Broadband Video: Business Models Take Shape

The advent of digital distribution for theatrical, television and user-generated content comes at a time of enormous pressure for the traditional entertainment industry. The industry enjoyed years of strong returns at the box office and from DVD rentals and sales from the late 1990s into the early part of this decade, but U.S. revenue growth has slowed significantly as of late.

After averaging a healthy growth of around 8 percent between 1996 and 2002, box office revenues haven’t budged since 2003 (and in fact declined nearly 6 percent between 2004 and 2005, before rebounding 6 percent between 2005 and 2006).

DVD rentals and sales have also lost their luster in recent years. After very strong growth between 2001 and 2004 (nearly 240 percent), DVD sales revenues were close to flat between 2005 and 2006. DVD rental revenues have also settled into a slower growth rate in 2005 and 2006 — around 10 to 14 percent by many estimates.

Television networks have similarly struggled against digital distractions (the Internet, game consoles, DVRs, etc.) that have eroded the prime time audience for many programs (“American Idol” notwithstanding). Their revenues have been impacted in the form of decreased “up-front” ad sales (typically referring to the early buying of advertising for the fall prime time season).

In June, the Wall Street Journal reported that up-front sales had rebounded slightly compared to previous years, but television networks continue to re-evaluate their ad strategies as major advertisers seek alternative outlets, particularly the Internet. When an online video service such as Joost can land 30 major companies as primary advertisers (among them Coca-Cola, Nike and HP), you can definitely sense that the rules for traditional media have changed.

Ads Trump User-Paid Movies

Parks Associates has been watching how both traditional and upstart media outlets have been addressing digital distribution for some time now, culminating in the report “Internet Video: Direct-to-Consumer Services,” released in late 2006.

In that report, we found that while big media of all types are actively engaged in digital distribution of some form, pure user-paid movies-on-demand services will constitute a much smaller piece of total U.S. revenue than ad-supported models, including the work of the major TV networks to put delayed prime time programming on the Internet, specifically the efforts of ABC.com, CBS’s Innertube, NBC’s Rewind, and News Corp.’s MySpace.

So far, this has held true, as the major broadcasters are still reporting good returns on their Web properties (an active viewership, no signs of cannibalization, and the ability to charge higher rates for ad inventory). Outside of the iTunes TV show and movie download service (which at last report had generated 53 million downloads), user-paid services — and particularly those specific to movies — are facing many hurdles. In the report, we wrote:

“Internet video for movie content faces stronger challenges in terms of technological challenges, resistance from major retailers, lack of easy connectivity between broadband services and the television, and the continued consumer reliance on tangible media.”

Our own consumer data back the notion that the early successes for broadband video are those efforts more focused on shorter (“snackable”) videos as opposed to a movie download.

The good news is that the number of broadband users paying at least monthly to download or stream video doubled between 2005 and 2006. (We compared data from a couple of our studies — “Digital Entertainment: Changing Consumer Habits” and “Digital Media Habits.”) Five percent of broadband users in Q3 2006 reported paying for video streams and downloads. We’re going to be really interested in the results from “Digital Media Habits II,” which should be available soon. However, consumers active in watching video on the Internet were twice as likely to be downloading short clips (such as movie trailers, news clips and animated cartoons) than longer videos such as feature-length movies or TV shows.

The challenges of selling premium video content materialized in a couple of significant announcements from the user-paid broadband video space. First, Blockbuster announced on Aug. 8 that it was acquiring the online movie service Movielink.

Rumblings about Blockbuster’s potential acquisition of Movielink had been around since March, when the purchase price was rumored to be US$50 million. In last week’s news articles, rumors had the purchase price at $20 million. It turns out that both price points were off by several multiples. In an Aug. 14 SEC filing, Blockbuster reported that it had purchased Movielink for $6.6 million in cash. For a service that was created in 2002 from a reported $100 million in investment from the major movie studios, this price drop is one clear sign that a pure movies-on-demand business over the Internet just isn’t ready for prime time.

The second broadband video announcement of significance came on Aug. 13, when Google dropped its user-paid video service the Google Video Store. Both of these news items reflect the continued challenges facing online services but also open opportunities for content developers and distributors.

Blockbuster Seeks an Edge

As a company, Blockbuster’ experiences in the video distribution business mirrors the opportunities and threats for the industry as a whole.

As a movie rental company, Blockbuster’s reach in the U.S. is unparalleled. The company operates more than 5,000 stores in the United States and its territories. In 2006, Blockbuster reported gross profit of more than $3 billion on revenues exceeding $5.5 billion.

However, the company’s financials have declined in the last two years. In 2006, Blockbuster experienced a 3.1 percent decline in DVD rental revenues and an 18 percent decline in DVD sales revenues. Netflix has been pressuring Blockbuster’s core rental business, and mass retailers are also a threat to its DVD rental and sales businesses because of a movie studio practice known as “sell-through pricing.” This term means that the studios release nearly all DVDs at a price low enough so retailers can entice customers to purchase with a small price markup. This practice is particularly advantageous for large-volume retailers such as Wal-Mart or Target because they can sell higher volumes of movies than Blockbuster.

Blockbuster is no stranger to experimentation with online content. In 2000, it announced a deal with Enron and other broadband providers to deploy a video-on-demand service over 1.5 Mbps (megabits per second) DSL lines. Needless to say, given the collapse of Enron and the fact that broadband connections were not nearly as widespread or robust as they are today, that effort was shelved. Now, Blockbuster has announced the purchase of Movielink, one of the first online movies-on-demand services.

The recent commentary and analysis from major news and financial media outlets have provided interesting insight into both Blockbuster’s business and predictions about the overall broadband video-on-demand space.

Our own conclusions from this sale include the following thoughts:

• Blockbuster is perceived as a follower of Netflix. Netflix initiated the online DVD rental business in 2001; Blockbuster began its online DVD rental business in 2004. Netflix announced its digital movie service in January 2007 (and it was commercially available in June 2007); Blockbuster announced its acquisition of Movielink in August 2007.
• The investment community sees Blockbuster’s brick-and-mortar retail stores as both a blessing and a curse. They are a curse because they account for high overhead. However, recent comparisons between Blockbuster’s and Netflix’s online DVD rental businesses indicate that Blockbuster has been experiencing much higher growth in the last year, probably because its retail stores give it more flexible rental options.
• Movielink hasn’t been popular because of restrictive digital rights management that doesn’t provide full flexibility. We also argue that the lack of fresh content is also a reason for its limited growth. Why use a movie download service if the content isn’t any newer than what one can get via a DVD rental?

A more successful model for broadband video is wide distribution of content across multiple aggregators, as opposed to creating exclusive portals. TV broadcasters found that — in this early stage –exclusive portals providing only one source for accessing the content are non-starters among an ever-fragmenting audience. Certain pockets of the viewing audience, including teens and ethnic groups, are already dramatically changing their media consumption behavior, and the channels need to diversify accordingly. For media companies trying to establish an online presence, it is essential to define a clear identity for each of their online channels.

Google Bails on User-Paid Content

Google announced the Google Video Store in January 2006. This service offered a variety of video, including sports, movies and TV shows, for download or rental at prices ranging from $1 to $20.

Although Google’s ability to drive revenue from search-generated ads is unmatched, the company — according to critics — struggles in areas outside its core competency. The Google Video Store was one of these areas. Critics such as David Pogue at the New York Times panned the site for its poor design and for not allowing users to play copy-protected content on portable devices such as iPods and notebook computers.

Second, Google faced an identity crisis of sorts in providing user-paid and relatively high-value content while at the same time pursuing (and ultimately acquiring) YouTube, which was made famous (or infamous, depending on one’s stance) for providing lots of user-generated video and (in some cases) serving as a clearinghouse for copyrighted content. One could argue that Google’s efforts managed to alienate two key constituencies — users who criticized the lack of flexibility in enjoying their paid video and owners of high-value content, suspicious of Google’s motives and upset that YouTube wasn’t (in their minds) acting quickly enough to protect their copyrighted content.

On August 13, 2007, Google announced it was shutting down its user-paid service. Our conclusions from Google’s pullback including the following:

• Google’s own YouTube posed a threat to user-paid video services. Google is struggling to gain credibility with major content producers because the YouTube site has come under fire for its role in the illegal distribution of copy-protected content.
• As in the case of Movielink, consumers struggled to find value with copy-protected broadband video when 1) much of it was free to view (illegally) on YouTube (or peer-to-peer sites); and 2) a DVD can be played pretty much anywhere.
• Google’s core strength lies in ad-supported Web content, and it has struggled in challenging PayPal with Web payment schemes. This means that advertising will continue to be Google’s “currency” of choice for generating revenues on the Internet.
• Google has sown the seeds of discontent with consumers, who paid for video clips and no longer have access to that content, sowing even more skepticism about broadband video services — why would a consumer trust any of these sites versus buying a DVD that they can own “forever”?

The broadband video space is still in a strong degree of flux. Major players still haven’t figured out the exact formula to make the provisioning of online video a complete success. With services such as Movielink, MovieBeam (which Movie Gallery bought earlier in the year for a reported price under $10 million), and YouTube (which generated about $15 million in revenue for Google in the last year) are underperforming, there is clearly a lot of experimentation yet to be done.

The hybrid approaches of Netflix and Blockbuster are intriguing. Both companies are betting on the DVD’s relevance for the next few years, and it’s a prudent choice to make.

We are not yet at the stage where all of the content that consumers want can be found on the Internet. We are also intrigued by the ad-supported content model, as early returns from the major networks (ABC, NBC, Fox and CBS) have shown that consumers are willing to watch a few ads in return for free content.

Certainly, most of the amateur video on YouTube won’t have an ad value, but Google is addressing premium content for now. Also, several direct-to-TV solutions have emerged recently, which warrant attention as they could solve some of the critical challenges in providing a quality viewing experience in the living room. They could set the stage for a real shift in consumer video consumption and provide us with new models to study.

It’s certainly a dynamic market, and we’re continuing to watch it closely.