On-line TV: A Cycle Ride to the Tipping Point

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In the debate over the future of cable television, “cord cutting” is often presented as a static yes/no choice.  We believe this oversimplifies a complex chain of negotiations and choices by an evolving set of participants that are repeated in a rapidly changing context.  With consumers rapidly gaining access to on-line content on tablets and on their living room TV, the audience for Internet TV is rising, drawing advertisers intrigued by the interactivity and targeting offered, and thus, attracting new and better programming to the medium.  At the same time, content owners are able to use the Internet as leverage, driving higher fees from network owners, who, in turn, use the same leverage to drive higher fees from cable operators, who have little choice but to try to push their higher costs onto consumers.  With time, we expect that the status quo will become increasingly unstable, as these self-reinforcing cycles push us toward a tipping point that will trigger widespread cord cutting

Analysts are projecting 2011 global tablet sales of as many as 40 million units, with at least half coming from the US.  If true, nearly 10% of American adults could have a convenient platform for Internet video viewing by year end.  At the same time, connected game consoles, blue-ray players and Internet ready TVs are bringing on-line to the living room big screen, fed by the growing availability of HDTV capable 6+ Mbps broadband connections.  This dramatically changes the competitive potential of streaming video vs. the traditional channelized model

The growth of viewership for on-line video has been explosive, drawing increasing spending on Internet video advertising.  Inevitably, this will draw content from more aggressive creators and owners, which will stimulate further audience growth, and so on.  Already creative pioneers have hit the mark with original content for the medium, while the big media players edge their way into the market.  We believe that this positive cycle has begun, is irreversible and will accelerate

While the status quo may appear solid, with cable MSOs and media companies aligned behind the channelized model, we believe that it is an unstable equilibrium that could deteriorate more quickly than many believe.  Transactions along the television value chain – networks buying rights to programming, system operators renegotiating agreements with networks, consumers choosing to watch content from alternative sources, or even to cut the cord – are repeated over time as the underlying conditions continue to change and the on-line opportunity becomes more attractive

It is typically presupposed that networks “own” their content, and that choices that promote “cord cutting”, thus endangering the primary revenue stream for video content, will not be made.  In fact, most network programming is bought through negotiations with production companies, which in turn, often must negotiate with the talent that creates it.  As most content deteriorates in value as it ages, network executives must seek out new content and bargain for distribution rights.  With on-line emerging as a viable alternative, negotiating power is shifting toward creators and owners, keeping rights fees a sharp upward trajectory

Channel line-ups are dominated by a concentrated group of media companies, who use the leverage of their flagship properties to push expanding channel bundles and extract ever growing rights fees from cable, satellite and telco TV systems.  While media companies have a vested interest in perpetuating the status quo, the risk of losing relevance as viewership shifts to the new distribution model is a powerful motivating factor as well.  We also note that a relatively small subset of programs dominate viewership ratings – NFL football and other sports, reality competition shows, Oprah, etc. – and that most of these properties are not “owned” by the networks that air them and many have chosen to launch their own networks.  It would seem likely that the most powerful content would be considering the opportunity to cut out the middlemen and go directly on-line

The experience of the recorded music, where Apple has disintermediated incumbent labels, is a stark memory for media companies.  With sites under their own brands, and ventures like Hulu and TV.com, channel owners have already begun to hedge their bets on the future of channelized video.  As time goes on and the on-line audience grows, we expect the most daring players to push the envelope so as to establish their brands ahead of competitors and forestall the emergence of a dominant aggregator, such as iTunes.  These pioneers will force the laggards to follow

Finally, consumers vote with their pocketbooks and their eyeballs.  To date, demand for cable service has been relatively inelastic, despite widespread consumer distaste for the cable industry, with basic rates rising more than 6% per annum over the past two decades and attractive content shifted to higher priced tiers.  Over that time, satellite and telco TV have been fairly benign competitors – pricing has moved in tandem, satellite installation and line-of-sight requirements remain a barrier, and telco TV is available in a small minority of US markets.  With a rapidly growing percentage of Americans able to access video content via convenient platforms, the inelasticity of demand may be put to a test

Cord cutting begins with a meaningful shift of viewership to on-line programming.  It continues with significant churn on premium tiers.  The final chapter comes with widespread cancelation of basic service.  The timing of these changes is difficult to predict, as they depend upon hitting “tipping points” of critical mass and momentum, but we believe that the ultimate demise of channelized video distribution will be apparent to investors well before the end of the decade

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