How much does it cost to offer pay TV service?

I want to know how much it cost for providers to offer pay TV service.  Especially, I want to compare the cost to offer pay TV services between cable TV MSOs, satellite TV providers, and over the top providers (direct over the internet).

Note I used the word subscription versus subscribers.  Comcast ended 2011 with 22.3m video subscriptions, 18.1m broadband subscriptions, and 9.3m voice subscriptions.  However, they did not mention how many unique subscribers (households) use their service.  Each household may have 1 or more subscription (i.e.: video and internet).  To get the number for Comcast, I divided Comcast’s cable business operations cost with the total number of subscriptions at 49.3m at the end of 2011.  ARPU is also lower because broadband and voice pricing are lower than cable TV.

DirectTV can generate $80/month from each of their 20m+ subscribers and spends $60/subscriber/month to attract, install, retain, and offer programming services.  About 40% of the cost goes to contents (cable channels, sports, movies, TV shows).

Netflix does not require cable/satellite dish installation, set top boxes to lease, or cable equipments to operate.  They just borrow the internet to offer the service and therefore only spends $9/subscriber/month to offer the service.  They offer the video service over the internet where the infrastructure is already built by Telcos and MSOs.  They do however spend ~40% of the revenue on streaming content.  Content Delivery Networks (CDN) cost and renting servers from Amazon is insignificant to the size of their revenue.

From technology stand point, the internet is definitely the future of pay TV as it can offer the service with the lowest operational cost.  There is no technology barrier today that prevents the same contents you get on cable channels via the internet.  However, as I mentioned in my previous blog, the cable and satellite operators who are also content owners will starve the internet-only player from contents.  At the same time, they are also offering similar services as Netflix as additional feature for their subscribers (see Xfinity Strempix, Verizon/Redbox).

The cable and satellite operators seem to be winning the war so far as they are able to maintain (lose less for Comcast) their subscribers in 2011 and come up with their own internet streaming solutions.  Netflix, on the other hand, is positioning itself as a premium cable channel where they are producing their own original programming (see NYT article).

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US Pay TV market overview

Recent earning reports from DirectTV, Dish, and Comcast have indicated substantial subscriber growth in the industry. I want to compare the metrics in these companies and also compare them with over the top player such as Netflix.

motion chart for US pay TV market

I have to make some assumptions to build the chart as I need to consolidate financial reports from different companies.  I will write some articles on my takeaways in the next few days.  The chart is work in progress and I will keep updating as I learn more about the companies.

Why Netflix struggles?

Netflix was gaining so much momentum that it felt like they were going to take over the world and change Hollywood forever.  Their stock soared to an all time high of $298 in the summer of 2011 valuing the company at close to $20B.  They had a stunning subscribers growth from 10m (Q2 2009) to 24m (Q2 2011).   So why has Netflix struggled recently with subscribers leaving and their stock plummeting?

Despite all the media noise putting the blame on the way management handled the price increase and the qwikster debacle, we forgot to ask the question as to why they were doing those things in the first place.  To answer this question, we should look at the cable/pay TV industry that Netflix is disrupting.

  • Comcast – represents 22m cable TV subscription with annual revenue of roughly $36B (not including NBC Universal).  Comcast also has majority ownerships of a number of cable program/channel companies (i.e.: USA, SyFy, CNBC, etc), Universal pictures, and NBC TV network and broadcasters.
  • Time Warner Cable – revenue of $20B.  Their parent company Time Warner owns movie studios who produce hit movies such as Harry Potter and other cable channels such as HBO.
  • Direct TV – revenue of $21B.  Liberty Media (owner of Starz channel and others) owns controlling stake of Direct TV.
  • Dish Network – revenue of $13B.  Dish also owns Blockbuster movie on demand subscription that are *only* available for Dish’s subscribers.

If we ignore the rest of the cable/satellite TV providers (i.e.: Cox and other smaller players) and just combine these 4 giants, this is a $90B plus industry.  A significant portion of the $90B pie goes to cable channels (Starz, USA, CNBC, etc), Broadcast TV networks (NBC, ABC, FOX, etc), and movie studios that supply the programming.  The ownership structure in this industry ensures money flows between entities that are owned by the same person or group.  This creates a powerful force in the value chain that prevents outsider or new player to enter and disrupt the industry.

Netflix offers valuable on-demand movie services at a fraction of the cost of subscribing to cable/satellite TV channel.  Netflix has premium movie contents with their Starz Channel along with older movies and TV shows for $8/month.  Their offer is so compelling that the power of references and word of mouth propelled them to insane subscriber growth for a period of time.  Consumers suddenly see a significantly lower cost alternative for their $80/month cable bill and opt for Netflix instead.

The success annoys the cable TV industry because Netflix’s gain is their loss.  But they have a powerful leverage to use against Netflix and they are using it.  Netflix still has to license contents from the cable companies, cable channels, movie studios or their subsidiaries.  As an example, Netflix has not been able to renew their deal with Starz and will lose Starz premium contents from their streaming service starting in Q1 2012.  Starz has a simple goal, they would be happy to license their contents to anybody (Netflix included) as long as they can keep the cable industry strong and allow the $90B to flow within the value chain.  It would be hard to do a deal unless Netflix sells a significant stake of the company to one of these cable companies.

There is another industry that also wants a piece of Netflix’s revenue, the internet service provider.  Netflix is distributing videos on their distribution networks for free (i.e.: cable and DSL networks require massive capital to build) .  They want a piece of Netflix’s service revenue.  Since they are not getting anything from Netflix because of FCC’s affinity for Net Neutrality, they are discussing new pricing model for broadband internet where consumers pay for the amount of bandwidth they use (as opposed to unlimited today).  The new pricing will increase the cost to stream Netflix video to the consumers.

Therefore Netflix’s recent struggle was not caused by the price changes or anything else.  The real fundamental problem is they are fighting a strong and intertwined value chain that has every reason for Netflix to fail.  This is a classic example of disruption theory at work where an entrant is trying to fit disruptive technology in an established market with powerful incumbents.  Netflix will not be able to afford premium contents going forward because the incumbents will do whatever they can to protect their business.

But Netflix will always have a niche – a powerful niche in my view.  They still have 20m+ subscriber and $2B plus to spend on contents.  They have control over their profitability on the minimum they need to spend to satisfy and grow their user base.  There will always be a subset of the consumers that want low cost video subscription service ala Netflix  ($8/month as opposed to $80/month cable bill).  They will be satisfied with the limited selection of documentaries, kids’ cartoon, teen dramas, foreign titles and be pleasantly surprised with a newer title from Dream Works once in a while.  Netflix will dominate this segment.

Tablets will also be favorable to Netflix as they are mainly media consumption devices.  A 10″ tablet device just does not feel right if you don’t have a video service such as Netflix.  Yes, Amazon has a competing service that they bundled with Amazon Prime.  But if you look at the movies and TV shows that are available at Amazon.com, you can tell that their catalog list is still mediocre because this is not their main business.  They want to hook people with their Prime membership and free 2-days shipping to generate even bigger sales for their $40B e-tail business.  The digital video subscription is just an additional marketing cost to lure people into Amazon prime.

Go to Best Buy today and look at all the new TVs and Bluray players that are displayed, *all* of them advertise the ability to stream Netflix.  This is a very large distribution channel that makes it easier for Netflix to gain new subscribers.  They still have a lot of room to gain more subscribers domestically and internationally.

It is my view that Netflix will continue to be successful as a business that caters to the low end of home entertainment market.  From hearing and reading about Reed Hastings, he just does not seem like a guy who will sell his company – unless maybe he lost control of the investors/boards.