Nick Ehle

This post is in response to a similarly titled article on Gawker, written by Edward Jay Epstein.

I am continuing to wait for cable and TV companies to understand the technological market forces that will revolutionize their industry, but I am still seeing signs that they will be caught by surprise when the inevitable consumer shift happens. The main theme of Epstein’s opinion piece in Gawker today is that Netflix is going to be hitting a brick wall in terms of growth prospects within a few years because its mail order DVD service is not profitable enough, and it does not have the digital distribution rights to the right content to attract subscribers. In summary:

HBO, a subsidiary of Time Warner, is the undisputed leviathan of Pay-TV. It has over 40 million subscribers, $4 billion in revenues, and a cash flow of $1.3 billion. And, unlike Netflix, it owns the digital rights to a large amount of exclusive material, much of which it produced.

What Epstein is missing is that Netflix is not trying to directly compete with HBO or other content producers. The goal of Netflix’s digital distribution business is to supplement content on cable in the short-term and supplant the cable industry in the long-term. In summary, Netflix is steadily building a ubiquitous digital video distribution platform.

Let’s look at the opportunity in the market. In 2008, the residential video market for the domestic cable industry was nearly $52 billion, and is estimated to have grown by 5% in 2009, not including ancillary services provided by cable companies such as digital phone or Internet services. By contrast, the TV industry is estimated to have realized $15.6 billion in revenue for 2009, a 22% drop from 2008.

Part of this gap is short-term, including the consideration that TV content producers are heavily reliant on advertising, which continued its slump throughout 2009 as advertisers cut their budgets in the face of the recession. However, most of the gap is structural. Cable providers make a huge profit margin through selling cable packages with hundreds of channels, of which most consumers never watch. In addition, the “triple play” (TV, phone, Internet) has become ever more popular among consumers in the last decade, with much of that revenue going straight to the bottom line. On the other hand, TV content producers, especially the big networks, have been facing increasingly diluted audiences in face of competition, and as a result, they have realized lower advertising rates and lower advertising revenue. As a result of their advertising revenue stream becoming increasingly softer, these content producers have become more reliant on the subscriber fees that they earn from cable and satellite companies that distribute their content.

In the face of this industry landscape and the opportunity in the market, Netflix’s strategy clearly becomes that to supplant the cable companies. Despite analyst assertions in 2008, I believe that Netflix shuttered its Red Envelope Entertainment division specifically because it wanted to send a clear message to the content creators that it is not in competition with them. Netflix is in competition with the cable companies.

It is only a matter of time before the cable companies lose their monopoly to distribute video content, and the shift will be led by consumers that demand to have the video content they want, where they want it, and when they want it. The cable companies have been developing various “TV Everywhere” digital distribution solutions for over a year, but meanwhile, Netflix has been putting its content into TVs, receivers, Blu-ray players, DVRs, and game consoles. Netflix has already built the infrastructure to deliver content they way that the audience wants to consume it, and when the tipping point occurs, content producers will be beating down the door to get onto Netflix’s platform.