Netflix: Who will win and who will lose?

Transcription

1 November 2014 Netflix: Who will win and who will lose? With a market capitalisation on a par with BT and Sky and UK penetration of 15%-20%, Netflix is becoming a major media player. And this is just the start. Netflix is rampingup investment in original and exclusive content and securing distribution with Virgin, Vodafone and now BT. Its aim is to reach 150m global subscribers by However, delivering these targets may not be easy. In Europe, pay TV platforms and channels are looking to preempt Netflix, making the 31% penetration that Netflix has secured in the US look ambitious. In addition, the need for quality programmes (and a more astute supply market) is pushing up content costs so that the 10% penetration Netflix needed to breakeven in the US is likely to rise to nearer 20% in Europe. Prospero provides strategic advice to the media and sports sectors internationally. We help our clients make major decisions about the future and work with them to deliver results. Whatever the final outcome, Netflix is here to stay and is fundamentally changing the dynamics along the pay TV value chain. Prospero has partnered with STL Partners to produce a comprehensive briefing on Netflix. This looks at Netflix s consumer proposition and financials, its performance to date and attitudes of the financial markets. We also examine the impact Netflix has had across the media value chain: on content owners, premium and free to air channels, pay TV platforms and broadband operators and on how key players are responding to the new market dynamics created by the Netflix approach. For more information contact: tabitha.elwes@prosperostrategy.com Prospero Strategy 18 Marshall Street London W1R 7BE

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3 In partnership with: Executive Briefing Netflix: Threat or Opportunity? Understanding and evaluating Netflix s impact on Telcos, Content Providers and Pay TV providers NOVEMBER 2014 Excerpt Netflix s success in the US and in Western Europe has demonstrated that consumers are willing to change how they watch and pay for TV and movies. As a result Netflix s OTT proposition is challenging traditional pay TV models and changing how new broadband services are looking at content. For some players Netflix is a threat and for others an opportunity. So, how should content owners, channels, pay platforms and broadband providers respond? Telco 2.0 keywords Netflix, content, entertainment, disruption, OTT, video, VOD, HBO, Time Warner, BSkyB, cable, telco, telecoms, strategy, pay TV. Who should read CXO, Strategists and Marketers from Telco Operators, cable companies, entertainment companies, and Vendors, etc.

4 Table of Contents Executive Summary... 4 Netflix #1 priority: Driving customer acquisition... 4 Netflix: Enemy or Ally of TV industry players... 5 Introduction... 7 Overview of Netflix... 8 History... 8 Consumer Proposition and USPs... 8 Netflix International Expansion Netflix Financials Attitude of the Financial Markets Impact of Netflix on the Market Impact on Rights Owners and Producers Impact on Channels Impact on Pay Platforms Impact on Broadband Operators Summary impacts on players along the value chain Responses to Netflix Case Study: HBO Case Study: BSkyB Case Study: Broadband Operators Case Study: New Competitors STL Partners and the Telco 2.0 Initiative Prospero Strategy STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 1

5 Table of Exhibits Figure 1: Selected Media Companies Market Capitalisation, 1 st Sept (left) & 1 st Nov (right), USD billion... 4 Figure 2: Netflix s subscriber targets for 2020 (announced launches only) in USD million... 5 Figure 3: Summary of Netflix s Impacts along the Value Chain... 6 Figure 4: Netflix subscribers (Q3) in 000s... 8 Figure 5: Reasons Netflix streamers subscribe to the Service... 9 Figure 6: Netflix s Evolving Content Proposition Figure 7: Netflix s user interface Figure 8: Netflix geography and timeline Figure 9: Netflix s Market Penetration since launch (% households) Figure 10: Netflix revenue per service area, , USD million Figure 11: Netflix s revenues & costs per business line, (Q3), USD million Figure 12: Netflix s net income and free cash flow, , USD million Figure 13: Netflix s streaming content obligations, , USD million Figure 14: Selected Media Companies Market Capitalisation, 1 st Sept (left) & 1 st Nov (right), USD billion Table 1: Comparison of Key Value Ratios Figure 15: Netflix s share price (USD), Jan 2010 October Figure 16: Players along the Value Chain Figure 17: Subscribers to premium channels in the US (%of TV households) Figure 18: Changes in US Pay TV Penetration Figure 19: Percentage of Households that are cord-cutters Figure 20: Real Time Entertainment Share of Downstream Traffic Figure 21: Share of Traffic of Downstream Peak Time Applications Figure 22: Summary of Impacts along the Value Chain Figure 23: Overview of Sky Expanded Offering Figure 24: Sky s offering across All Windows Figure 25: Vodafone / Spotify and Sky Sport deals Impact on mobile broadband usage STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 2

6 Figure 26: Netflix Broadband Partners Figure 27: Netflix Competitor Set Figure 28: Telco 2.0 'two-sided' telecoms business model STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 3

7 Executive Summary Netflix #1 priority: Driving customer acquisition Since the inception of its subscription streaming service in 2007, Netflix has grown beyond all market expectations; creating a new paradigm for on-demand content. However, to maintain its momentum and market dominance, Netflix needs to drive rapid customer acquisition in an increasingly competitive world with rising content costs At the height of the summer of 2014 Netflix had a market capitalisation of USD28bn; making it one of the most highly valued international media companies (worth nearly half the value of Time Warner and more than BSkyB). The high revenue multiple reflected market expectations of longrun growth potential. To justify these expectations, Netflix would need to repeat its US success internationally, and reach over one third of households in new markets and ultimately drive more margin per household. However, replicating US market share is not a given and Netflix has already demonstrated how vulnerable its customer base is to rises in price. In 2011 a price hike led to a rapid increase in churn and the immediate loss of 0.8 million subscribers. Additionally, the announcement in October that HBO is going to be made available over the top, liberating the premium channel to compete more directly with Netflix, has led to a 20% downward adjustment in price but expectations on Netflix remain high. Figure 1: Selected Media Companies Market Capitalisation, 1 st Sept (left) & 1 st Nov (right), USD billion % +2.7% % +2.7% -17.4% % 0 Fox Time Warner BSkyB HBO AMC Netflix Total Subscribers (M) n/a n/a Revenues (USD bn) Operating Incomes (USD bn) Yahoo Finance, Time Warner quarterly report, Netflix annual report, STL Partners and Prospero analysis * HBO accounts for roughly 18% of revenue and 25% of operating income at Time Warner so 18%-25% of Time Warner's $58bn market cap is attributed to HBO ($11-$15bn). STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 4

8 Driving customer acquisition is essential. Netflix s business model is based on large volumes its content costs are broadly fixed per market and so we estimate it needs ~20% penetration to break even (versus the lower 10% required in the US where content costs were lower and competition limited). In the US, Netflix achieved an impressive ~30% penetration and Netflix CEO Reed Hastings has said Netflix aims to achieve penetration of one third of a market seven years after launch. However the international markets are proving more competitive, and key players like the incumbent pay TV platforms and premium channels such as HBO are evolving their business models to compete with Netflix. As a result we believe the international markets are likely to mature at significantly lower penetration levels for Netflix (circa 25%). To compensate Netflix will need to drive more ARPU per subscriber (with tiering such as their multi-stream and HD services) and will also need to extend their geographic reach beyond its current markets to become a truly global player. Netflix recently announced that they aim to reach penetration of one third of households in a given market seven years after launch. This would imply a total subscriber base of 155 million in 2020 (looking at their currently announced markets). Our analysis suggests that these targets are ambitious and we forecast that Netflix will achieve approximately 123 million subscribers in Figure 2: Netflix s subscriber targets for 2020 (announced launches only) in USD million m m High Netflix (Netflix expectations Expectations) Low STL (STL/ Prospero / Prospero expectations Expectations) US Europe Lat Am Canada Source: Digital TV Research, STL Partners & Prospero analysis. *Assumption that there will only be one Netflix subscription per household Netflix: Enemy or Ally of TV industry players Whatever the level at which Netflix matures, it is fundamentally changing the pay TV ecology. While Netflix s increasing need for exclusive rights is a boon to rights owners and producers, the Netflix model of a carved out discrete pay service is putting pressure on established pay platforms and premium channels (such as HBO and Canal Plus) potentially eroding the markets and creating price pressure. It is a catalyst to innovation in packaging, bundling and enhanced services, and for STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 5

9 broadband providers it is both stimulating demand for high speed services and putting pressure on capacity. Figure 3: Summary of Netflix s Impacts along the Value Chain Black = current impacts. Grey = possible impacts Source: STL Partners & Prospero analysis How players respond to Netflix will depend on whether they are a market leader or a market follower. We believe that: For a market leader, a partnership deal with Netflix will probably not be optimal, as these players, be they pay TV platform or broadband operator, will want to own their own customers. However, there can be no complacency about the existing model. Netflix will change consumer expectations tiered packages of content which are only accessible with buy-through from basic will become increasingly anachronistic for certain market segments. New models will have to have the flexibility to unbundle non-linear services for price sensitive groups without eroding core pay TV economics. For second tier players, Netflix may represent an attractive partner. It will be able to deliver breadth and depth of content and a strong consumer brand. However, any partnership will require sacrificing ownership of the consumer and the insight and data that goes with that. The terms on which these deals are struck will be crucial. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 6

10 Introduction The way in which audiences consume movies and television content appears to be changing. While linear viewing of scheduled channels remains robust, the market for DVD has collapsed and new pricing and consumption models are opening up. At the forefront of this is Netflix with a total of 59M paying subscribers across 41 markets (it is present in a large number of smaller Latin American and Caribbean markets) and a penetration of over 31% in the US, Netflix has created a new paradigm for on demand content. How this model is going to impact other players in the market in the long term is as yet unclear. To date in the US, pay platform penetration has remained robust, premium channels such as HBO are also performing strongly, and for rights owners and producers a new player bidding for rights is hugely welcome. So is Netflix a win: win opportunity for all concerned? It may not be that straightforward. For leading pay TV players, Netflix will be yet another factor forcing investment in innovation to minimise customer churn, and reducing flexibility around price increases; For TV channels Netflix could lead to programme rights inflation, as a new player with a distinct business model comes into bid for premium exclusive content rights For both established TV platforms and premium channels there is the risk that in price sensitive markets or demographics Netflix may gain traction, particularly among younger consumers at the expense of traditional subscription models. For telcos looking to compete with cable and satellite, while Netflix could offer a cost effective way to deliver attractive premium content, it also carries a risk of constraining the telcos into the position of a dumb (or happy) pipe, not sharing in upsides and not owning the consumer who deals directly with Netflix. STL Partners has partnered with Prospero Strategy Consultants, who work extensively with content and platform players on new market dynamics, to prepare this Briefing. The work has drawn on interviews with key players and analysis of quantitative and qualitative market data, to determine the threats and opportunities emerging from this new content ecosystem and how these are likely to develop. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 7

11 Overview of Netflix History Netflix began as a postal DVD business in the US in 1997, launching its US subscription streaming service in Since 2011 it has focused on rapid expansion into international markets with the biggest growth now coming from international subscribers (45% growth between 4Q2013 and 3Q2014) while its US DVD business is now in decline. Figure 4: Netflix subscribers (Q3) in 000s US Total US Streaming US DVD International Global expansion Streaming on Xbox, PS3, Blu Ray, STBs, Connected TVs, Apple Launch personal recommendations 0 Launch post IPO Launch streaming service Launch on Apple ipads and ipods Start original programme investment Consumer Proposition and USPs Source: Netflix annual reports, STL Partners & Prospero analysis Netflix changed its reporting methodology from Q The success of the Netflix proposition to consumers has been based on a number of components: Low Price and refusal to tie users into long-term contracts Volume and exclusivity of content Effective User Interface, recommendation engine and multi-device access Customer Data STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 8

12 Low Price The low monthly price point of Netflix (USD7.99 per month in the US rising to USD8.99 for new subscribers in 2014) has been a key component of the company s success. This price point is less than the cost of purchasing a single DVD and significantly less than monthly premium drama channels such as HBO (at ~USD15 per month). This price point (and that users are not tied into long term contracts) allows Netflix to attract distinct audience groups. First, the high-end audience who are already pay subscribers. These customers have demonstrated that they are typically price inelastic and willing to pay for more, buying Netflix on top of existing services. Second, the price constrained audiences, for whom traditional pay TV is out of reach but who are interested in expanded choice. These are often younger demographics for whom the concept of non-linear consumption is very familiar. There is a third audience group, the price sensitive pay TV subscribers for whom Netflix could be an effective substitute and who could churn off traditional pay TV (either completely or partially) as a result. While the evidence around the impact on this group is as yet nascent, it is this segment that is making incumbent pay TV players nervous. Figure 5: Reasons Netflix streamers subscribe to the Service 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% It's cheap Quantity of content Continues to add good content Accessible anywhere TV show selection New content Movie selection Other Source: Alphawise, 3 rd Annual Streaming Video Survey More Devices, More Consumption, March 2013 Volume and Exclusivity As demonstrated in Figure 5above a key to success has been offering both range and quality of content. However, over time the shape of the Netflix library has changed as it has used its customer insight and data to inform its rights strategy. In February 2012 the Netflix US library consisted of ~15k titles (Source: SNL Kagan) of which nearly three quarters were movie titles. Since 2012 the volume of library titles has declined by approximately 30% nearly all of which is accounted for by a decline in movie titles. Netflix has increased its focus on long run drama series which already have brand recognition and which are effective at attracting and keeping audiences. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 9

13 Interestingly, the volume of content being offered in its international markets is significantly less than in the US (about one-third) as Netflix shifts its focus to quality (as opposed to quantity of content). Netflix s early content deals were typically library rights and non-exclusive. Over time that mix has shifted as Netflix increasingly looks to have a component of exclusivity with the aim of shifting from a nice to have to a must have service. Netflix is investing in original production of a limited number of high profile, high end drama series (such as The Queen, House of Cards, Orange is the only Black and the recently announced Crouching Tiger Hidden Dragon sequel). For these Netflix can retain its exclusive rights indefinitely. In addition, Netflix is bidding aggressively for exclusive windows for high end content (such as the recently announced deal for exclusive VOD rights in all territories for Gotham and first window rights in several territories for Penny Dreadful). Figure 6: Netflix s Evolving Content Proposition Volume Value Volume Value Movies 2nd Run TV Ist run TV Original Content Source: STL Partners & Prospero analysis Effective consumer interface on multiple devices Netflix has evolved a highly effective consumer interface, enabling personalisation by individual members in the household, with an easy to manage and visually effective selection mechanism. Since 2008 Netflix has rolled out its proposition across multiple connected devices, with the most recent development being access on mobile devices and partnership with 4G operators such as Vodafone. Cross device functionality gives users a consistent experience. The consumer is able to choose when and where to consume Netflix content leading to a new dynamic of series bingeing analogous to box set consumption. In addition, Netflix s deals with Smart TV providers gives consumers the ability to by-pass traditional pay TV gatekeepers. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 10

14 Figure 7: Netflix s user interface Source: Netflix & SNL Kagan Customer Data Underlying a huge part of their success is Netflix s control of its data. This includes knowledge of individuals within households (who will have their own profiles), detailed insight into viewing behaviour (not just what, but when and how much), knowledge that no linear channel can match. In all markets (regardless of its distribution partners) Netflix retains its customer data and does not share it. This informs its rights negotiations and new programme investments. Netflix continues to refine its customer understanding using sophisticated A/B testing where small sub groups are given slightly different user experiences to see how this changes behaviour Netflix International Expansion In 2010 Netflix started to expand internationally, and now operates in 40 plus countries. The expansion has been in waves. First, Canada as an obvious English language extension to the US. Second, Latin America where US media companies have traditionally done well in pay TV and there are strong existing relationships. These are currently served under a single LATAM service. Third, UK, Ireland and the Nordic areas with strong demand for English language product, growing economies and existing familiarity with on-demand through catch up services and strong broadband. Fourth, the rest of Western Europe - although leaving the weaker economics (such as Italy and Spain) to last. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 11

15 Figure 8: Netflix geography and timeline Source: Netflix, STL Partners & Prospero analysis Given the high fixed costs of Netflix s content (rights are typically market specific and per title rather than per subscriber) it needs to reach a critical mass of subscribers in each market to deliver profit. In a recent interview, Netflix indicated that it needed to secure over 10% household penetration to be profitable in a given market. However, our analysis suggests that with increased competition and rising content prices in international markets that figures is nearer 20% penetration. As of June 2014, outside the US Netflix had secured 17% of household penetration (weighted average) and achieved -9% operating margin. In the US, penetration has reached in excess of 30% households with growth gradually slowing implying a plateau at about 35% of households. In Europe speed of uptake has been quicker than in the US (as Netflix benefits from its brand and experience and existing demand from illegal subscriptions to the US service). However mature levels of penetration look likely to be lower (nearer 20-25% penetration) as Netflix faces increased competition from incumbent on-demand propositions. Historically, the waves of roll out have been timed to manage peak levels of cash flow with existing markets reaching a critical mass before new markets are launched. However, with rapid expansion of incumbent pay platforms and channels in to on-demand services Netflix has been forced to accelerate its roll out recently announcing expansion into the rest of Western Europe (September 2014: Germany, France, Austria, Switzerland, Belgium, and Luxembourg; 2015: Spain). STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 12

16 Figure 9: Netflix s Market Penetration since launch (% households) Year Year Year 1 Year 2 Year 3 Year 4 US Canada UK Ireland Sweden Denmark Netherlands Netflix Financials Source: Digital TV Research, STL Partners & Prospero analysis. *Assumption that there will only be one Netflix subscription per household Figure 10: Netflix revenue per service area, , USD million 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, US Total US Streaming US DVD International Source: Netflix annual reports, STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 13

17 Netflix has adopted a growth strategy based on international expansion funded by its domestic US businesses. Total revenues have grown at a CAGR of 21% over the last five years to USD4.4BN. The biggest component is the US streaming business which accounts for 62% of total revenues and contributes a margin of 29% (Source: Netflix Q financial statements). Netflix s DVD rentals business is shrinking (down 20% in 2013), but still accounts for 10% of customers and 13% of revenues. More importantly, the DVD business is highly profitable; with a contribution margin of 48%, more than twice that of the US streaming business. Whilst international revenues are quite small (just 25% of total) they are the single biggest driver of growth, up nearly 150% in However, the international business is still not profitable with a USD274M operating loss in If Netflix maintains growth for the second part of 2014, we could see the first ever quarter of positive contribution profit from its existing international operations in Q (excluding planned expansion to German speaking markets and France). Figure 11: Netflix s revenues & costs per business line, (Q3), USD billion Source: Netflix annual reports, STL Partners & Prospero analysis Free cash flow has been deteriorating since This can be explained by: 1) the decline of the high margin DVD business; 2) the cash flow intensive nature of streaming contracts which require annual STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 14

18 or bi-annual up-front payments on content and; 3) the cost of expanding into new geographies (in particular Europe). Figure 12: Netflix s net income and free cash flow, , USD million Net income Net cash provided by operating activities Free cash flow Source: Netflix annual reports, STL Partners & Prospero analysis Historically, content costs are broadly fixed in any market (i.e. per title not per subscriber) meaning that Netflix has to reach a certain penetration in each market to drive profitability. This contrasts with traditional pay platforms whose content costs (excluding sports and own channels) are driven by subscriber numbers with limited minimum guarantees. However, as Netflix matures studios are likely to demand more upside (based on subscriber numbers) and as Netflix moves into more premium programming, their costs per hour will rise and will accelerate programme inflation. Netflix s content obligations (advance commitments to programming licensing costs incurred when signing programme licence agreements) have drastically increased over the past 4 years (53% CAGR between 2010 and 2013) as Netflix has had to invest in more premium content. Figure 13 shows both Netflix s total content obligation growth, and the split of the term of commitment, showing that a large proportion (~60%) of Netflix s streaming content obligations are now for a term greater than one year. This fixed cost growth will impact Netflix s financials and particularly its cash flow. Figure 13: Netflix s streaming content obligations, , USD million 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, less than 1 year 1-3 years 3-5 years More than 5 years Source: Netflix annual reports, STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 15

19 With cash flow deteriorating and rising content costs, Netflix s net debt has risen to USD900 million, with the latest increase of USD400 million having occurred in January 2014 to fund the international expansion. Driving customer acquisition is essential. Netflix s business model is based on large volumes its content costs are broadly fixed per market and so we estimate it needs ~20% penetration to break even (versus the lower 10% required in the US where historical content costs were lower and competition limited). In the US, Netflix achieved an impressive ~30% penetration and Netflix CEO Reed Hastings has said Netflix aims to achieve penetration of one third of a market seven years after launch However the international markets are proving more competitive, key players like the incumbent pay TV platforms and premium channels such as HBO are evolving their business models to compete with Netflix. As a result we believe the international markets are likely to mature at significantly lower penetration levels for Netflix (circa 25%). To compensate Netflix will need to drive more ARPU per subscriber (with tiering such as their multi-stream and HD services) and extend its geographic reach beyond current markets to become a truly global player. Attitude of the Financial Markets Despite recent market corrections with a market capitalisation of USD24bn Netflix now ranks as a major global media company valued at one third of Time Warner, approximately the same as UK pay-tv gorilla BSkyB and 60% more than our estimate of the value of HBO (part of Time Warner). Figure 14: Selected Media Companies Market Capitalisation, 1 st Sept (left) & 1 st Nov (right), USD billion % +2.7% % +2.7% -17.4% % 0 Fox Time Warner BSkyB HBO AMC Netflix Total Subscribers (M) n/a n/a Revenues (USD bn) Operating Incomes (USD bn) Yahoo Finance, Time Warner quarterly report, Netflix annual report, STL Partners and Prospero analysis * HBO is responsible for roughly 18% of revenue and 25% of adjusted operating income at Time Warner. Taking 18%-25% of Time Warner's 58bn market cap, it's reasonable to assume the market values HBO at $11-$15 billion. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 16

20 Analysis of key metrics show that much of that value is based on high expectation of long-run growth potential; that Netflix is creating a new model for the consumption of television and film that will drive subscribers, revenues and income and will justify the premium at which the stock currently trades. Table 1: Comparison of Key Value Ratios Fox Time Warner BskyB # HBO* AMC Netflix Revenues Growth YoY (2012/2013) 9% 3.6% 6% 4% 12% 17% Market Cap / Revenues Market Cap / Operating Income In the 20 months to September 2014 Netflix shares rose nearly 10x in value. Source: STL Partners & Prospero analysis # BSkyB global revenues including broadband, fixed line and TV This follows a steep decline in July 2011 when changing its business model and consumer offering (separating streaming and DVD) led to high churn and a loss of 0.8 million subscribers. Subsequent share price growth has been driven by an improving consumer proposition (with a refined understanding of what content is effective, more cautious price rises and the introduction of HD and multi-stream tiers), aggressive expansion into new markets, and rising profitability in maturing markets with high penetration. However, in October 2014 disappointing subscriber growth, declining international margins (with aggressive expansion) and a new OTT strategy from key rival HBO in the US led to a market correction. While value remains high, the pressure on Netflix to maintain subscriber and margin growth is considerable. Figure 15: Netflix s share price (USD), Jan 2010 October July 2011 Netflix to separate Streaming & DVD plans in the US Oct 2012 Netflix launches in the Nordics Jan 2013 Turner & Warner Bros. content deal Oct 2014 Lower growth and new strategy from HBO May 2014 Fee increase for new subscribers 100 Jan 2012 Netflix launches in the 0 UK and Ireland 04/01/ /01/ /01/ /01/ /01/2014 Source: Yahoo Finance, STL Partners & Prospero analysis Source: Yahoo Finance, STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 17

21 Impact of Netflix on the Market Given Netflix's high market capitalisation, it might be supposed that the impact that Netflix has had on the market has been highly disruptive. In practice the impact needs to be examined along the value chain. This analysis is complicated by the fact that a) many players operate in more than one point along the value chain and b) the impact of Netflix particularly at the platform level may vary depending on whether the platform is a market leader (typically an incumbent satellite or cable operator) or a relatively new entrant (typically a broadband operator). Figure 16: Players along the Value Chain Rights Owners and Producers Channels Pay Platforms Broadband Endemol Warner Bros HBO / Turner Time Warner Cable Disney /Dream Works BBC Productions Disney Channels BBC Channels Sky Atlantic BSkyB Deutsche Telecom Virgin Bouygues Telecom Source: STL Partners & Prospero analysis Impact on Rights Owners and Producers Interviews with rights owners show that they are generally enthusiastic about the impact of Netflix on their market. As one interviewee said They re a new buyer, what is not to like? For them Netflix has done a number of things First, Netflix came into the market willing to place value on library rights that were often not being sold. More recently, Netflix has increased competition for earlier windows (either first window, or first VOD window) showing willingness to pay a premium for exclusivity and acting as a catalyst to rights inflation. It has become more selective over what it wants to buy, and rights owners have become more circumspect over the prices at which they are willing to sell. Netflix s small but growing budget for production investment is bringing new money into original programming (and again acting as a catalyst to rights inflation for hot properties ). It could also force premium channels such as HBO to increase their spending. In addition, the presence of Netflix is allowing rights owners to place a value on the hold backs often demanded by established platforms. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 18

22 Rights holders told us: Netflix is focused and clear about what rights they want and what value they are prepared to pay which means that operationally they are an attractive client unlike other players who are interested in a complex set of rights and do not necessarily have clear values assigned to these. There are some areas where rights holders are less clear on what the long term effects will be: Netflix is acting as a further catalyst to the reduction of windows the time between the availability of different rights. For instance in Scandinavia, Netflix has an early window for Warner s content. This should be broadly positive, both speeding up the ability of studios to access new revenue streams and arguably, helping to reduce piracy as content is more readily available through legitimate means. However, managing windows to protect core areas of value (such as free to air and premium linear) is a crucial part of optimising content returns and some rights owners are cautious about the speed of change. Netflix is increasingly leveraging its insight around audiences to inform its content negotiations in terms of what it wants to buy and what it is willing to spend. For right s owners, this is taking them into new territory: We are nervous that we do not have the same market knowledge about the value our content is generating as Netflix has (in traditional television we have access to rating data and know how our content performs). The rights owners are given some limited data by Netflix about their content (and are able to map this against information from other windows). However, some players feel that they are being disempowered by their lack of knowledge, which while it may not be material now, could be in the future. Finally, a new unknown is Netflix s interest in and willingness to pay for multi-territory rights. Their deal with Warner Brothers for exclusive VOD for Gotham across all Netflix territories is ground breaking. If there is a move to global or multi-territory deals this changes the way in which rights have traditionally sold and it is not yet clear what the pros and cons of these could be. Impact on Channels Pay Channels Arguably, it is this segment of the value chain that has potentially been the most vulnerable to Netflix s arrival. In the US, the price point of Netflix is typically under half of the standalone HBO proposition but this in turn can only be bought on top of a basic tier subscription, so accessing premium channels costs from $50 per month upwards (versus $8.99 for the simple Netflix proposition). Netflix and the premium movie channels are competing for and with similar content (i.e. long run high value drama). Interviews with pay channels suggest that they have been unsure about how to deal with Netflix: Our views on Netflix have gone through a number of phases. Stage One was somewhat dismissive Netflix was a big talker with money to burn but not a serious challenger. Stage Two was disbelief; we couldn t believe the traction they had gained. Stage Three was a view that Netflix was not cannibalistic but complementary, but we would have to evolve our business model Pay Channel Provider Evidence of cord cutting is as yet inconclusive. Over the last 18 months, the US premium channel groups have continued to grow their subscriber base, suggesting that while their markets are maturing it is not, yet eroding. There are, however, some surveys showing that in aggregate the number of premium pay TV households is declining. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 19

23 Figure 17: Subscribers to premium channels in the US (%of TV households) Source: SNL Kagan (subscriber numbers), NPD Survey of 7,500 TV households This contradictory evidence seems to be based on the following dynamics: Many households who subscribe to premium pay TV services are price in-elastic. They want more content and choice and are willing to pay. Over time they expand their range of premium channels driving the growth in subscribers to individual channels but not aggregate household penetration. Typically premium channels (and Netflix) over-index in households that already take other premium content. In some households (typically younger demographics and lower income households) the price of premium content becomes prohibitive and when valid lower cost alternatives become available they churn off premium tiers. Finally, Netflix also gains traction in price sensitive TV-free households offering an affordable premium option for the first time. Given that the relationship to content is often emotional and powerful arguably the pace of churn is slow. For instance a Game of Thrones fan will be reluctant to forgo future series. However, there may be break points, as favoured series terminate, when willingness to churn increases and there will be behavioural changes as audiences get used to the dynamics (and flexibility) of ondemand content. As a result, this puts increased pressure on the premium channels to keep the quality and exclusivity of their content up. HBO invests an estimated USD1 billion in original programming each year, about 200 hours of new content including high end series such as Game of Thrones and Broadwalk Empire (with budgets of between USD5-6m per episode). This is significantly more than Netflix. However, the pressure to respond is now leading premium channels to re-evaluate their business models. The biggest change being HBO s recent announcement that from 2015 it will make services available over broadband internet. This should allow HBO to access new subscribers, reduce the impact of Netflix, but managing churn off its higher premium cable services will be difficult. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 20

24 Free Channels Typically free-to-air channels are more insulated from potential impact by Netflix but not entirely. Scandinavia witnessed a reduction in total linear viewing (for instance down by about 10% in Denmark over the last five years); part of this is attributable to moves to on-demand consumption. While premium channels may be the worst affected, these changes put the onus on free channels to establish their catch-up services to respond to the changing dynamics. However, Netflix can also present an opportunity. Free channels are facing competition from premium channels for high cost acquisitions for instance in the UK Channel s Five and Four are increasingly out bid for US dramas by Sky s portfolio of channels (Atlantic, One and Living) who can bid for multiple windows and monetise through subscription. Partnership with the likes of Netflix to secure a mix of free and on-demand rights may make bidding for these rights more feasible. We think that jointly bidding for rights with Netflix may be a win: win. We can deliver the brand building of a first run on free TV that will drive demand for the second pay window on Netflix, and bidding with Netflix can help us secure rights that are now going to pay channels. FTA Channel provider Impact on Pay Platforms Historically, in the US Pay TV platforms have been remarkably resilient to the impact of Netflix and other OTT services. However, particularly over the last twelve months the impact has begun to be felt. In 2013, for the first time, total pay TV subscribers declined in the US by 250k according to SNL Kagan with cable operators losing nearly 2M video subscribers. Figure 18: Changes in US Pay TV Penetration Source: TVB Research, STL Partners & Prospero analysis Notes: Year to July Interestingly, despite this decline in penetration the cable companies have succeeded in insulating their pay TV revenues through effective bundling and price increases although in the last twelve months this growth has also begun to decline. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 21

25 The beginning of cord cutting is confirmed by market research by Experian Marketing Services in the US which shows that the number of households who are cord-cutting from a package of subscription pay services is rising across all demographics. However, this figure is dramatically higher in younger households and now nearly 20% of Netflix or Hulu homes are cutting their pay TV subscriptions. Figure 19: Percentage of Households that are cord-cutters 18.1% % 12.7% 4.5% 6.5% 7.9% All Households Any age household Household with Netflix or Hulu Account Source: 24,000 US adults, Experian Marketing Services, STL Partners & Prospero analysis The extent to which this pattern will begin to become manifest in other markets will depend on a number of factors. First, the strength and exclusivity of the pay TV propositions, second the pricing and tiering (i.e. the flexibility of subscribers to buy smaller packages), thirdly, the robustness of the broadband infrastructure. Another influence may be around the cultural propensity towards (or against) on-demand consumption influenced by of the demographic profile of a country but also by the existence of other on-demand services (such as catch up). Impact on Broadband Operators For broadband operators (both wholesale and retail) Netflix and other media services are increasingly putting pressure on capacity. In the US, 64% of traffic is now real time entertainment. While the figures are considerably lower in Europe, they understate the importance of video traffic in more mature markets such as the UK, Ireland and Scandinavia. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 22

26 Figure 20: Real Time Entertainment Share of Downstream Traffic 36% 57% 46% 55% 64% 43% 54% 45% USA Europe Asia Latin America Entertainment Other Source: Sandvine Global Internet Phenomena, Report H Digging into this data in more detail it is possible to see that in the US Netflix is significantly the largest driver of downstream traffic, accounting for 34% and well ahead of YouTube at 13%. Again while across Europe Netflix is still small, in the UK and Ireland it is already accounting for 18% of traffic and will shortly surpass YouTube. In Latin America Netflix accounts for 5% of traffic. Figure 21: Share of Traffic of Downstream Peak Time Applications Source: Sandvine Global Internet Phenomena, Report H For broadband suppliers Netflix is a mixed blessing it is both the driver of demand for super-fast broadband which they are desperate to sell to customers but also puts enormous pressure on their network capacity. Netflix can undermine broadband suppliers own OTT propositions to consumers but simultaneously erode the market dominance of incumbent cable and DTH pay platforms in favour of broadband based services. How broadband suppliers respond will be influenced not just by commercial dynamics but crucially by regulatory factors (particularly attitudes to net neutrality). STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 23

27 Summary impacts on players along the value chain Figure 22: Summary of Impacts along the Value Chain Black = current impacts. Grey = possible impacts Source: STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 24

28 Responses to Netflix The changes that Netflix drives are most noticeable among younger demographics so these effects are likely to rise as this younger new market of on-demand consumers grows older (and educates their parents). While, to date, the impacts of Netflix (and equivalents) have been manageable by incumbent players along the value chain going forward these impacts are only likely to increase. As a result a number of players are evolving their strategies to deal with Netflix. Below are some selected case studios Case Study: HBO In the US, HBO faces the challenge of protecting its high margin, high priced premium channel whilst positioning to access the growth and consumer dynamics of new on demand services. Its approach has included a variety of tactics: HBO has refused to license any of its content to Netflix, protecting the value of its premium programme brands and limiting the attractiveness of Netflix service offering. It has licensed selected back catalogue to Netflix s biggest US competitor: Amazon Prime. This is effectively a second window syndication model for the 21 st century, so allows HBO to access value, but with a service that is not positioning itself as head-to-head with HBO (as Netflix is). HBO has developed HBO Go a streaming service which is currently available to existing HBO cable and satellite subscribers. While this does not drive much new demand it reduces churn, and enables existing subscribers to binge and consume as they want. HBO has taken steps to partner with cable companies (for instance their Internet Plus Comcast deal) to bundle HBO with cheaper broadband-only products, reducing the price point for accessing HBO. HBO announced in October 2014 that it will offer HBO Go as a stand-alone service to nonsubscribers. How it does this and protects its highly profitable existing customer base is not yet clear (it may involve making a limited number of rights available and only selected windows). In Scandinavia HBO tried to pre-empt the arrival of Netflix with the launch of its own SVOD service HBO Nordic arguably this has not been successful perhaps because unlike Netflix the model initially required a six month commitment from subscribers (unlike Netflix s easy churn on and off model) and was not integrated into the EPG of the key cable providers. In some markets (notably the UK and Russia) HBO has struck comprehensive content deals across all windows (including the valuable premium linear windows) with incumbent pay TV operators (see below) to secure long term value and pre-empt Netflix. Finally, HBO is continuing its significant investment in high end original programming. In 2013, HBO spent almost USD3.6bn on content (CAGR +6%) - of which 72% (e.g. USD2.6bn) for original and sport programming. It has been estimated that HBO adds about 200 hours of original content every year (which includes recent hit series such as "Game of Thrones," "Boardwalk Empire" and "Girls" along with sports and documentaries). Case Study: BSkyB Sky is facing a double threat, with Netflix going head-to-head in drama and movies, and BT attacking Sky s heartland of sport. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 25

29 Sky has responded by expanding its offering to the consumer First, it is looking to tie in existing consumers with added flexibility (mobile services such as Sky Go), greater utility (such as triple play) and increasingly network side services such as DTO and potentially network PVRs which can be accessed from all devices Second, Sky is looking to access non-subscribers with lower priced services Figure 23: Overview of Sky Expanded Offering Source: STL Partners & Prospero analysis In addition, Sky has tried to tie down key content exclusively, effectively preventing Netflix from accessing key programmes. Sky s most important move in this direction has been its deal with HBO. The five year deal to 2020 is estimated to be worth ~ 275m (up from 150m in 2010). It gives Sky exclusive UK rights for the entire HBO TV catalogue (from classic programmes such as The Sopranos and Six Feet Under, to current programmes such as True Blood to future productions such as The Leftovers). The agreement also gives Sky a first look for co-funding and co-producing topend dramas with HBO. Because Sky is buying rights across all windows of value (including now Download-To-Own - DTO) it is able to ensure that key brands are not available to any competitors (the one exception being DTO which is never an exclusive window). It is using this buying power to negotiate earlier release windows for movies making sure there is clear blue water between its highly premium proposition New, Unmissable, Exclusive and Netflix. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 26

30 Figure 24: Sky s offering across All Windows Source: STL Partners & Prospero analysis Case Study: Broadband Operators For broadband operators Netflix can be both a good thing (eroding the power of incumbent pay operators and increasing demand for superfast broadband) and a bad thing (eroding telcos nascent broadband offering). Our interviews showed that the market is still divided about how to respond to Netflix. It is not an ideal partner as it insists on exclusive control of their subscribers (ownership, data and billing) and is not willing to share revenues. As such, adding Netflix to a broadband proposition risks limiting the broadband provider to the role of dumb (or happy ) pipe. However, increasingly broadband providers are partnering with Netflix. The partnership brings the benefit of an established brand and PR, an existing portfolio of content deals and a very effective consumer interface for on-demand. We have decided that it is better to have access to the brand and a well understood ondemand proposition that will complement our linear service and forgo that segment of consumer relationship. We would rather be in partnership with Netflix than against them as we are both trying to take share from the incumbent pay TV platform Broadband Operator. The broadband operator can cross-promote (using Netflix as a cost of sale especially in six-month free offers). In the UK, Vodafone partnered with Netflix to support the promotion of its newly-launched 4G network: when subscribing to top-end post-paid Red plans, customers get six month free access to Netflix. Vodafone s objectives are multiple: Drive 4G service adoption: as opposed to its main competitors (which are charging little or nothing extra), Vodafone UK applies a significant premium to faster internet access. Bundling Netflix with 4G packages enable Vodafone to justify the high price tag. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 27

31 Increase data usage: bundling is an effective way for mobile operators to increase data usage. Similar deals with Spotify and Sky Sport have seen impressive results. Figure 25: Vodafone / Spotify and Sky Sport deals Impact on mobile broadband usage Source: Vodafone UK shareholders presentation Broadband operators area able to add functionality to consumers by offering pan-service search (e.g. on TiVo boxes) across all content on their platforms (important when there are still linear and catch-up windows for key programme brands as well as Netflix). Given that Netflix is increasingly striking deals with smart TV and DVD manufacturers, having Netflix on the inside keeps subscribers within the telcos EPG and universe. Recent announcements include major players such as Deutsche Telecom and BT. Figure 26: Netflix Broadband Partners Country UK France Germany US Sweden Belgium Partner Virgin (TiVo) Vodafone BT Bouygues Telecom Deutsche Telecom Vodafone RCN (TiVo) Com Hem Belgacom (not yet confirmed) Source: STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 28

32 Case Study: New Competitors While five years ago all players in the value chain were sceptical about Netflix s ability to make an impact, its huge success (in terms of subscriber numbers) has forced reassessment. As a result, other players are moving in. The main competitors fall into three groups. Global players such as Amazon, Propositions from incumbent pay TV platforms and channels Niche players (usually offering a highly curated service with limited content). In addition there are other models that will serve elements of consumer demand advertising funded models (though these usually have access to limited rights), download to own and rental players such as itunes and pirate services which still appeal to younger demographics. Figure 27: Netflix Competitor Set Global Players Channel and Platform Players Niche Players Ad Funded Models DTO and Rental Pirate Services Examples Netflix - International Amazon Prime - International Sky Now - UK Hulu - US Sky Deutschland Snap - Germany Canal Play - France HBO Go - US Mediaset Infinity - Italy Vivendi Watchever - Germany Mubi - International Screen Hits - International Play.com International Hopster kids, international YouTube - International ITV player - UK itunes - International Amazon Instant Video- International Wuacki - International Blink Box - UK Popcorn Time - International Pirate Bay - International Model Netflix is very much a pure play Amazon offers mixed models and bundling with delivery of purchases Typically operated by existing pay platform or premium channel Service may be a standalone subscription service or bundled in with existing linear pay packages Enables channel to leverage purchasing power in linear windows to secure SVOD rights Aim to both defend existing subscriber base, to provide entry point for new price sensitive players and to ensure exclusivity of key programme brands in different windows Niche models Usually with highly limited rights in terms of volume and length of window (e.g. 30 day rights) Focus on curation Typically multiple markets and very low price points Basically split into catch up services offered by broadcasters (or platforms) or advertising funded usually with only second tier rights DTO or rental rather than a monthly subscription service Value per title higher, volumes significantly lower arguably initial success of itunes in movies has begun to be eroded by SVOD models Typically DTO windows are non-exclusive so able to secure rights For some players (Amazon, Blink Box) about offsetting declining DVD sales Pirated services using bit torrent New services are always arriving Highly popular with younger (esp. teenage) users with limited disposable income Source: STL Partners & Prospero analysis STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 29

33 Within Europe, the presence of these players before Netflix has established itself is likely to cap their market penetration (at nearer 25% versus the 30% plus in the US). The incumbent pay platform models seem likely to be the most credible player such players have the ability to buy rights across multiple windows (as Sky has done) making it difficult for Netflix to carve out a clean proposition. Conversely though, Netflix increasingly has the ability to buy across multiple territories (see its recent deal with Warner brother s for Gotham) which may give them leverage. Who the ultimate winners will be is not yet clear but it looks as though Netflix is here to stay. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 30

34 STL Partners and the Telco 2.0 Initiative Telco 2.0 is a collection of research, brainstorming and consulting services designed to catalyse change in the Telecoms-Media-Technology sector. Telco 2.0 Research & Analysis Telco 2.0 Executive Brainstorms Telco 2.0 Consulting The Initiative stimulates new ways of thinking about Business Models, Service Portfolios and Technical Architectures. Created by boutique analyst and consulting company, STL Partners, the Telco 2.0 Initiative was launched in May 2006 and is supported by the GSM Association, among other organisations around the world. Telco 2.0 first described the core challenges facing the industry six years ago in How to make money in an IP world, and proposed the two-sided telecoms business model as a key part of the solution four years ago. Over the last year we have published the Roadmap to New Telco 2.0 Business Models describing core innovations needed, and Dealing with the Disruptors Google, Apple, Facebook, Skype and Amazon outlining strategies in the adjacent competitive landscape. Figure 28: Telco 2.0 'two-sided' telecoms business model We re now driving a range of implementation projects with individual players and collaborative consortiums and will be publishing a further detailed Telco 2.0 implementation guide later this year. Through our research we will also be benchmarking telcos strategies, to help the capital markets better understand how to make investment choices in the industry, and looking in-depth at creative strategies in voice and messaging, m-commerce, cloud services and M2M, as well as continuing our work with the World Economic Forum on one of the biggest prizes, how telcos can play a pivotal role in enabling the emergence of a new class of economic asset, Personal Data. We will also be running a further invitation-only Executive Brainstorm at Digital Asia in Bali (2-4 December 2014). contact@stlpartners.com or call +44 (0) to find out more. STL Partners and Prospero Strategy Consultants EXECUTIVE BRIEFING 31