Much has been said about AT&T’s supposed plans for HBO, the US-based premium cable network that’s often considered the most valuable component of Time Warner (which AT&T bought for $108B in June 2018 and renamed WarnerMedia). The prevailing narrative suggests AT&T wants HBO to become Netflix – something Netflix has been expecting HBO to attempt since at least 2012. This sparked considerable outrage from fans of HBO, most of whom believe such a move would not only dilute the network’s best-in-class content offering, but fundamentally rewire the company. After all, this is the brand that long professed “It’s not TV. It’s HBO.” And, well, Netflix is trying to be TV.
Being protective of the HBO that exists today is sensible. No matter who you are, there’s something to love. Not only is HBO the most profitable single network in the world, it also produces much of the industry’s best content (averaging ~25% of all nominations for Outstanding Drama Series and Outstanding Comedy Series at the Emmys since 2013, despite airing only 4% of all series). The company’s talent-friendly development team and creative expertise have also made it the “network of choice” for Hollywood’s most celebrated showrunners, writers and stars. And for video distributors, there’s no network they can sell that has a greater impact on profitability than HBO.
But to continue to win, HBO, like all successful businesses, needs to change and grow. This isn’t about failure, nor empire building. Instead, its about adapting to the fundamental changes to the very business HBO conquered. Over-the-top distribution means more than moving content from the TV to an internet-enabled device. It means competing in a market that’s not fair, that’s fought both locally and globally, and where every participant must make and do more than ever before. And so before one critiques what HBO should be, or what AT&T might want it to be, it’s important to address three key areas of context.
#1 – Why HBO Needs More Content
While the SVOD narrative typically focuses on original television series, movies are incredibly important. This is particularly true for HBO. While the network’s catalog is primarily composed of TV content, films represent 73% of total viewing and 34% on HBO Go/HBO Now (the network’s closest Netflix comp). In addition, 40% of all of HBO’s viewers watch only on the network’s film content. This engagement stems from HBO’s dominant share of major studio “Pay-1” deals, which provide the network with an exclusive first window to the films theatrical distributed by Warner Bros., 21st Century Fox, Universal Studios (excluding DreamWorks Animation) and Summit Entertainment. To point, the network has often marketed the fact that it had exclusive rights to half of the biggest 25 films at the prior year’s box office. However, increasing verticalization across the media industry means that most Pay-1 deals are likely to be taken off the market in the years to come.
Although HBO will likely be able to renew its deal with sister company Warner Bros. (#2 at the 2017 box office), the recently acquired Fox (#4) is likely to be retained by Disney for its forthcoming streaming service and/or Hulu. Universal’s Pay-1 (#3), meanwhile, is expected to stay within NBCUniversal/Comcast (though its OTT video play remains unclear) and Summit is now owned by Lionsgate (see below). Among studios not on HBO today, the odds are long. We already know Disney’s catalog (#1) will be exclusive to the company’s streaming service once its deal with Netflix ends in 2019. Lionsgate/Summit (#6) is expected to divert its content to Starz (which it bought in 2016). Paramount’s (#7) remains up for grabs, but if/when Viacom is acquired by CBS, it’s likely to end up on CBS All Access. Sony (#5) is also TBD, but as a perennial acquisition target, its Pay-1 may also vanish. And should any deals come available (such as Universal), they’ll be hotly contested and unprecedentedly expensive. For years, HBO faced only one or two competitors in bidding for these rights. Now it also faces well-capitalized competitors such as Netflix, Hulu and Amazon. And if HBO does win, they will still experience a net reduction in their total Pay-1 share of top films.
However, this is as common a problem as the solution is clear. Most modern networks, including AMC and Netflix, began with only licensed content. But as licenses became more costly and scarce, and programming competition more intense, almost all of these networks progressively shifted their budget to original content (85% of incremental spend at Netflix is now on originals). HBO helped pioneer this path back in 1995 when it greenlit Oz, and today nearly 50% of its budget is on Originals and exclusive sports. Going forward, this share (and thus the company’s output) will need to grow further. Fortunately, the company has several years to replace its Pay-1 catalog as its current deals covers movies released through 2021 and 2022 (and these films would then be available for roughly 15 months before leaving the service).
Beyond simply offsetting Pay-1 losses, it’s important to consider how the programming requirements for SVOD services are greater than those of traditional (i.e. pay-TV) networks. Today, fewer than a quarter of HBO’s subscribers actually subscribe to HBO at $15 per month. Instead, most subscribe to a premium cable bundle of HBO+Showtime+Starz (at $25 or $30) or as part of an “everything TV” package ($120+). Over-the-top, however, HBO is sold à la carte – which provides greater pricing transparency to customers, lacks multi-network bundling, and is month-to-month versus annual. This challenges HBO core’s programming strategy, which aspires to have at least one show for every subscriber at all times.
In the over-the-top world, HBO is asking customers to pay $15 to watch four episodes of a single show each month (and $45 total to watch a single season), plus the occasional movie. Not only can these subscribers choose lower-priced substitutes with substantially greater volume (and an increasingly comparable library of Emmy nominees), they can simply wait until a given HBO show has finished its weekly releases and then binge it for a single month’s fee (or they can wait until several shows have accumulated and binge them all for that same $15). This “binge-and-churn” behavior is common in for à la carte SVOD services, but it’s new for the premium cable networks who used to collectively offer several shows per month as part of an annual, bundled contract that their subscriber couldn’t pause and restart.
For similar reasons, HBO’s low-volume strategy also exposes the company to significant creative risk. If a series misfires (HBO’s Here and Now premiered in February 2018 and was cancelled two months later), the network can ends up with no new content to offer the show’s target audience for more than two months. As a result, HBO can encounter significant customer churn (which means lost revenue, increased customer acquisition costs and lower viewership of all other HBO content – including future premieres). Increased output not only reduces this programming risk, it also helps sustain a $15 month-to-month subscription.
#2 – Why HBO needs to be more global
While HBO content is available worldwide and the company counts close to 90MM international subscribers, the nature of these subscribers and the company’s foreign operations varies significantly. Outside the US, HBO operates under a number of business/operating models. The first model is “owned and operated channels” (or “O&Os”) where HBO shares the same responsibilities and costs as it does in the US. In some markets, HBO’s O&O networks are available only via traditional TV (HBO Asia) or OTT subscription (HBO Nordic), while in others it might be available through both channels (HBO in Brazil). The second model is joint venture networks, which are co-financed by HBO but co-owned and operated by a local partner (HBO Latin America was set-up by minority owner and day-to-day operator Ole Communications, with Sony, Disney and Universal all serving as partners). HBO’s third model is licensing. Here, the network either licenses its brand and original content to a foreign operator (HBO Canada is owned and operated by Bell Media, a large telco) or just its content (in the UK, Germany and Italy, HBO content is only available on one of Sky’s self-branded networks, along with considerable non-HBO content). In some of these markets, HBO isn’t even a paid channel – it might be available on basic cable, or even via broadcast.
This multi-model strategy create a substantial range in per-subscriber economics, with HBO receiving as much as $10 per viewer/subscriber month in some markets and as little as $0.08 in others (both subject to currency swings). In aggregate, REDEF estimates that HBO’s foreign business (90MM subscribers + international licensing revenue) generated $1.3B last year – with its domestic operations generating more than three times as much on 60% fewer subscribers. While HBO’s international strategy might thus seem to have left considerable money on the table, it also allowed the company to expand globally without investing heavily in local offices, navigating complex regulatory and distribution agreements, or developing (and in many cases, even licensing) market-specific content. As a result, HBO spent some 20 years generating billions in revenue with almost no costs or efforts. International was, in a sense, considerable upside to a lucrative domestic business.
However, many of these advantages have atrophied as over-the-top distribution has emerged. For example, a network can now operate in foreign markets without many of the aforementioned operational costs and burdens (Netflix is available in Cuba, for example). And international exposure produces competitive advantages that bolster every other market, including domestic. As a result, HBO’s remunerative foreign model has begun to feel expensive, not gilded. We see this in a few ways.
First, it means HBO doesn’t have a direct relationship with (or individually know) the majority of its international viewers and subscribers. Second, the network can’t serve these customers on a common platform. This makes investing in technology and product more costly, limits customer data/personalization, hinders the ability to perform content analytics and prevents subscribers from watching HBO outside their home country (Netflix subscribers can watch Netflix anywhere). Third, HBO’s foreign deals can tether the company to the decline of traditional TV and/or limit its ability to prepare for life after it. In today’s brand-centric marketplace, for example, HBO is without a consumer-facing brand in many of the largest global markets (e.g. the UK, Germany, Italy). And in some of the markets in which HBO is a branded channel (Canada), HBO only controls its brand guidelines – it can’t force its partners to launch à la carte OTT offerings, increase marketing spend, invest in local originals or licenses, etc. With its joint ventures, HBO faces the even larger challenge of having to persuade its local partners to reinvest in and cannibalize their shared business in order to help HBO improve/grow the business they don’t share (i.e. other markets, their tech stack, etc.).
This model can also limit HBO’s ability to invest in content overall. Netflix, for example, uses its foreign markets not as upside to its US operations, but as an opportunity to bolster its worldwide content catalog (including the US). There’s no The Crown, Dark or 3% if Netflix doesn’t operate in the UK, Germany or Brazil, for example. There would also be fewer US-originated series (and likely fewer high-budget series) were Netflix not available – and thus able to monetize – on a truly global basis. Finally, there’s the economic argument. Due to the low-touch nature of OTT distribution, global networks benefit from unprecedented operating leverage. While HBO’s largely risk-free and margin-rich $1.3B in international subscription revenue makes Netflix’s high-risk 4.5% margin on $5.1B (or $227MM net) seem paltry, Netflix has seen international contribution margins grow an average of 11 percentage points in each of the past four years. If this trend (and that of revenue growth) holds, Netflix will net $1.25B abroad in 2019.
#3 – Why HBO needs more subscribers and more usage
Scale, defined by both the number of subscribers and their frequency of use, has always mattered in the video business. But it is now existentially relevant. As a network gets larger and more used, every aspect of its business becomes easier and more defensible. Growth makes it easier to afford content (costs don’t vary based on viewership, while efficiency does), launch this content (viewers tend to concentrate their online video use on their default service), and ensure these investments are successful (even the smallest niches can be economical if a network’s install base is large enough).
Today, for example, Netflix will often release B-grade shows to greater success than its primary competitors (Amazon/Hulu/HBO/Showtime/Starz) do with great ones (which are far harder to find and make). Furthermore, Netflix can often economically outspend these competitors on either category of series while releasing more of them. In today’s blockbuster-driven media environment, the number of “at bats” is a significant advantage; one “home run” (e.g. Game of Thrones) can be worth dozens of singles or doubles, if not more.
We also see scale dynamics play out in HBO’s most valued market: talent. Over the past year alone, Netflix has made $100-300MM deals with top-tier showrunners Shonda Rhymes, Ryan Murphy and Kenya Barris. While each creator doubtlessly would have loved to produce for HBO, the network can’t put out the sufficient volume of series needed to recoup nine-figure deals or satisfy the appetites of each creator (in 2019, Murphy alone will have more than half as many shows on the air as HBO). No other network or studio has ever made a nine-figure deal based around potential output (WBTV’s Greg Berlanti deal involved buying out the back-end for nearly a dozen series already on the air). Reach is also believed to be behind Netflix’s deal with Barack Obama, who is rumored to have turned down higher offers from competing networks because he wanted to maximize his social impact.
It’s not just former presidents who are attracted to Netflix’s sizable audience. Netflix’s attempt to corner the market in stand-up comedy is buoyed by the exposure it affords comics. Ali Wong recently told Fortune that while she was previously unable to fill a venue in San Francisco, she’s now selling “out within 30 seconds” thanks to Netflix. Networks have always raised a comedian’s profile, but never to this degree and at such volume. And HBO, the previous leader in premium stand-up, admitted in 2017 that the prices Netflix was paying had largely forced the company to pull out of the category.
What I’ve described above is a positive feedback loop (or “flywheel”) – one that’s distinct from the competitive dynamics of traditional television, and helps to smother competition (Netflix’s investment strategy is predicated upon squeezing many of its competitors out of the industry). Consumers only need additional à la carte services if the service they’re already using isn’t good enough. And given there’s no ceiling to how much content these digital services can provide, and many reasons to crank out ever more, viewing time inevitably concentrates. This is why many people believe only a few D2C platforms will be viable over the long run (and the top one or two platforms will capture almost all of the value). While this theory is in stark contrast to the communitarian dynamic of pay-TV (which supports dozens of Big Media companies on a relative equal basis), it adheres closely to the outcomes and dynamics exhibited in most consumer digital markets (e.g. social networking, ride sharing, smartphones, search, online advertising).
This “(a few) winners take most” dynamic has also transformed HBO’s competitor set. There has never been evidence that any of the big three premium cable networks (HBO, Showtime, Starz) cannibalized one another. In fact, their individual successes tended to lift the premium cable bundle overall. But in the new digital, à la carte world, each of these networks is determined to be one of the few enduring digital platforms. As a result, they – and others such as CBS All Access – are ramping up their original programming, growing marketing spend and rapidly expanding abroad (and on a D2C basis). Those that do so successfully will compress the success of the others.
And then there are the digital players. In each of 2016, 2017 and 2018, Netflix grew its content spend by HBO’s entire budget. While the network’s average quality might lag that of HBO, volume and spend compensates for a lot (the two networks had roughly the same number of Emmy nominations in 2018, and Netflix had four Outstanding Series nominees to HBO’s five). And while many of HBO’s newest competitors (e.g. Amazon, Apple) have different business models, they compete for the same finite supply of potential series, consumer spend and consumer attention. Apple, which has yet to launch its video offering, looks to be pursuing HBO’s content model – a dozen or so annual releases of highly differentiated, high quality programming – except that the shows are likely to be given away for free to the company’s 1B+ active users. One can debate whether the need to generate a direct profit in video is a strategic advantage or cost, but not whether this will affect HBO both directly and indirectly. To defend against these challenges, HBO needs to fuel every component of its flywheel.
The War of Would-Be Usurpers (and Its Many Battles)
As any Maester would tell you, the fate of any war’s victor is to await the next one. By almost every measure, HBO has won the past two decades of cable television (thus covering both its ascendance and peak). But the future of media looks very different than its past. And while the company’s profits, B2B and B2C brands, internal development capability, and market-leading content catalog will endure for years to come, HBO will need to change and adapt.
Many envision (or expect, or fear) this means HBO will need to replicate Netflix. It shouldn’t and doesn’t have to. There can be a bigger, stronger and better version of the HBO we enjoy today. And in the second part of this two-part series, we’ll detail a six point plan to get it there.