The War on TV: The Attack of the Boxes

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June 12, 2013

The War on TV: The Attack of the Boxes

  • New devices are stepping in front of TV set-top-boxes, wresting platform control of the living room from multichannel operators. The latest, MSFT’s Xbox One, raises the bar, delivering a powerful voice/gesture driven interface that puts on-line content on equal footing with TV. With pent up demand from gamers, Xbox One should be fast out of the gate, adding to the pressure on ambitious and deep-pocketed rivals, like AAPL, GOOG, AMZN, and INTC to deliver their own disruptive innovations to a TV platform. With further competition from Sony’s new PS4 console, innovative next-gen set-top offerings from Roku, Boxee, Dish and others, and the growing influence of portable platforms, consumer awareness of superior alternatives to the set-top box and its cumbersome remote control will rise quickly and erase remaining barriers to the consumption of streaming media in the living room. This will be a significant boon to purveyors of on-line video, such as NFLX, Hulu, GOOG, AMZN, AAPL, YHOO and others, and, in the long run, an existential threat to the channelized TV model.
  • For years, the cable set-top-box ruled with an iron fist. From its birth, cable TV grabbed the default input 1 to the television, establishing the set-top-box and its cumbersome remote as the primary interface to the living room entertainment system. VCRs, game consoles and DVD players were shunted to the secondary inputs, unable to control channel selection on the TV feed. This inside position has allowed multichannel operators to co-opt valuable functions, such as DVR recording, pay-per-view, and on-demand, for themselves, and to force on-line video services to reach the living room via peripheral devices attached through secondary inputs.
  • Innovative living room devices beginning to challenge set-top-box hegemony. In the past few years, technology companies have begun to attack cable domination. TV makers have begun to employ their own “smart” interfaces to give consumers better ways to navigate between TV and other services/applications. Game consoles – Xbox360, Sony PS3 and Nintendo Wii – added streaming media access to their internet-based gaming networks. Alternative set-top-boxes from TiVo, AAPL, Roku, Boxee, Dish and others have delivered significant innovations – AAPL’s Airplay integration with iOS devices, Boxee’s Cloud DVR, Dish’s ad skipping Hopper, etc. – and have gained footholds in US households.
  • Tablets/smartphones vying for viewers, augmenting TV experience. The proliferation of portable devices drastically changes the TV proposition. Individual household members can opt to view alternative programming directly, or to “multitask” drawing attention from the television, particularly during commercials, and offering an alternative vehicle to advertisers looking to reach viewers. MSFT with its SmartGlass application, and AAPL, with its Airplay, have both moved aggressively to integrate portable devices into the big screen experience. With continued tablet penetration and ever more sophisticated integrated viewing apps, the portable threat to the traditional TV value proposition will only grow more intense.
  • Xbox One ups the ante. MSFT’s recently announced Xbox One steps in front of the set-top-box on input 1, replacing the clunky grids and menus with a slick voice/gesture/portable device controlled interface that seamlessly shifts from TV, to on-line, to games, and allows split screen multitasking. That interface is tied to a comprehensive list of on-line programming partners, including an exclusive deal with the NFL for multi-screen content, and a powerful cloud infrastructure, with 300,000 servers explicitly assigned to Xbox One. MSFT will also benefit from the community of 77M Xbox360 users, 46M of whom subscribe to the Xbox Live on-line service. MSFT sold more than 10M of the 8 year old Xbox360 in 2012 – the new model will likely sell MUCH better, given pent-up demand from the gamer community. This is a serious play for the future of the living room.
  • We expect AAPL, GOOG, AMZN and others to step up their efforts. Sony will offer its recently announced PS4 console to compete with MSFT. AMZN is widely believed to be readying its own next-gen TV device, almost certainly to feature AMZN content and to sell at a highly subsidized price. The constant yet unfulfilled rumors of an iTV have been nerd comedy fodder, but the more pedestrian Apple TV box has sold more than 13 million units, offers some cool features, and is due for an upgrade. Roku just secured an additional $60M in funding, and intends to pitch its next-gen set-top software to smart TV makers. Boxee has announced a Cloud DVR service for storing programming. GOOG has whiffed a few times with its GoogleTV concept, but its skills, assets and ambition suggest that the company is unlikely to give up. INTC has confirmed that they are also at work on a TV solution that would combine a next-gen box with an associated programming service – rumors have suggested support for 4K video and significant progress on programming deals with network partners. All of this could hit the consumer market for this Holiday season, a potential living room rout for traditional TV.
  • On-line video viewership could spike up into 2014. We believe that innovation and competition amongst new living room devices will spur a step function increase in category demand. Combined with interface designs that will make users source agnostic as to whether programming is available on traditional channelized TV or on-line, important barriers to video competition will have been broken. We believe strong adoption of these devices will greatly exacerbate the downward trend in television viewership evident over the past two years. We believe that Microsoft and its Xbox One will be clear beneficiaries, with the success of would-be rivals like AMZN, AAPL, GOOG and INTC determined by the quality of their yet-to-be revealed solutions. The changes will be unambiguously good for distributers of on-line video content, such as GOOG, NFLX, AMZN, and YHOO. In contrast, this phenomenon is a bad sign for channelized networks, such as DIS, VIA, TWI, NEWS and CBS, and multi-channel distributers, such as CSMA, TWC and DTV.

The War On TV: Controlling Input One

In most American living rooms, the cable box rules. Turn on the TV, the last channel you were watching comes right up. The user interface is a cumbersome system of grids and menus controlled by an archipelago of buttons on the set top box remote. The “Guide” button tells you what is on now, and if nothing is appealing, you can hit “Menu” and check programs recorded on the integrated DVR or browse on-demand or pay-per-view programming provided by your multichannel system operator. To watch anything else, you’ll have to dig up that remote that came with the TV, or get up and manually scroll to the second or third input for a game console or an alternative TV box to find on-line programming. Cable domination of TV “Input One” has stunted the inevitable shift to on-line video by exploiting the inertia inherent to the coach potato in all of us. That box, leased to its prisoners at usurious rates, works its cable master’s bidding pushing channels and thwarting access to the Internet.

However, change is afoot. Tablets have grown into a formidable TV alternative, siphoning many viewers that might otherwise have watched whatever was on the living room television. There are 85 million game consoles in the US capable of connecting to on-line video. Next-gen set-top-boxes, like the legendary TiVo, the hipster Roku, the upstart Boxee, and the “just a hobby” AppleTV, have linked in another 15-20M. On this tide, Netflix, with more than 29M US subscribers, has passed HBO to be the number one pay TV service in the country. However, despite these inroads, channelized networks still dominate overall viewership, and on-line distributers face an uphill battle as long as the cable box continues to control input one.

Microsoft aims to change that. Xbox One is designed to front-end the cable box with a slick voice/gesture/smart device powered interface that simultaneously searches both on-line and channelized feeds for programming, even enabling split-screen viewing of network and web content. Others will follow this lead. Sony’s vaguely defined PS4 will compete against the Xbox One when both are released in 4Q13, lacking Microsoft’s Kinect interface technology but playing well to a passionate gamer community. Amazon is believed to be readying its own next-gen box, undoubtedly featuring its Prime streaming service and priced to move at cost or below. Apple and Google have disappointed with their TV efforts to date, but both have more than enough resources and ambition to rise to the Xbox challenge. Even Intel is planning a self-proclaimed revolutionary set-top-box and streaming service launch for later this year. Add to this the legion of next-gen TV box startups and “Smart” TVs from traditional makers with sophisticated interfaces, some home grown and some licensed from the likes of Google and Roku. The battle for “input one” may be fierce indeed.

All of this is unequivocally bad for the purveyors of channelized TV, but how bad will only be revealed as consumers hook up these “Input One” boxes and begin watching. NPD reports that the number of viewers watching streaming TV is up 34% YoY, and the total monthly hours of programming streamed by Netflix are up from 1 billion in June 2012, to more than 1.33 billion on average during 1Q13. An acceleration to this trajectory as new living room devices remove barriers between viewers and content seems likely. Those viewing hours will have to come from somewhere.

When I was a kid, there were only 4 channels and you had to get up to change’m

Once upon a time, few people had cable TV and television sets came with one simple input, which most families used to hook up their rooftop antenna. If you had another device to hook up – an early cable box, a first generation Betamax VCR or an Atari Pong set – you unhooked the antenna and attached the device, sometimes reattaching the antenna to the back of the device for an electronic pass through of the signal.

Exh 1: US Cable Video Customers

The Cable Act of 1984 sparked a massive decade long expansion of the nation’s cable TV infrastructure, coinciding with the rise of the VCR. TVs still typically featured a single input, shared by the cable box and the VCR in households so equipped. By the turn of the millennium, total US cable households topped 60 million, DVD players and cartridge gaming consoles had emerged, and TVs featured multiple input ports to accommodate the growing roster of possible peripherals (Exhibit 1). The Internet challenge for video viewership was still years away – YouTube would be founded in 2006 – and the cable set-top-box was ensconced in television “input one”. In practical terms, cable service (or satellite or telco provided multi-channel TV service) was the no effort default option. In most households, the set-top-box remote was the primary user interface for the entire system. The TV set remote, which was useful only for changing the picture settings of the screen and scrolling to the alternative inputs, wasn’t used very often and subsequently, got lost between the cushions on the sofa.

The AV equipment makers had tried to thwart the now ubiquitous set-top-box earlier in its life, by creating TVs that could tune directly to the various broadcast frequencies on the cable, but were thwarted in turn, as cable operators began to employ sophisticated scrambling and encryption technologies that could not be interpreted by the so-called “cable ready” sets. The battle for platform control in the living room shifted to the regulatory theater with the Telecommunications Act of 1996, passed by Congress and containing, amongst many other things, a requirement that multichannel service operators, such as cable companies, offer the security, authentication and other content access mechanisms on a computer card, which could be inserted into consumer electronics devices, thus, giving them access to programming without a full blown set-top-box.

Exh 2: US Installed Base of CableCards , 2007-2012

While these CableCards have been available since July 2000, adoption has been poor, with about 600,000 cards in 3rd party boxes and TVs today (Exhibit 2). In practice, the cards have failed to keep up with system functionality – multituner CableCards able to support DVR recording while watching a different channel, and two-way Cards allowing use of on-demand services were late to market. Device manufacturers also gripe that the monthly rental fees charged for the cards are excessive and that MSO service support for them has been inadequate.

Batting First, and Playing Input One … The Set Top Box

Input one has been very good to the multichannel television distribution industry, allowing it to dominate new services, such as DVR functionality and on-demand viewing, and to roadblock on-line video competitors as they began to emerge. For consumers, the television feed and the various associated services are the default option – anything else requires an active switch to a different TV input that is not facilitated by that omnipresent cable remote. A consumer searching for viewing options will almost certainly begin by scrolling the cable channel guide or perusing the contents of the integrated DVR, with on-line content invisible until the would-be viewer actively seeks it out via another connected device. This friction has been a considerable barrier to building a web-video audience in the living room.

Exh 3: US DVR Penetration, 2007-2013

Exh 4:TiVo Subscriptions, 3Q2005-1Q2013

That hasn’t stopped potential rivals from trying. TiVo was the first to take on the cable industry, introducing its groundbreaking DVR in 1999 and reaching a peak of 4.44M users in 2006. However, beginning in 2003, the cable industry struck back with DVR set-top-boxes, and by 2012, TiVo’s installed base had fallen to just over under 2 million in 2011, while the MSO-supplied DVR universe had expanded to more than 40M US households (Exhibit 3-4). Apple launched its Apple TV product in 2007, offering access to downloadable and streaming video content to its users. With the strength of the Apple brand behind it, this unassuming device has sold more than 13 million units since its birth. Archrival Google followed with its own TV platform in 2010, preferring to license its software solution to hardware partners like Sony and Logitech. This effort has been diffuse and relatively unsuccessful, although it remains an obvious priority for the company. Similar media access boxes from start-up companies such as Roku and Boxee have gained critical praise, but remain small factors in the overall market.

Perhaps the biggest challenge to set-top-box hegemony has come from gaming consoles. Initially, game devices like the Nintendo Entertainment System, Sega Genesis, Sony Playstation and Microsoft Xbox were standalone devices able only to play games based upon their proprietary formats. Eventually, as games shifted physical format from cartridges to CD-ROM, the consoles took on a secondary role as DVD players. Eventually, with the introduction of the Xbox360 and Playstation3 in 2005, Microsoft and Sony added an on-line connected element to their system, an idea that was mimicked by Nintendo in their Wii console introduced a year later. While initially defined to enable gamers to play and communicate with friends over the internet, media content was quickly added to the mix on all of the consoles, including support for the leading streaming video distributers, such as Netflix, Hulu, YouTube and Amazon.

Exh 5: XBox Live Subscribers

As of March, Xbox 360 has sold 77M units world-wide, with 46M of those users subscribing to the Xbox Live on-line service. Playstation 3 also has an installed base of 77 million users, a large but unspecified percentage of which use the on-line capabilities of the console. Wii is believed to have a base of more than 90 million global users, but less than half are believed to be connected to the Internet (Exhibit 5). While there is some overlap between these user bases, game consoles are, by a large measure, the biggest route for streaming media to reach the American living room. Netflix reports that Sony’s PS3, which features free access on-line video partners, is its largest platform. Xbox 360, which requires a $5/month fee for on-line content but has a much larger US presence, is undoubtedly number two (Exhibit 6). The total monthly streaming hours on Netflix are up by a third in less than 9 months, while the domestic subscriber count was up 13.8% YoY. Clearly some viewers are making it over to Input 2.

Exh 6: Total Seventh Generation Console Shipments

The Path of Least Resistence

Still, Input 1 has its privileges. A cable industry study by Rentrak found that the number of households viewing on-demand programming at least monthly jumped by 60% in 2012 to more than 43 million, dwarfing the Netflix subscriber base in the same time frame by more than 16 million (Exhibit 7-8). The total hours of on-demand viewing increased by 40% YoY and the number of programs made available via on-demand increased by 29%. Arguably, this audience, much of which is spent on widely syndicated shows like “Big Bang Theory” and “Family Guy”, could be addressed by on-line services if they were able to compete on an even basis. Pay-per-view programming, a $4.6B business for multichannel operators would also be vulnerable to on-line distribution were it able to compete for viewer attention on an equal footing.

Recording functionality is also dominated by the set-top-box, with more than 46% of television households now employing DVR set-tops. Nielsen’s published data on DVR use implies only modest use of the functionality – it reports that the average American watches less than 30 minutes of recorded programming a day out of the 5 hours of total average daily TV viewing. However, these numbers don’t fully jibe with Nielsen’s newer reports suggesting that 23% of prime time shows are viewed in playback or with a 2012 study by Motorola, which found DVR recorded programming responsible for 29% of total viewing. Reconciling these data points, we the believe that Nielsen’s methodology may do a very poor job of distinguishing between attentive and ambient television audiences, essentially greatly overestimating the audience for live TV, particularly outside of prime time, while the DVR functionality is inherently an active audience experience. Controlling recording and playback keeps this growing block of viewership at home on the set-top-box platform.

Exh 7: Cable VOD Households, 2004-2014

Exh 8: NetFlix Subscribers and Percent Utilizing Streaming Features

Exh 9: U.S Households with Connected Devices for Viewing OTT Delivered Content

These Cards are Marked!

The obvious way to beat the set-top-box is to slide in between it and the television, in the same way that VCRs used to take the cable feed as an input and pass it through to the television (Exhibit 9). Of course, the multichannel distributers don’t make it that easy. CableCards restrict the number of tuners that can be employed, still do not widely support two-way functions like on-demand services, and carry monthly fees from system operators similar to those charged for set-top-boxes. System operators also routinely change the command structure for remote control of their cable boxes, putting the onus on 3rd party box makers to update their own equipment promptly to avoid nettlesome disruptions for their customers. Finally, the certification process for plug-and-play CableCard slots on consumer electronics is expensive and time consuming. The cable industry has responded to these criticisms by offering its Tru2Way solution, which includes software to be run on a CableCard equipped 3rd party device to manage the navigation functions needed for 2-way services. The catch? Tru2Way requires that the TV functions operate entirely separately from all other services available on the box, essentially asserting input one priority within the unwitting host.

While TV makers and most 3rd party streaming video boxes have more or less given up on adding CableCard slots given their limitations, the lack of broad public support, and the added expense of including the interface, DVR pioneer TiVo has embraced the technology, even adding another slot for a second CableCard to facilitate recording and watching different shows. Still, TiVo’s quest for marketplace relevance has been fraught against the onslaught of cable industry marketing. At this point, the FCC has been seeking comment on alternatives to the CableCard standard for 3 years, with little to show for it.

Exh 10: Global Tablet Sales, 2010-2017

Exh 11: U.S. Tablet Penetration Among Adults, 2010-2013

Take Two Tablets and Call Me in the Morning

The iPad was the first real challenge to TV’s domination of video consumption, shifting viewing from the living room big screen to the user’s lap. Since its launch in 2010, 296M tablets of all brands have been sold, including 107 million in the US (including replacements) now used by 34% of American adults and available in over 39% of all American households (Exhibit 10-11). While tablets are often billed as alternatives to computers, usage statistics suggest that their primary application remains media consumption, with tablet video viewing a rapidly growing market. According to Ooyala, the share of all hours spent watching streaming video on devices grew 100% in 2012, with tablet viewing the biggest percentage. Nielsen who we believe is understating mobile device consumption saw nearly 38% YoY growth in video viewed through mobile devices in the first quarter of 2013 (Exhibit 12). While tablets do not dislodge the cable box from input one, they are siphoning eyeballs away from the living room TV.

Exh 12: Aggregate Mobile Video Growth, 1Q2011-1Q2013

Xbox One – Fronting the Set-top

Microsoft avoided the CableCard issue entirely, designing its new Xbox One console to take an HDMI input from a set-top-box and grab input one for itself. To the set-top-box, the Xbox One looks like a TV and a programmable remote control, and Microsoft signed deals with Comcast, Verizon and AT&T that assure that its control commands will be current and that its programming metadata will be searchable (Exhibit 13).

Exh 13: Microsoft XBox One versus Sony Playstation 4

While the consumer still has to pay to rent that marginalized set-top-box, Xbox One will replace the almost universally reviled grid and menu cable navigation system with its own user interface, able to seek, discover and access content from TV and on-line sources simultaneously and without favor. Microsoft also offers some slick new technology – the integrated Kinect system offers state-of-the-art gesture controls able to track subtle and fine movements such as facial expressions and finger twitches for as many as 6 different people in a room. Kinect also adds voice controls, so the statement “Xbox On” brings the system out of sleep mode and “Xbox watch Netflix” brings up the video streaming service directly. The system will so take commands from the SmartGlass app for tablets and smartphones, or from the gaming controllers, so the need for that 120 button cable remote control goes away.

The scariest part for multichannel TV distributers is that the Xbox One treats TV like just another application. Program searches will bring up options on streaming sites as well as live TV, the DVR list and on-demand. Viewers will be able to keep multiple windows open, receive electronic notifications on screen, and swap applications in a snap – perhaps checking email during the commercials. Thus, the friction imposed by “input 2 on alternative content in the living room is gone, and almost certainly, the consumption of that content will increase at the expense of traditional television. Moreover, the tools for avoiding the advertising on television programming just got more sophisticated. Should Xbox One prove popular in American households, this is a serious threat to the channelized television hegemony.

Exh 14: Global unit sales of current video game consoles

Xbox Nation

There are more than 77 million Xbox 360 consoles in the world, the majority in the US, and 60% of those users subscribe to the Xbox Live service including access to more than a dozen streaming video providers on top of its on-line gaming functionality. At the end of an 8 year run, the Xbox 360 still sold 10 million units in 2012 at a $299 price point (Exhibit 14). With considerable pent up demand from gamers, and an inevitable marketing blitz from Microsoft, it does not seem farfetched to predict that the Xbox One could hit the 10M unit mark before Christmas, assuming a timely 4th quarter launch (Exhibit 15). For 2014, it is widely believed that Microsoft could launch an even cheaper, media-only version of the Xbox One, a product that, if the living room interface is as good as promised, could reach an entirely new demographic. If these prospects don’t frighten TV executives, they should.

Exh 15: Xbox Sales Growth by Version, First 5 years

Exh 16: Internet Connectable TV and Device Penetration Forecast

With Microsoft breaking the ice on input one, it is very likely that others will follow. Intel has taken a high profile with its project to “revolutionize” TV. Amazon is rumored to be readying a next-gen TV box of its own, as a way to promote its Prime streaming service. Apple analysts and bloggers have been salivating over the prospects of an iTV for years, while consumers have snapped up more than 13 million of the simpler AppleTV boxes, many intrigued by the innovative Airplay feature that facilitates content sharing between the television and iOS devices. Start-up Boxee is encouraging cord cutting, augmenting its alternative TV box with a cloud-based DVR. TV makers Sony, Samsung and LG have all looked to add advanced navigation/search functionality to their products, both with proprietary platforms and in partnership with Google, which has fumbled the ball a few times with its GoogleTV initiative but must still be considered a serious player. Next-gen TV box maker Roku just raised an additional $60 million in funding, purportedly to push its own software platform to smart TV makers. Given Microsoft’s move, it can be assumed that all of these players will be going after input 1 as well. If any of the products are in the market before year end, it will exacerbate the problem for channelized TV in 2014 (Exhibit 15).

Exh 17: TV Households and Average Number of Televisions

The Eyes are the First Thing to Go

While many observers seem focused on subscriber losses to judge the health of the channelized TV industry, we think cord cutting is a lagging indicator. Certainly, the number of television households in the US has been stagnant since 2010, after an almost unbroken run of growth over the previous 50 years, but the more dangerous consideration is the shrinking television audience (Exhibit 17). Prime time ratings are down across the board, most obviously for the big 4 broadcast networks, but also across the universe of cable networks as well (Exhibit 18). As we mentioned previously, Nielsen numbers suggest that total television hours watched by Americans remains absurdly high, at more than 5 and a half hours a day, but we believe Nielsen’s methodology fails to adequately capture a deterioration in the quality of that audience (Exhibit 19). Consumers may be in the same room as a television, but it doesn’t mean that they are watching, and increasingly, Americans have alternative diversions, evidenced by the explosive growth of on-line video. Netflix alone reports more than 1.3B hours streamed to US households per month, and assuming that an average of 2 people are watching each stream, it works out to about 30 minutes a day per person, in Nielsen equivalent viewership. Netflix itself makes up almost a third of all downstream internet traffic on fixed broadband networks (Exhibit 20). It would seem that those hours had to come from somewhere.

Exh 18: Big 4 Broadcast Network C3 Households, March 2012/March 2013

Exh 19: Monthly TV Viewing Hours, All Demos 2+ 3Q2007-1Q2013

As TV ratings slip, advertisers get worried and networks have to make good on promised audiences by giving away ad slots that they would have otherwise sold. Advertisers are also increasingly worried that viewers are ignoring their commercial spots. Estimates from the former Motorola set-top-box business suggest that as much as 29%of television viewing is now from digital recordings, where advertising is often skipped. Dish Network’s Hopper DVR goes the extra mile and makes the ad skipping automatic, much to the displeasure of network executives and advertisers everywhere. Nielsen’s own numbers suggest that the propensity to DVR is highest with the highest rated shows, the very programs that command the highest commercial prices.

Exh 20: Netflix traffic on fixed broadband networks, 2H13-1H13

The combination of falling viewership and questionable advertising efficacy will be deadly to TV network economics, where 60% of total industry revenues derive from ad spending. We believe the new “input one” devices, led by the Xbox will exacerbate the trend, facilitating an exodus of eyeballs away from channelized TV and toward on-line video.

Winners and Losers

Our scenario expects significant demand for next generation video equipment, of which, we believe Microsoft’s Xbox One will have the biggest impact. This is obviously good for Microsoft, but could have positive implications for Intel, Amazon, Apple, Google and others should they deliver compelling TV products for the 4th quarter. It is also a boon to providers of on-line video, such as Netflix, Google, Amazon, Yahoo, and others (Exhibit 21).

In contrast, the rise of the “input one” alternative device is a significant negative for advertising dependent television networks, such as Viacom, Time Warner, Disney, NewsCorp, Comcast, and even CBS, and for channelized TV distributers, such as Comcast, Time Warner Cable, DirecTV, and Verizon.

Exh 21: Winners and Losers

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