripps) – appear to be the losers.  On-line aggregators (e.g. Netflix, Google, Apple) are advantaged, as are owners and producers of high value content (e.g. Lions Gate, Dreamworks).  Big integrated media players (e.g. Disney, News Corp, Viacom, CBS, Time Warner) face a mixed bag of opportunity and threat where success will be determined by the relative exposure to channelized aggregation vs. production and their ability to transition their channelized properties into effective on-line aggregation and marketing franchises

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