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

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Paul Sagawa

203.901.1633

sagawa@ssrllc.com

January 6, 2011

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

  • 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

The Great Cord-Cutting Debate

In one corner: Brian Roberts CEO of Comcast: “There’s not any real evidence that [consumers] want to get rid of my distribution, whether it’s satellite, cable, or phone, and just go to the Internet” – speaking at the Cable Show in May 2010. Jeff Bewkes CEO of Time Warner Inc.: “We’re not seeing it – we doubt that we’re going to see it … although we’ll all watch for it. If you look at TV viewing across all the different networks, it’s a very healthy picture, ratings, programming quality, the strength of these brands.” – responding to Q&A on the 3rd quarter conference call.

In the other corner: Ivan Seidenberg, CEO of Verizon: “We never thought anybody would cut the cord on telco, right? We have got 30% of our customers cutting the cord. Young people are pretty smart. They’re not going to pay for something they don’t have to pay for.” “ I think cable has some life left in its model, but that it is going to get disintermediated over the next several years.” – speaking at a Goldman Sachs conference in September 2010. Cable industry analysis firm SNL Kagan: “It is becoming increasingly difficult to dismiss the impact of over-the-top substitution on video subscriber performance, particularly after seeing declines during the period of the year that tends to produce the largest subscriber gains due to seasonal shifts back to television viewing and subscription packages.” – report published in November 2010 (Exhibit 1).

Technological Myopia

An infamous McKinsey study performed at the behest of the soon to be broken up AT&T in 1983 came to the conclusion that very few Americans would ever be interested in mobile telephones, and recommended that the parent include the fledgling cellular business amongst the pieces to be divested to the regional Bell operating companies. This study used a sophisticated computer-driven survey methodology called conjoint analysis to ask consumers to assert their preferences when presented with various service and pricing scenarios. The problem was that the survey questions failed to anticipate the impact of changing technology – the respondents were asked about “car phones” – and didn’t account for the effect that the changing market might have on consumer preferences. 10 years later there were more than 16 million US cellular subscribers, by 2000, the number topped 100 million and today, more than 30% of American adults have discontinued wired telephone service in favor of their mobile service.

Over the same decades, the cable industry has grown to be a behemoth, pushing penetration to saturation levels while simultaneously taking prices ever upward at a 6% annual clip (Exhibit 2). Demand for high quality video entertainment is obviously fairly inelastic under the tepid competition in the US market. Satellite TV requires a clear view of the southern sky, a willingness to have a dish installed on the roof, and acceptance of a loss of interactivity, all for a modest price break. Telco provided TV service, via Verizon’s fiber based FiOS or AT&T’s less capable copper based U-Verse, is available in limited neighborhoods, with no plans for further expansion. The cable industry is also uniquely unpopular amongst consumers. In March 2010, the web site “The Consumerist” ran an on-line tournament to determine the “Worst Company in America”. Comcast walked away with the not-so-coveted “Golden Poo” award, leaving the much reviled financial industry in its wake despite serving just 20% of the nation’s households. It would seem that Americans would be interested in a viable alternative if it were available at an attractive price.

We believe that “Over the Top” and “Cord Cutting” skeptics may be failing to fully appreciate the effects that changing technology and consumer attitudes may have over time. Internet TV is going from a low quality and unreliable application accessible from the PC in the home office, to reliable, HDTV quality programming streamed directly to living room big screen TVs. Connected video game consoles, Blu-Ray players, and Internet-ready TVs now fill the shelves at Best Buy, all giving households a back door to bypass the cable-box and watch Netflix and YouTube from their comfy sofas and recliners (Exhibit 3). The iPad phenomenon is another game changer – by year end 2011, more than 30 million Americans are expected to own tablets, with entertainment almost universally touted as the killer ap (Exhibit 4).

This change in convenience will likely be a considerable catalyst for video streaming – it can already be seen in the furious growth of Netflix subscriptions. Consumers, especially the highly coveted younger demographics, are experimenting and learning to like the freedom and economy of the on-line model. As time goes by, and consumers make their daily choices of what to watch AND of whether to continue subscribing to the full bundle of services that they buy from their cable provider, it would seem inevitable that the shift in attention toward the Internet will continue apace, eventually to the detriment of the channelized television model.

Eyeballs, to Ad Spots, to Programming

Consumption of internet video viewing has been growing at a rocket pace. The total number of videos served and the number of videos watched per user on YouTube have been more than doubling year over year (Exhibit 5). The same is true for Hulu, and for Netflix streaming subscribers (Exhibit 6). This growth has attracted advertisers, who value the ability to target very specific categories of consumers, to interact with them, and to be sure that they are not forwarding past their messages. This is evidenced in both the growth in Internet video ad spend and in the higher prices that Internet impressions garner relative to traditional television. Growth in on-line advertising is a beacon for content creators and owners who are universally at least dipping their toes in the water, if not jumping in the deep end (Exhibit 7). Obviously, improvements in the scope of programming available on-line draw new eyeballs to the medium, drawing more advertising, then more content, and so on, and so on (Exhibit 8).

In a static snap shot, the conditions may not seem scary. Traditional television viewership does not seem to have suffered in recent years, although some of the resiliency may be related to the growth in the number of televisions per household and to repeat viewings via widely deployed DVRs. However, we believe that the relatively recent phenomena of tablets and living room access will likely take an unexpected toll on the traditional TV audience over the next few years, and that immovable object of channelized TV will continue to cede ground to the irresistible force of on-line video as far as the eyeball can see.

Weak Links in the Chain

The value chain for channelized television has been historically linear (Exhibit 9). Independent programming creators – talent, agents, producers, sports team owners, et al. – pitch ideas to and negotiate terms with television networks. Television networks, generally part of a bundle of network properties owned by one of a group of large media companies, buy rights to programming to fill their schedules. As programming ages and contracts expire, networks must regularly seek out new deals and renegotiate old ones. At the same time, media companies negotiate with cable, satellite and telco TV operators to set per subscriber fees for their networks, generally leveraging their most valuable properties to help establish their newer concepts. Despite well publicized staring contests over these rights fees, the system operators typically blink first and then push the costs down on subscribers by raising basic rates and pulling popular channels into premium tiers requiring additional monthly payments.

This chain has been good for big media and big cable. Viewership remains high. Television’s share of the advertising pie has remained solid – Internet advertising has taken share from newspapers and yellow pages. Consumers have absorbed the over 6% annual rate increases, and then some, as the total number of subscriptions has grown. Media profits have held up well and cable companies are finally enjoying an attractive return on capital. Why then, ask the skeptics, would anyone disturb the status quo?

Well, most of the participants wouldn’t, at least not today. But that is not to say that all of the participants will remain united in opposition to the on-line revolution, nor does it mean that the hold outs will maintain the hard line forever. Some content creators have already staked out a place on the Internet – MLB.com streams major league baseball games out of market, Will Ferrell’s Funny or Die is establishing an impressive audience, amongst others (Exhibit 10). Independent on-line portals are flourishing, like Netflix, YouTube and iTunes. Even networks have ventured into the water via their own branded sites and via ventures like Hulu and TV.com.

You Don’t Own Me

It is often presupposed that the big media companies – Disney, TimeWarner, NewsCorp, CBS, NBC-Universal, Discovery, Scripps, et al. – own all of the best content, and thus, are positioned to thwart “over the top” video by starving it. While this may be true at any specific point in time, we note that television programming is not eternally youthful. Programs run their course and must be replaced with new programs, which must be bought from the largely independent producers that create them. Even successful, long running programs are often under contract for finite terms, subject to periodic renegotiation. For example, Fox, CBS, NBC and ESPN do not “own” NFL football, the league negotiates rights with the networks for fixed length contracts (Exhibit 11).

The content owners – creative talent, agents pulling together creative packages, independent producers, sports leagues and teams, event organizers, etc. – traditionally negotiate with networks to extract ever larger fees and to push secondary content (Exhibit 12). If multiple networks can be drawn into to bid against each other for particularly hot properties, the content owner gains leverage. With the emergence of the on-line alternative, this leverage increases, particularly as many content owners will see value in establishing their on-line brands early. Some of this has already begun, particularly in the production of low cost comedy programming under brands like Funny or Die and Campus Humor, and some Internet-only series, like Neil Patrick Harris’s Dr. Horrible have gained considerable cultural currency. Similarly, some particularly powerful content owners have chosen to bypass the media companies to establish their own networks – like Oprah’s OWN, the NFL’s NFL Network and the New York Yankee’s YES. These players may have enough power to have their network cake and eat their Internet cake too.

In this context, the simple choice of network or on-line is muddied by the existence of content creators without a significant stake in the status quo and by content pioneers who might be willing to forgo some near term network money in order to reinforce their position on-line. As time goes by, and as convenient access fuels growing on-line audiences and advertising spending, more content owners will find on-line a viable option. At the same time, content owners inclined to the status quo will find their negotiating leverage enhanced by the changing environment, keeping network programming costs on their economy ++ growth path.

Ultimately, we believe these dynamics will lead to higher prices for network exclusive programming, to more content created specifically for on-line audiences and to more content owners retaining and exercising their digital rights.

We’re In This Together, Right?

Having filled their network buckets with fresh new programming, media companies turn and negotiate with their distribution partners (Exhibit 13). In recent years, these negotiations have been fairly one sided and occasionally acrimonious (Exhibit 14). The recent Fox showdown with Cablevision, which blacked out two weeks of programming, including the first two games of the World Series, is an example, ending with Cablevision releasing a strongly worded statement: “In the absence of any meaningful action from the FCC, Cablevision has agreed to pay Fox an unfair price for multiple channels of its programming including many in which our customers have little or no interest.”

With rising programming costs, exacerbated by the leverage provided to content owners from the emerging on-line alternative, network owners are pushing higher fees down onto their distributors (Exhibit 15 and 16). However, as consumers discover the joys of on-line TV from the comfort of their living room couch, it is not clear that distribution can continue to pass this off to their subscribers. Against this backdrop, the cautious media companies are dipping their toes in the water with their own branded sites and through collaborative efforts like Hulu and TV.com. While the networks have shown skittish behaviors like cutting access to their web sites and to Hulu through GoogleTV equipped set-ups, we believe that it will be extraordinarily difficult to control access so finely. Indeed easy hacks to circumvent the Google prohibition are already circulating.

If the ability to extract ever higher fees from Cable operators comes into question, or if non-network programming on the web gains obvious momentum, media companies may be prompted to move more aggressively to develop their web presence. Moreover, the various media companies may not draw the same conclusions vis a vis on-line content – some will choose to be more aggressive than others, who may be forced to follow the lead of the pioneers. Again, these choices will play out on an iterative basis over time, with a growing on-line audience and rising advertising dollars at stake. At some point, the competitive balance will reach a tipping point and the risks of losing advantage in the on-line opportunity will outweigh the benefits of preserving the status quo.

You’re Gonna Take It, and You’re Gonna Like It!

Few cable subscribers are willing to fully cut the cord yet. Streaming video is a lot better than it used to be, but it is not yet perfect, particularly if you don’t have broadband fast enough to support HDTV. The content on line is also a lot better than it used to be, but you still need cable for sports, same-day access to the most popular programs, and must-see events like the Oscars. The truth is that most US households don’t have much of a choice. Yet.

The more acute phenomenon is a shift in attention (Exhibit 17). With the increasing convenience, performance and quality of on-line TV, more people will watch it, and watch it more often. Subscribers that take premium channels and those that use pay-per-view may scale back. Even a subtle shift in advertising away from channelized television or a reversal of rising average revenue per user could ripple back up a value chain used to a constant drumbeat of rate increases, and stimulate content and network pioneers to get more aggressive with their on-line projects. The trend of rising basic rates, and of moving popular channels into premium tiers, will begin to test the historic inelasticity of consumer demand as on-line becomes a more viable substitute. The slow trickle of cord cutters will accelerate, becoming a torrent once the tipping point is reached and the shift of must-see content begins in earnest (Exhibit 18).

Monopoly Power

In recent years, the bull case for cable stocks often included a blanket dismissal of the risks of cord-cutting that ran along the lines of: “Multi-channel video is cable’s least profitable business. If consumers want to cut the cord and go all-internet, operators can simply charge them more for the high margin broadband connection”. Implicit in this perspective is the dominance of the nation’s cable industry in providing broadband connections. For more than 70% of US households, the only option for Internet at the 6+ Mbps speed necessary for high quality video streaming is a cable modem (Exhibit 19).

Moreover, this dominance potentially gives cable operators the weapon necessary to kill internet video. It is technically feasible for them to block access to or impair the performance of streaming video providers for the customers of their broadband service. While cable operators have been largely on their best behavior thus far, the FCC has decided that tighter rules and scrutiny are probably prudent, lest they follow the obvious incentives to thwart their potential competitors. Thus, Net Neutrality regulation was enacted and a storm of rhetoric has followed. While a future Republican administration may be tempted to scale back formal rules, we do not think Cable will ever be afforded the freedom to kill Internet video or to take broadband prices high enough to cover for the pain of cord cutting.

The 4G Threat

Verizon CEO Ivan Seidenberg speaking about 4G as competition for wired broadband at a UBS conference in December:

“I think, in time, 4G will be a modest substitute. When you look at the introduction of all these new technologies, this is a pattern that has followed for the last 20 years. So the first five, six years a new technology is introduced, it’s generally additive. So 4G will generally be additive, just like 3G was, just like broadband was. But over a three- or four- or five-year period, you start to see the mainstream of that technology become somewhat substitutable. And we’ve seen that over the course of time”

For many investors, looking past the three- or four- or five-year period is the equivalent of never. However, the development roadmap for LTE technology and the likelihood that the Government will make considerable chunks of attractive new spectrum available for wireless broadband make 4G a realistic threat to cable modem hegemony before the end of the decade. LTE should be able to support speeds in excess of 100 Mbps, and up to 1 Gbps if implemented with limited mobility, more than ample for even Blu-Ray quality 1080p video or 3D video (Exhibit 20). The FCC has identified 415 MHz of spectrum, including 120 MHz in the highly sought after 700MHz range, that could be freed for commercial use over the next 5 years. Furthermore, the one issue that the FCC supports in a bipartisan manner is the benefits of greater competition, suggesting that future spectrum auctions will seek to strengthen the hand of network builders beyond the big two, Verizon and AT&T. We believe that it is likely that at least one network will be built specifically for wireless residential broadband.

How’s it Gonna Be?

In the near term we do not expect a rush of subscribers cancelling their basic cable (Exhibit 21). Rather, consumers will just spend incrementally more time watching video streamed over the net and that it will eventually begin to sap viewership for channelized television. At the same time, consumers will begin to cancel premium services and subscriptions for secondary televisions in the home. As prevalence of TV internet access and tablet ownership increases, as the average performance of residential broadband improves, as more and better programming becomes available on-line, and as cable prices continue to rise, full on cord cutting will move from a trickle to a noticeable stream. The growing trend will raise the stakes for the owners of the most valuable content and networks, with the risk that opportunities to establish their own on-line brands and eco-systems will be exploited by others. At some point, the unstable equilibrium of the status quo will hit the tipping point, most content will be made openly available on the net, and the stream of cord cutting will turn into a flash flood. When is that point? Certainly not in the next two years, and probably not in the next five, but likely in the next ten. When will the inevitability of the end game be apparent to investors? Well before the tipping point.

How Long, Really?

Before 2005, the percentage of American adults without a wired home telephone was negligible. Today, the number is nearly 30%. In 2001, the percentage of recorded music sold as electronic files was negligible. Today, digital downloads constitute more than a third of music purchases and the profitability of CD sales has been decimated. A sizeable paging industry was destroyed in less than a decade by text messaging. Yellow pages and newspaper classified advertising was co-opted by the internet in less than a decade. Innovation in the on-line world is moving very quickly. Assuming that the conditions that protect the media-cable status quo will persist indefinitely does not appear to be a safe bet.

Who Wins?

In the emerging world of on-line video, consumers will need tools to help them find content to watch and to conveniently pay for it. As we believe that it is unlikely that one service will be able to aggregate all of the most attractive content – akin to the role of the cable operator in the channelized model – we anticipate the rise of “meta-aggregators” that give users a starting point to browse the availability of programming provided from a broad variety of branded providers (Exhibit 22). Cable operators themselves might seek out this role, but their natural opposition to the on-line model suggests that they will come to it far too late to show much success. Rather, Internet savvy leaders Amazon, Apple and Google are already gear up to take advantage of the disruptive innovation of video streaming to forge a new business. Each of the three brings important assets to their pursuit of this opportunity: Amazon can leverage its recommendation engine, transaction capabilities, and an existing position in video distribution, Apple brings an unmatched brand, a loyal user base and relationships with media partners, while Google brings search firepower, an ecosystem of partners and the biggest and fastest delivery network.

Other winners will include creators and owners of the most attractive programming, able to cut out middlemen riding on their coattails to pull through less desirable content. Purveyors of the infrastructure of over-the-top video – Cisco, Juniper, F5, Riverbed, etc. – and video friendly device platforms – Apple, Google, Qualcomm, etc. – will also be beneficiaries.

Media companies face risks in navigating the transition from channelized to on-line television. Those pioneers that embrace the new world early could initially suffer from it via deteriorating rights fees, but will be better for it in the long run. However, it is too early to make distinction amongst the big players, all of whom are playing both sides of the aisle.

Cable companies have the most to lose in our scenario, and while the industry may enjoy a relatively cord-cutting free 2011, the long term prognosis is ugly. We would recommend that any investment in cable operators, which certainly screen as cheap against strong cash flows, be viewed as short term in nature. Satellite operators have a bit more room to spare, as the subscriber base is far less penetrated by broadband, and thus, less vulnerable to substitution by on-line streaming.

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