Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age (20 page)

Netflix itself may some day be overtaken by other online destinations, like Amazon's digital rental services. (In the short run, the hike of monthly rates and the end of the Starz deal triggered a sharp decline in Netflix's stock price.)
²⁸
But what is sure is that Netflix's (or the Amazon service's) future depends on reliable access to movies and television. Netflix had made a tentative effort to get around the distribution-programming
megalopolis by arranging for its own original programming, but for the television shows and movies that are its standard fare, it depends on traditional providers. Netflix CEO Reed Hastings tried to fend off destruction by the sledgehammer of the combined distributors and programmers by agreeing with Brian Roberts's assessment: Netflix was a complementary service, a non-competing provider of older television shows and movies, with no plans to tread on the cable companies’ prime turf: sports, news, or current television.

But that wasn't enough for Bewkes—who, as it happens, had his own plan for online video that would keep the interests of the programmers and distributors aligned: TV Everywhere. Rather than let Netflix erode his industry's foundation, he forced Netflix to play defense.

TV Everywhere is rooted in a simple and elegant idea: large cable distributors provide the same pay-TV content online that their subscribers can get through their traditional cable subscriptions. This online product is “free”—at no additional cost—to existing pay-TV subscribers. Once subscribers have been authenticated by the TV Everywhere system, they will be able to access their particular pay-TV package online, whether on their laptop, mobile device, or Internet-ready television.
²⁹

The genius underlying TV Everywhere is that most pay-TV subscribers will believe that their cable provider's online aggregation of content is free, whereas they will perceive that they have to pay extra for, say, Netflix. This will presumably make those subscribers unwilling (or at least less willing) to pay a substantial fee for any competing online aggregation of content, like Netflix. At the same time, programmers will be able to ask for an increase in their licensing fees to cover the online portion of their agreement with the cable distributors. And the cable distributors can push subscribers toward bundles of pay-TV and Internet access by pricing Internet-only subscriptions at a higher rate than that of the bundle. A win-win for the megalopolis.

TV Everywhere became a major asset for the cable distributors in 2010. The ability to put all cable programming behind an “authentication wall” (you had to already be a pay-TV subscriber) would help keep the status quo in place—tens of billions of dollars in fees paid to programmers, hundreds
of billions of dollars in pay-TV subscription fees paid to distributors. Broadcast network shows, which account for only a tiny portion of the media conglomerates’ overall revenue, might be allowed to float online free of high-priced bundled pay-TV subscriptions, but the lucrative cable channels would be available online only via TV Everywhere, where the conglomerates’ traditional revenue streams were secure. Cable distributors were also anxious to retain their revenues from Video on Demand (VOD) packages that give subscribers instant access to movies at home for extra payments; if Netflix or another aggregator had enough content, it could offer a compelling alternative to VOD.

Any independent online video aggregator like Netflix would have a tough time in this environment: if the choice is between an upstart and a behemoth, who is likely to win? If you're Disney, why risk the entire package of payments you're getting for your broadcast stations, your retransmission consent fees (more on those later), and the subscriber fees for your juggernaut ESPN from your cable-distribution partners? If you irritate those partners, they will find ways to make business more difficult—cutting the subscription fees your cable channels command, giving you less for retransmission consent. Sticking with the cable guys is an economic decision, as Greg Maffei of Starz made clear: would you earn so much from online streaming that you're willing to risk the fees you receive under the current business model? Particularly knowing that ad rates online are about a fourth of what the programming can command when it's distributed via cable? You, the media conglomerate, may need the cable distributor more than it needs you.

Moreover, cable distributors who are vertically integrated into programming—like Comcast and its regional sports networks, or Cox (another regional monopoly cable-distribution company) and the San Diego Padres—own quite a bit of important content that new subscribers to an independent online video aggregator would still want, even after giving up their cable subscription. These cable distributors have no interest in licensing to a new online video provider inside or outside their territories. Federal law does not give that independent online provider any help because the existing scheme was set up to enable competing cable providers and satellite companies to get access to programming owned by cable
distributors—not online distributors. Even if Comcast is forced to give a new company access to its cable-network programming, it can make this access expensive in more ways than one—for instance, by requiring endless data-security audits. Whichever subscribers chose, Comcast or Time Warner would pocket the fee the users paid for high-speed data, but not getting their video-subscription fee on top of that payment would turn their lucrative services into a mere pipe. Comcast is unlikely to accept being treated like a commodity provider of transport, a conduit for the moneymaking operations of other people. Even if Comcast is making 90 percent-plus margins for its high-speed Internet access product,
³⁰
it wants to be able to
also
charge for premium video services that travel across the Internet.

True, things could go a different way. Suppose Netflix moved on from the cable guys to ask content companies like Scripps, which owns the Home and Garden and Fine Living channels, directly for licenses to their cable-network content. The new online company might love to distribute Home and Garden and Fine Living to its subscribers.

But Scripps is not an eight-hundred-pound gorilla like Disney's ESPN. It needs Comcast distribution—badly—to survive. Here even before the NBC Universal merger Comcast had leverage. It could say to Scripps, “If you make your material available online, we'll make life materially uncomfortable for you. We'll move your channels to a less-widely distributed tier. We'll cut the subscriber fees we pay you. Your life will be hell.”

The online aggregator might, of course, land one of the big guys. Disney might license ESPN to it, because ESPN is big enough that Disney did not have to care what premerger Comcast thought. Then again, ESPN would be an extremely expensive proposition for a new online video business. And it would probably come with a lot of demands: “We won't license unless the online video aggregator also has name-brand channels X, Y, and Z signed up.” Why would Disney make these demands? Because it can, and because the unbundled (“a la carte”) model is, from Disney's perspective, the worst thing for its overall success, which depends on selling indivisible bundles that include content the user really wants. And licensing a “Disney package” and allowing a new company to redistribute it online would smell like a la carte.
³¹

Any new aggregator venturing into this swamp would soon learn what happened to AT&T and Verizon when they went into the pay-TV business. The two companies, in a hurry to launch their new video products, were mercilessly gouged by programmers. They paid enormous fees for content because they had no leverage. They needed access to programming more than the programmers needed them.
³²
If these two giants could not succeed, how would a new startup online video business ever make it?

In other words, the problem with innovation in online content distribution outside the cable industry's shadow is that the status quo works too well for all the big players. If you're Disney/ESPN, you can demand that the cable operators distribute your channel to 100 percent of their subscribers (even if 25 percent or more of subscribers never watch ESPN), and you can demand that your complete bundle (not just ESPN, but the Disney Channel and Disney Junior) be carried. In exchange, you get a guaranteed large payment, year after year.
³³
If you're Scripps, the model isn't working perfectly for you, but you're on your way up and you can't afford to make anyone mad at you. And if you're Comcast, you have no interest in helping anyone who would undermine your ability to command large monthly pay-TV subscription fees.

As an independent online aggregator, outside the club, Netflix needed to keep its head down and declare its pacifist nature. Direct, outright competition with the cable payment structure would have jeopardized its ability to obtain any programming at all. As it got bigger, there might come a day when the programmers and the cable distributors would need Netflix more than it needed them. But until then it was prudent for Netflix just to try to survive. Broad adoption of TV Everywhere was a persuasive argument that the status quo would stay in place.

Survival was never easy for aggregators. In mid-2011, Hulu—whose business relied on next-day streaming of broadcast content—was forced to bend to the TV Everywhere model. Fox announced that everyone but authenticated subscribers to pay-TV would have to wait eight days to watch a show online;
³⁴
ABC was rumored to be considering a similar limitation.
³⁵
Hulu itself looked less attractive as a destination. Things would be even tougher for new entrants; attracting investment in any new online video-aggregation businesses dependent on the media conglomerates would not be easy.

Online aggregators’ problems do not end when they get access to content. A second precondition for a healthy Netflix (or any other online video service) is reliable access to high-speed Internet subscribers over a standard connection, so that the company's movies and other long-form videos will not hiccup and stall. Distribution is always an issue for any media. For newspapers, it's newspaper racks; for new online video businesses, it's high-speed Internet access. And therein lies Netflix's hidden problem and the cable industry's hidden advantage: the existing industry structure makes this precondition for success more uncertain than any business would like. There is no guaranteed level playing field for reaching an audience of cable high-speed-data subscribers.

This is where the titanic battles over the idea of common carriage during 2009–10 become relevant. The distributors won a couple of key skirmishes and, as a result, competing video providers using their high-speed data connections were in for a rough ride.

First, even though wireless connections cannot carry as much data as a wired cable connection, they are still extremely useful for getting content from cable wires to Internet-enabled televisions in peoples’ houses. So Netflix would like its content to go over the wireless carriers’ connections. But video imposes a big burden on wireless connections, particularly live video, and the wireless providers will therefore want Netflix to compensate them for the privilege of reaching their subscribers. And nothing in federal law or regulations establishes what rates wireless carriers can charge or how discriminatory those rates can be. Netflix will be at the wireless carriers’ mercy.

Wired providers, meanwhile, have a variety of ways to charge an online video aggregator and prioritize their own services. They can underprice the aggregator by charging less for their own video packages than the aggregator can (Comcast gets the lowest prices for content because it has the most subscribers). They can charge higher prices to any data-transmission network the aggregator works with to get its programming to their gateways. They can charge users for the data usage involved in getting access to the aggregator's programming, while keeping their own material on “specialized services” portions of their own pipe, which aren't subject to the same pricing schemes. There are a thousand ways to turn the knife.

The investment community has had long debates over whether distribution or content is king. Where are the best businesses? Where should we put our money? The genius of the cable industry model, when it comes to the future of online video, is that Comcast and the other cable distributors win either way. They are making tremendous, unthreatened margins on their data services. At the same time, the cable operators want to provide online video to their users because they know that video availability will drive adoption of high-speed data service. It already has. The only catch is that they would prefer users to embrace their TV Everywhere financial model, which requires an authenticated pay-TV subscription. Only through the TV Everywhere umbrella do users get “online” access to sports, news, new television series, or cable-network programming. Consumers can make an economic decision: they can buy an “extra” subscription to a new online aggregator (if it can promise them interesting programming) and stream a connection across an “open Internet”—that part of the cable pipe that is subject to the weak and probably unenforceable nondiscrimination rules adopted by the FCC, where the cable operator caps usage—or they can buy from the cable operator and play “free” online video that is not subject to caps. But they make their decision within a carefully controlled context. The cable operator can decide what the prices are by controlling the reliability and amount of Internet access, prices for content, and the price paid by the subscriber for Internet access without a cable subscription.

Here's the kicker: if Comcast sells Xfinity (its TV Everywhere–model service) in other cable distributors’ territories, what is the result? The major players have divided up the country.
³⁶
Let's say that Comcast decides to market TV Everywhere in Time Warner territory. Then it will be using Time Warner's infrastructure. If that happens, Comcast can easily undersell Time Warner's own TV Everywhere package because, again, Comcast pays the least for this content. It will have the best and cheapest video package in America.