Netflix finally knocked off Blockbuster yesterday. Leaders of pay TV services might be wise to start doing the business equivalent of digging foxholes and manning the battlements, or the same thing could happen to them.
There's a growing body of evidence that pay TV services--that is, cable, broadband, and telephone companies that offer films and TV shows--are ripe for a smackdown. Talk of cord-cutters is all over business news and the momentum in home-video distribution appears to be with companies that do it over the Web, such as Netflix, Hulu, Apple TV, and the upcoming Google TV.
Skeptics say the Internet players aren't big or rich enough to compete with the likes of Time Warner Cable or Comcast. That sounds familiar. In 1997, when Reed Hastings and Marc Randolph founded Netflix, few could even conceive that the little Internet start-up would some day crush the mighty Blockbuster, which at the time seemed to operate a video-rental store in every U.S. neighborhood and was synonymous with weekend entertainment for millions of Americans.
But that's what happened. On Thursday, with $1 billion in debt hanging over the company, Blockbuster filed for Chapter 11 bankruptcy protection. The company said that it hopes it will re-emerge a more streamlined entity capable of competing in a digital world.
Pay TV operators should heed the lessons that Blockbuster's downfall teaches. The first is that they shouldn't delude themselves into thinking their superior size means bullets bounce off their chests. If they do, they risk suffering the same fate as Blockbuster or Tower Records, travel agencies or newspaper classified sections.
Here's why Blockbuster lost:
Better consumer proposition
Netflix was far more consumer-friendly than traditional brick-and-mortar video-rental stores.
The Los Gatos, Calif.-based company mailed discs to customers who ordered the films from their home computers. That meant no more driving to the store to rent or return. Hastings also killed the much-hated late fees that traditional video stores once charged for tardy disc returns. Late fees stuffed plenty of money into Blockbuster's coffers but also alienated customers.
"Blockbuster also plans to test an annual subscription rate for customers who want to avoid late fees. For $59.99, customers who pay for a basic video rental won't have to return the film all year. The upfront fee says you don't have to pay late fees."
--From 2002 CNET story
Netflix used technology to provide customers a better experience. By developing Netflix's streaming video service, the company took a giant leap past competitors in customer convenience. With the help of a score of third-party set-top boxes, such as Microsoft's Xbox or the Roku box, Netflix's Internet service delivers digital movies nearly instantly to customers' TVs.
Perhaps most important, these cheaper distribution methods helped Netflix undercut Blockbuster on price. According to Michael Pachter, an analyst who covers Netflix for Wedbush Securities, what hurt Blockbuster most was that customers could pay $5 to rent a video while Netflix, on average, charged $12 a month for all-you-can-eat rentals.
Netflix competes with pay TV the same way. The economy continues to sag and many consumers want to trim costs. That $75 to $100 monthly cable bill must appear onerous to some--especially when Netflix mails discs and streams movies all for $9 a month.
Yesterday, Verizon CEO Ivan Seidenberg acknowledged at a conference in New York that cord cutting is real, despite what the rest of the industry says. He added that this "is going to be a pretty big issue for cable." Last week, Credit Suisse downgraded big cable and media stocks after a study by the financial services company showed that nearly a third of the service's users between 18- and 24-year-olds have dumped pay TV in favor of Netflix.
In the second quarter of 2010, paid TV subscriptions fell for the first time ever, with cable taking the biggest hit, according to the research firm SNL Kagan. Whether or not these people are leaving because of Web video services is besides the point. The numbers shows that pay TV subscribers are ready for a change.
Against the odds, Netflix navigated Hollywood
Netflix has always had an uneasy relationship with its most important suppliers. For a long time, the six major Hollywood film studios treated Netflix as an annoyance.
Theatrical releases, DVD sales, and pay TV services returned much larger profits for the studios than rental services, even Blockbuster, Pachter said. Within the rental sector, studios once again favored those companies that paid the most. "Blockbuster paid out on average 40 percent of its revenue to Hollywood," Pachter said. "Netflix paid about 25 percent of revenue and Redbox paid even less."
"What the studios are going to do is sell to the highest bidder. If Google were to say, 'We'll pay you $100 a month per subscriber,' they would get what they wanted."
--Michael Pachter, analyst
But the pecking order can easily change, said Pachter. For decades, the cable companies paid billions to the studios, and if someone comes along willing to pay more, then Hollywood will favor them.
I saw an example of this recently. Nearly a year ago, I visited some of the big studios and was told by executives that Netflix's long string of profitable quarters hadn't escaped their notice. The word was if Netflix wanted rights to more movies and TV shows for its streaming service, then Hastings had better be prepared to pay what they considered a fair price.
So, that's exactly what he did.
Netflix reportedly paid $1 billion to Epix, a company owned by Paramount, Lionsgate, and MGM, for Internet access to some of their films and shows. Analysts expect Netflix to continue to spend big on acquiring content. When I returned to Hollywood this summer and met with some of the executives from a year before, I was surprised to see how attitudes about Netflix had improved.
"The content owners have the control," Pachter said. "Amazon, Google, and Apple they are all going to offer IP TV. It's going to be ubiquitous. What the studios are going to do is sell to the highest bidder. If Google were to say, 'We'll pay you $100 a month per subscriber, they would get what they wanted.' But who knows if Google will do that?"
If that's true, then consumers could play a huge part in which sector prevails. If pay TV subscribers begin jumping to Netflix and the other Web-video providers, then Hollywood may not have much choice but to follow the money.
What the pay TV companies have going for them is they still have far better selection to the latest films and TV shows. Broadcast and cable stations have major sporting events locked up and Web distributors likely won't get access to them for a long time. Internet-connection speeds can sometimes hurt the quality of the Web viewing experience.
For the cable companies, the game is still theirs to lose. During a radio interview on this subject I participated in this week, a couple of people who called in said that when they tried to cancel their cable service, the customer service reps offered to lower their rates if they agreed to stay.
The deal they offered was good enough to convince one person to remain a customer.
That's good because it shows the pay TV services are willing to compete for customers. More competition is certainly good for consumers.
"These [Internet] companies will bid up the costs and they'll end up paying more," Pachter said, "But the consumer is going to get more content. What might happen is that we'll end up paying more a month, but we'll get access to all the content we want."