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The Netflix effect across the entertainment business has taken root in deep and meaningful ways this year. The turmoil caused by Netflix’s meteoric rise is all that media moguls could talk about last month during their annual conclave at the Allen & Co. conference in Sun Valley, Idaho.

“Just look at the state of our business,” one prominent CEO observed, with equal parts fear and wonder in his voice.

The direct-to-consumer streaming video business model refined by Netflix is the reason Disney and Comcast chased 21st Century Fox with such fervor. It was a big part of AT&T’s motivation for scooping up Time Warner. It marks the biggest shift in entertainment industry economics in decades, and it is an evolution largely driven by a company that has been in the original content business for barely six years.

Trying to play catch-up to Netflix, the largest U.S. media conglomerates are bent on reinventing part of their operations as a direct-to-consumer business model. The industry’s biggest content producers aim to tap into the efficiency of streaming video via the internet to build proprietary pipelines into America’s living rooms, laptops, tablets and smartphones.

“The modern media company must develop extensive direct-to-consumer relationships,” AT&T chairman-CEO Randall Stephenson told investors last month. “We think pure wholesale business models for media companies will be really tough to sustain over time.”

Traditional media conglomerates feel the urgency to act now out of fear that Amazon, Facebook, Apple and Google are also busy crafting global content platforms that will dwarf their operations. It’s no surprise that Disney — the world’s biggest media company — is leading the race among Hollywood’s old guard to catch up with Netflix, et al. Disney chairman-CEO Bob Iger calls the planned launch of a suite of DTC services “the biggest priority of the company during calendar [year] 2019.”

“The modern media company must develop extensive direct-to-consumer relationships. We think pure wholesale business models for media companies will be really tough to sustain over time.”

In a world awash in streaming video, Disney no longer needs to rely on Comcast and DirecTV and a host of international distributors to deliver its TV shows and (post-theatrical) movies. Netflix eliminated middleman distributors, slashed the monthly price (compared with cable) for a robust content package and made all of its content available 24/7 in a commercial-free, on-demand format.

But as with any historic shift, change won’t come easily — or cheaply. To build their own platforms, Disney, AT&T and others will have to invest billions of dollars in high-end content while at the same time forgoing much if not all of the traditional licensing revenue that they would have commanded by selling rights to third-party networks and distributors.

Moreover, the emphasis on launching attractive DTC alternatives will likely hasten the pace of cord cutting. That will only put more pressure on the billions of dollars the congloms take in annually in carriage fees from cable operators for channels that may no longer be first in line for the hottest properties coming from their parent studios.

In short, the evolution of the DTC marketplace for content will be costly, messy and risky. For starters, Disney will say goodbye to about $300 million in annual revenue it currently gets from Netflix for pay-TV rights to its theatrical releases, starting with its 2019 movie slate. Those movies — including “Captain Marvel,” “Dumbo,” “Toy Story 4,” “The Lion King,” “Frozen 2” and a new “Star Wars” installment — will now be key selling points for the new service Iger has referred to as “Disney Play”.

“All of the media companies will have to become more consumer-oriented,” says Jessica Reif Cohen, media analyst for Bank of America Merrill Lynch. “Five years ago, none of us thought people would watch as much as they do on their phones. Content consumption is going mobile, nonlinear and on-demand.

The media universe has never evolved this quickly — we haven’t seen this kind of change in the last 40 to 50 years. This has been the big concern in the market about media for the past three years.”

The industry’s traditional media companies have been experimenting with DTC options for the past few years. CBS surprised skeptics by making a go of its CBS All Access streaming service, which blends live feeds of CBS programming with original series including a new “Star Trek” entry, the “Good Wife” spinoff “The Good Fight” and a growing roster of other originals. CBS All Access won’t rival Netflix’s growth, but there’s enough demand to generate more than 2.5 million subscribers to date.

“From a business-model perspective it’s really the Holy Grail for us,” says Joe Ianniello, chief operating officer of CBS Corp. “The highest-margin consumers we have are CBS All Access subscribers. Consumers are demanding content on the go at the click of the button, and they’re willing to pay a fee for it.”

Hulu has evolved over the past decade from a catch-up service on the previous night’s TV shows to a consumer platform now coveted by Disney, which is poised to take majority control of Hulu through its $71.3 billion purchase of Fox assets.

Ted Sarandos, Netflix’s chief content officer, is neither surprised nor daunted that more major players are looking to elbow in on Netflix’s turf. “We knew that direct-to-consumer was a great model and that people would hold us to a high standard,” Sarandos says. “The pay-TV business has always been more of a B-to-B model. For us, our customers have always been our users. We have to keep them happy all of the time. The one-click cancel [option] makes us keep the value very high.”

Disney Fox counteroffer

Netflix’s leap into the top echelon of the entertainment industry in just a few years has left Hollywood in a state of near bedlam. While the major studios were fighting with cable operators over carriage fees and retransmission consent deals, a company with roots well outside the Hollywood mainstream was unleashing the biggest innovations in the television-viewing experience.

In the process, Netflix has also rewritten the rules of TV and movie dealmaking, talent paydays, TV scheduling, film release windows and marketing campaigns. It’s an extraordinary level of influence exerted on a mature industry dominated by long-established stalwarts.

Consumers have voted with their wallets, taking Netflix from 27 million U.S. subscribers in 2012 to 56 million as of June. Around the world, the number has grown to 130 million as of June. Netflix keeps every penny of the $8 to $14 monthly fee that “members” pay for access to the service. Disney and its ilk, on the other hand, receive a small slice of the much larger check written every month by traditional MVPD subscribers.

Banking on the power of the Disney brand halo, the media giant comes to battle armed with Marvel, Pixar, “Star Wars” and other gold-plated brands. But Disney also has a big problem that Netflix (so far) hasn’t faced: profit expectations from Wall Street.

Netflix has set sky-high industry records for content spending — a projected $12 billion-$13 billion in 2018 — at a time when it is still in building mode. Investors are more concerned about seeing gains in market share than in earnings per share. Disney doesn’t have that luxury. And yet it is embarking on the launch of Disney Play after it takes on considerable debt to acquire 21st Century Fox assets — companies and brands that it sees as more building blocks for other DTC businesses.

The stakes couldn’t be higher for Iger and his team. Disney has promised to find $2 billion in synergies within two years of the Fox acquisition closing, and it has vowed to chop down its debt load at the same time. Some question how Disney can pull off both of those things at the same time.

“The single worst thing Disney could do is launch a DTC product that consumers find underwhelming,” analyst Todd Juenger of Bernstein Research wrote this month. “We struggle to see how Disney can simultaneously make this [sustained] investment while also de-leveraging, even in a stable macro environment. We fear they will either underinvest in the DTC product, or fail to delever.”

The unchartered territory of Disney’s DTC ambition was underscored when analysts pressed the company on its most recent earnings call for details about how it would account for its spending on content for the new service (the answer: as a capital expense). Disney chief financial officer Christine McCar­thy was also asked how the company’s profit projections for theatrical films would change in the absence of the kind of traditional pay-TV output deal it had with Netflix for the past three years. (The answer: Disney plans to hold an investor conference specifically on the DTC business to address such questions.)

Wall Street speculation about Disney’s spending plan for DTC and lost revenue opportunities forced Iger to temper expectations about the studio’s blueprint for Disney Play. Disney has no intention of trying to match the tsunami of original TV shows and movies that Netflix is serving up. Nor will it try to pull other Disney- and Fox-owned movies and TV shows from existing SVOD and international licensing deals to funnel everything through the DTC platform. That would be logistically difficult and extremely costly. To wit, in September 2016, Disney struck a massive long-term TV rights deal for 10 “Star Wars” movies with Turner that runs through at least 2022. The timing of that deal indicates that Disney’s planning for a DTC service with “Star Wars” as a cornerstone brand has only recently come into focus for the company.
Disney Fox counteroffer

“We’re going to walk before we run as it relates to volume of content” for the DTC service, Iger told analysts on Aug. 7.

Disney is counting on the exclusivity factor of selected Marvel, “Star Wars,” Pixar and Disney-branded properties to drive interest in the service. Iger has acknowledged that the Disney Play price tag will be less than Netflix’s $8-$14 monthly fee — a reflection of the lighter content load. “We have the luxury of programming this product with programs from those brands or derived from those brands, which obviously creates a demand and gives us the ability to not necessarily be in the volume game, but to be in the quality game,” Iger said.

Juenger has estimated it will take 40 million subscribers paying $6 a month for Disney to break even on its DTC service. As he notes, Disney will have to shell out big bucks not only for programming and marketing costs but for infrastructure such as customer service and payment processing. There will undoubtedly be unforeseen costs on the technology side: Disney spent $2.6 billion to acquire a majority interest in digital streaming firm BAMtech to support its streaming plans.

AT&T faces a similar scenario as Disney after absorbing Time Warner for $85.4 billion (not counting the tens of millions of dollars spent fighting to save the deal in Washington). AT&T also has to weigh the impact of DTC services on the core channel-bundling business of DirecTV, the MVPD it bought for $48.5 billion just three years ago. As DirecTV’s subscriber base slowly but surely shrinks through cord cutting, the hope is that the expanded AT&T will leverage all of its customer relationships — from DirecTV and its international telco network — to entice its subscribers to try new services.

HBO is key to this plan. The premium channel moved into the DTC arena in 2015 with the launch of HBO Now, which marked the first time HBO was available to consumers without a traditional MVPD subscription. HBO Now has more than 5 million subscribers, compared with about 49 million for the linear versions of HBO and Cinemax combined. AT&T sees the HBO brand as a good consumer-marketing platform for a range of high-end services, even those that would not be branded HBO per se.

Tim Burton’s upcoming live- action “Dumbo” movie likely will be among the offerings in Disney’s digital service.

John Stankey, the newly appointed head of HBO parent WarnerMedia, has made it clear that AT&T has big plans in the space. HBO siblings Warner Bros. and Turner have launched a few niche streaming DTC offerings — notably The WB’s DC Universe (which launches in the fall) and the Turner Classic Movies-curated FilmStruck — but Stankey has grander ambitions. “There’s a number of different initiatives under way within the WarnerMedia companies, and they’re all good within their own right, but they all generate what I would consider to be relatively small-scale audiences,” Stankey told investors last month. “A company our size, we want to be generating audiences in the tens of millions, not in the single digits of millions.”

Stankey has also signaled his intent to rev up growth at HBO. The new WarnerMedia chief has been blunt in his internal conversations with HBO executives that the channel needs to drive more engagement with its subscribers.

“We need hours a day. It’s not hours a week, and it’s not hours a month. We need hours a day,” Stankey told HBO employees at a town hall meeting in June, according to a transcript of the private event published by website Recode. “You are competing with devices that sit in people’s hands that capture their attention every 15 minutes.”

Some have interpreted this as a sign that Stankey wants HBO to go more mainstream in its programming. The WarnerMedia chief has denied that there is any intention to radically change the mix of high-end programming at HBO. But there’s no question that AT&T wants to see the volume go up, and it’s willing to invest fresh cash in more programming. As Stankey said in the town hall, the challenge for HBO to compete in the new on-demand world is “how to expand the aperture of it without losing the quality.”

Meanwhile, Comcast is also looking at changes on the content side of the company at NBCUniversal and at the erosion of the old-fashioned bundle on the cable side of the business. That one-two punch puts Comcast under pressure to make some bold moves in the coming years, which explains the company’s dogged pursuit of the 21st Century Fox assets. Comcast is also vying with Fox and Disney to buy out a controlling interest in the European satellite operator Sky — a move focused on using Sky’s infrastructure to help create a global DTC content platform. Media analysts have pointed to AT&T’s experience with DirecTV as a warning sign of how hard it is to reconfigure an MVPD. DirecTV Now launched in late 2016 as a low-cost skinny bundle of channels available via streaming, without the need of a set-top box or satellite dish. It’s had modest growth so far, with an estimated 1.5 million subs, and has already seen a price hike of $5 from its initial $35-$70 monthly cost.

Disney Fox counteroffer

NBCUniversal is known to be developing some internal DTC offerings. It experimented in 2016 and 2017 with a subscription offering, at $4 a month, dubbed Seeso that corralled “Saturday Night Live,” “The Tonight Show Starring Jimmy Fallon” and other NBCU comedy properties as well as acquired and original series. But uptake from subscribers was lackluster. Seeso was shuttered late last summer.

More recently, there have been rumblings about NBCU developing a streaming service that would offer viewers a kind of points system for watching episodes of NBCU TV shows with some advertising included.

“Our future is selling wherever consumers are,” NBCUniversal CEO Steve Burke said last month on Comcast’s earnings call. “We’re trying to position our company to make sure that all those avenues are open and that we intelligently look at those avenues and maximize the profitability of our video business.”

NBCUniversal’s experience with Seeso is a cautionary tale that programming an on-demand outlet is very different from selling linear channels on a wholesale basis to MVPDs. The importance of offering users the ability to custom-tailor their viewing experience is vital.

Hulu has been an important training ground for its parent companies: Disney, Comcast, 21st Century Fox and Time Warner.

“The single worst thing Disney could do is launch a DTC product that consumers find underwhelming.”

The streaming service launched in early 2008 as an outlet for ad-supported streaming of programming from its parent companies, which at the outset were Fox and NBCUniversal (prior to NBCU’s acquisition by Comcast). Hulu has been a source of friction at times among its partners as they pursued different approaches to streaming. The company was put up for sale in 2013, but when offers from Yahoo and others were underwhelming, the owners opted to invest a collective $750 million to help it grow with original and acquired programming.

For now, Hulu has a unique position in the marketplace as a purveyor of original series — it hit big in 2017 with “The Handmaid’s Tale” — and as a fledgling provider of a skinny bundle of cable channels. The service has been growing fast, rising to 20 million subscribers as of May, up from 17 million at the end of last year. (It’s not clear how many of those subscribers pay for the $40 skinny bundle, which includes access to Hulu’s library and original series). Unlike Netflix and Amazon, Hulu also offers users the option of watching with commercials, for $8 a month, or without for $12 a month.
Disney will own a 60% stake in Hulu through its acquisition of Fox’s 30% interest. Hulu is expected to become another DTC avenue for Disney, providing an established foundation for a service focused on more adult-themed programming. This is where Fox’s FX Networks, Fox Searchlight and 20th Century Fox production operation will come into play for Disney.

The biggest lesson from Hulu’s decade of operations is the imperative to focus on the way it relates to customers. “Anything that truly connects the viewer to Hulu is a good experience,” says Hulu CEO Randy Freer. “If I’m commuting and I watch part of an episode on my phone and then I get home and finish it on my TV and [Hulu] knows where it should pick up — that’s a good experience. If the content recommendations are right for me, that’s a good experience. It always comes back to things that are driven by giving the customer more choice and more options.”
Netflix’s Sarandos counts himself among the many in the industry who are bowled over at times by the pace of change in the biz and Netflix’s role in moving it forward.
“The evolution of television has taken a very long time,” he says. “It’s a very exciting time in the business. All of these changes at all of these media companies are phenomenal to watch, as a competitor and as a fan of the product.”

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