Dark Shadows for OTT?

Netflix released its Q3 earnings results on Tuesday and on Wednesday its stock fell by 12%. Even though Netflix hit its Q3 financial targets, it missed estimates on domestic streaming subscriber growth. Plus, financial analysts worry about the collision between slowing streaming growth, rising content costs, international expansion expenses and declining DVD profits. Is this necessarily bad news for OTT in general? I’d say no. In fact, I think it reinforces that OTT diffusion is proceeding forward quite nicely, thank you.

In a nutshell, Netflix’s potentially rough road forward is in part due to Netflix becoming a victim of its own OTT success. When Netflix got into the streaming business in 2007, a movies/old TV shows OTT subscription service was an unproven model and content deals (if it could get them) were relatively inexpensive. Coupled with its excellent execution and being the first mover in a market with big consumer demand meant Netflix was able to grow its streaming business quickly and profitably.

But in 2012, thanks to Netflix’s success, it’s clear there’s gold in them there video bits and Netflix is having to spend a lot more to fill and expand its streaming content shelves, especially for its efforts to produce original content. This, together with a costly international expansion of streaming and a year over year subscriber decline of almost 40% in Netflix’s high margin DVD business, has investors nervous.

A look at the Q3 numbers provides some context. Netflix ended Q3 with 25.1 million US streaming subscribers. Below guidance, but still not bad as Netflix is probably within a year of passing HBO’s 29 million to become the #1 US premium video subscription service. Financially, domestic streaming generated Q3 profits of $93M against $556M in revenue. Netflix’s international streaming efforts (Canada, UK/Ireland, Latin America and last week’s launch in Scandinavia) lost $92M on revenue of $78M. The rapidly declining DVD business remains Netflix’s biggest money maker with $131M profits on $271M in revenue.

What of Netflix’s future and that of OTT in general? Netflix provided more information than usual about its strategies in its Letter to Shareholders for Q3, likely anticipating the stock market’s reaction to its earnings and guidance.

Netflix does believe, as I do, that OTT in general presents enormous prospects for growth. As the Q3 Letter says “our long-term domestic market opportunity remains 2-3x that of linear HBO.” That would mean 60-90M domestic subscribers which sounds like a tough row to hoe given the ever growing competition that Netflix faces. But as Netflix points out several times in the shareholder Letter, just as MVPD subs may pay for HBO and Showtime, having Netflix is not mutually exclusive from other OTT services. But 60-90M subs for Netflix? Time will tell.

Note that Netflix is comparing itself to “linear HBO” there. Likely carefully chosen words in light of the interesting Netflix statement that “We think it will make strategic sense eventually for HBO to go direct-to-consumer in the U.S.” HBO is doing just that with the OTT only HBO Nordic, but is this impossible in US? Perhaps in today’s market, but if Netflix is successful in passing HBO by a wide margin on subs, HBO parent Time Warner may be under a lot of pressure to find a way to work things out with MVPDs. Thus allowing HBO to go direct in order to expand (with the MVPDs likely getting a “piece of the action”).

Finally, there is one more Netflix supplied factoid in the Letter that reflects a very healthy future for OTT. Two thirds of Netflix viewing is “episodic content,” namely second-run TV shows. This is content that pre-Netflix was losing its value on regular TV. There’s a finite amount of space on channels that show what used to be called “reruns.” Even less so now that channels like TNT, TBS and USA are increasing their amount of original TV series.

This shows one of the greatest opportunities of OTT. Creating more value where before there was little. Given that by TDG’s estimates, Netflix is doing about twice the viewing hours of all MVPD VOD, this means that old TV shows are doing more hours on Netflix than the entire portfolio of content on VOD, including new TV shows and recently released movies. By allowing subscribers to access old TV series with their choice as to when and where, Netflix has created much more value for both consumers and content owners. Value that Hulu, Amazon and others are seeking to leverage.

And while Netflix has shown that it can create a big success out of older TV shows and movies in an OTT subscription model, we have yet to see a standout success in an ad supported or dual revenue model (although Hulu Plus and the slowly accelerating TV Everywhere are seeking to be that first big revenue creator for those models). I believe there’s also big OTT opportunities for niche content indicated by Netflix’s success, provided new content providers can “crack the code” on the right value for consumers in a subscription, ad supported or dual revenue mode.

So despite Netflix’s own potential friction points in growing its business, I’d say the overall OTT market is poised for continued dynamic growth, both in the US and especially worldwide. As indicated by this week’s official launches of Apple’s iPad Mini and Microsoft’s Surface tablets, the number of devices in US homes that will be able to provide high quality streaming video is set to increase rapidly.

And, this year will see the launch of several of Netflix’s original series, including David Fincher’s “House of Cards” with Kevin Spacey and Robin Wright and the seven years in coming fourth season of “Arrested Development.” If Netflix can make a consumer, critical, and financial success out of its big bet on original series, this itself will reinforce that OTT can be a distribution outlet for new creative voices. Just as HBO broke new ground for episodic dramas and comedies, so can content providers in OTT. It should be an exciting future.