February 17, 2015

Copying Originals

Two seemingly unrelated stories broke last week that are worth of comment. The first: Netflix continues to dramatically outspend the rest of its OTT competitors on content, with costs projected to top $5 billion by 2016. If true, this would be more than the 2014 content expenses of all other OTT services (including HBO) combined. The second: BitTorrent –- best known for helping create the modern peer-to-peer software architecture used for most illegal file-sharing of TV shows and movies –- has decided to produce and fund its own branded original TV content. Its first series, Children of the Machine, is expected to launch this fall.

What do these two announcements tell us about the state of today’s TV industry and (importantly) about its future? Two things.

1. Simply Aggregating Other’s Content is No Longer Enough
Let’s acknowledge at the outset that the Internet is a wildly complex system that defies any one-size-fits-all description. That said, when it comes to online services, we have a pretty good idea what does and doesn’t work.

First, we now know that successful intermediaries tend to be meta-sites that talk about particular topics in great detail without themselves offering branded products and services similar to those they cover. For example, Yelp does not run its own coffee shops or restaurants; TripAdvisor is not a hotel chain; Rotten Tomatoes does not run its own movie service; and Bleacher Report does not offer live NFL games. The result is increasingly sophisticated consumers who have the wisdom of the crowd on their side with respect to everyday choices and preferences. Bad products and services increasingly have no place to hide.

Second, search (i.e., Google) allows these hyper-educated consumers to go directly to the source of products and services, thus disintermediating traditional middlemen along the way. For example, if I want to shop for a car online, I am more likely to end up at Ford or Toyota’s sites, not that of a local dealer. If I want information about U2’s new album and upcoming tour, I go directly to the band’s website. Why? Because the direct source of the product or service knows more about it than any middleman who is at best repeating information from this very source.

Third, the Internet tends to drive intermediary margins to zero. That is, if I can book an airline flight directly with Southwest Airlines for price X, then all intermediaries also have to sell that ticket for X. The same holds true for products on Amazon, which provides a low-margin price point on practically everything. The opportunities for middlemen to mark up prices are disappearing across the whole economy.

So what does this have to do with the future of TV? Everything.

Video sites that try to live solely off of content aggregated from third parties have major issues with each of these factors. They are not neutral (as in the first model), because they are financially interested in the transaction (which prevents them from recommending content that is not on their service).

Second, they are not the source of the content, so the quality of their engagement with users is lower. Is the viewer more likely to engage with HBO or their cable company about the upcoming season of Game of Thrones? It’s not even close.

Third, margins on third-party video content are inherently low and approach zero over time. That is, where content is offered to multiple third party aggregators (i.e., Hollywood movies), the price will approach the cost the studios charge to license the movie. This is basic economics in a competitive environment. Note that the key variable here is content margin, not cost. BitTorrent, for example, has zero content acquisition costs for file-sharing. (Set aside legal costs for the moment.) Its distribution costs are also zero, due to its P2P architecture in which the users supply the servers and the bandwidth. Unfortunately, BitTorrent’s margins on this content are also zero, which creates some significant challenges for its business model.

The result is that (almost) all online video aggregators end up trying to produce their own original content. It is the only way to gain control over margins and escape the business model trap. The Netflix approach to this is to gain competitive advantage by outspending everyone else on original content. The idea is that this will create a virtuous cycle of more subscribers generating more revenue which can fund even more content. BitTorrent, it seems, wants to gain competitive advantage by being able to deliver original content more efficiently (and cheaply) than everyone else. That is, BitTorrent’s large user base (i.e., low customer acquisition costs) and P2P CDN (i.e., low content distribution costs) should mean in theory that a higher percentage of its budget can go into developing its own content (in contrast to other OTT providers).

So do the same challenges apply to traditional MVPDs? In a word, yes. As legacy TV and broadband video (TV-as-an-app) converge, the traditional MVPD’s role as wholesale video content aggregator must change or these companies will die. Smaller MVPDs, in particular, must become broadband operators. Mid-size MVPDs must do the same, with many also becoming resellers of OTT services like Netflix, HBO, or NBA League Pass (which is very different than being a traditional MVPD). The largest MVPDs will do both, in addition to producing or acquiring original video content.

2. Original Content Is No Longer a Competitive Differentiator
In 2014 there were 199 new original scripted TV series on pay-TV. (Across all platforms, including broadcast and OTT, there were 352). This is eight-fold the 26 original cable series created in 1999.

This represents an incredible outpouring of content, which is fantastic for viewers. At the same time, there is an unfortunate reality in economics known as the law of diminishing marginal returns. Business strategies do not work forever, as the most effective schemes are copied and augmented by competitors. As this happens, they lose their capacity for competitive differentiation. We may be reaching that point with respect to the original TV series gambit. Do viewers really care about the forty-seventh new science fiction series, or the fifty-seventh original series about vampires?

Keep in mind that the numbers above do not include news, sports, movies, reality shows, or documentaries. Total TV viewing in the US remains flat, so all of this new, original content is competing for a share of the same viewing pie, not growing it. Second, once every video provider (including BitTorrent) offers its own original content, the competitive advantage of having it diminishes. We expect original content to be an entry fee for all video providers going forward (and not a unique competitive advantage possessed only by a select few).

Conclusion
TV innovation seems to come in waves, as industry participants tend to arrive at the same insight at roughly the same time. For some innovations (such as TV-as-an-app), this can be extremely helpful, as collective action by multiple industry participants is needed to create a vibrant ecosystem and push the innovation forward. In the case of original programming, however, this is not necessarily the case. Video providers of all stripes have concluded that aggregating third party video content is no longer enough to be successful and are turning instead to original content production for their salvation. However, while a boon for viewers as a whole, the flood of new shows is diluting the value of original content as a competitive differentiator for incumbent TV providers and OTT services alike.

Going forward the true scarce resource and competitive differentiator will not be original content, but original strategy.

Stick with TDG and stay ahead of the curve.

Joel is a Senior Advisor for TDG and serves as an advisor and Board Member to the video ecosystem and technology companies. He lives near Seattle, WA.

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