Page 1 of 4

For the media world August 4 felt like a remake of The Day the Earth Stood Still. It began serenely enough, with a quarterly earnings conference call by Robert Iger, chairman and CEO of Walt Disney Co., the planet’s foremost entertainment conglomerate. From his Burbank, California, headquarters, a relaxed Iger announced record-high earnings and dividends above consensus estimates.

But then he lowered long-term guidance, noting that viewership was down at Disney sports juggernaut ESPN. Acknowledging “the rapidly changing media landscape,” Iger conceded that younger audiences were increasingly turning to video streaming.

The market freaked. If even ESPN, the most profitable channel on television, was losing viewers, what hope did traditional media companies have against cord-cutting upstarts, led by Netflix? In the five trading days that followed, more than $50 billion of market cap was swept away from older U.S. media companies, and there is no recovery in sight. Along with declines in Disney’s stock, the share prices of AMC Networks, CBS Corp., Comcast Corp., Discovery Communications, Time Warner Inc., Twenty-First Century Fox and Viacom plummeted. By September 19 shares of these leading media companies were down 11 to 23 percent from their August 4 levels.

“Investors got paranoid about the potential for accelerating changes around cord cutting and advertiser behavior,” says Brad Barrett, Los Angeles–based media analyst for Capital Group, which runs several funds invested in both traditional media and cordless newcomers. “In a business like media, with large fixed costs, changes in future revenue expectations can have a big impact on future profit expectations.”

Investors have good reason for paranoia. Netflix — offering on-­demand films and TV shows at a fraction of pay-TV prices — has become the media world’s great disruptive force. Skeptics think Netflix is overly dependent on subscription fees and vulnerable to cordless rivals it helped spawn. But over the past five years, the Los Gatos, California–based company has transformed itself from a struggling DVD rental business into the premier video streamer, with 66 million subscribers worldwide, 45 million of them in the U.S. Many of those viewers have turned their backs on cable and satellite companies that force them to accept bundles of hundreds of unwanted channels for access to a few favorite programs heavily interrupted by commercials. And the price for these privileges now averages more than $80 a month — about ten times the lowest subscription fee for Netflix. “The traditional pay-TV system is pricing itself into oblivion,” says Craig Moffett, a New York–based senior analyst and partner at MoffettNathanson, a leading media research firm.

Linear TV, with real-time programming, hemorrhaged 600,000 subscribers in the second quarter of this year alone. With the loss of these viewers, advertisers are turning increasingly to online players like Facebook and YouTube. “The two legs of the traditional media stool are subscriptions and commercials, and they are getting wobbly,” says Richard Greenfield, a media analyst at global brokerage BTIG in New York.

Nobody disputes that linear television will survive and reap profits, albeit at a slower pace. Most consumers still depend on their cable or phone companies for access to high-speed Internet. And many of them sign up for packages of phone, Internet and cable TV that are cheaper than buying these services separately.

But it’s hard to overestimate the impact of Netflix and other online companies in reshaping U.S. media, an industry with a whopping $150 billion in annual revenue. Cord cutting has exposed deep fault lines in traditional media. “What we are seeing is a bifurcation between the losers whose content is no longer viewed as interesting versus those who still offer top-shelf content,” says Lawrence Kemp, New York–based portfolio manager of BlackRock’s Capital Appreciation Fund, whose $3.4 billion in assets includes stakes in Facebook, Google and Netflix. Behemoths like Disney and Comcast — with film studios, theme parks and resorts as well as television operations — are profiting from their diversified revenue streams. Others, like Viacom, are struggling to revitalize business models too closely tied to linear television.

Netflix has been a driving force in M&A activity, splitting content providers — mainly, studio-based media conglomerates — and distributors (broadcast, cable and satellite companies) into separate camps that battle each other over slower profit growth in linear television. Both camps are looking to mergers to increase their negotiating powers against each other and cordless rivals.

But Netflix, with support from consumer advocates and regulators, has successfully lobbied against mergers it views as threatening to its broadband access. Comcast’s failed bid for Time Warner Cable (TWC) earlier this year was a direct result of Netflix lobbying. (Time Warner spun out its TWC cable operations as a separate company in 2009.)

Hoping to slow down Netflix, traditional media companies are making their own attempts at video streaming — with mixed results. The biggest such initiative is Hulu. But this joint venture of Comcast, Disney and Fox has been dogged by internal disputes over brand placement and content that have slowed its decision making and growth. “This is an industry with big personalities and competing interests that can make it difficult for large studios to work together,” notes Nidhi Gupta, Boston-based manager of the $865 million Fidelity Select Multimedia Portfolio, whose largest holdings include Comcast, Disney and Time Warner. Although the $8 monthly subscription fee for Hulu is virtually the same as for Netflix, it has drawn complaints because, unlike Netflix, Hulu interrupts its programs with ads. In response, Hulu in September began to offer a commercial-free monthly subscription for $12.

Although Netflix is the cordless leader, questions are rising about its business model, which single-mindedly focuses on fees from subscribers, whose numbers are rapidly growing around the world. This one-track strategy makes Netflix vulnerable to rivals. Amazon Prime has become the second-largest streamer by offering its videos free to customers who sign up for unlimited delivery of other goods and services for a $99 annual fee. Promoting itself as commercial-free entertainment, Netflix has ceded ad revenue to Facebook and YouTube, both of which are becoming video-streaming competitors. And lurking on the horizon as a video streamer and an advertising platform is Apple.

This variety of pressures on Netflix have given investors pause. Though at first the company seemed immune to the Disney-induced summer sell-off, Netflix shares dropped 15 percent from August 4 to September 19.

Although the impact of video streaming on linear television has been dramatic, big media companies had plenty of time to prepare for the onslaught, yet failed to do so. The worlds of music, publishing and retailing had already been devastated by Internet upstarts. Audio streaming now accounts for 350 percent more music sales than compact discs. E-book sales trail hardcovers by only 20 percent, while print advertising for newspapers and magazines is at all-time lows. And Amazon, with a $252 billion market cap as of September 19, has soared past mighty Wal-Mart Stores’ $203 billion valuation.

But media giants were convinced they would be the exceptions in the new digital age. In a memorable December 2010 interview with the New York Times, Time Warner CEO Jeffrey Bewkes scoffed at Netflix: “It’s a little bit like, is the Albanian army going to take over the world? I don’t think so.” Over the past 18 months, as the Netflix blitzkrieg has spread unchecked around the globe, media companies have become surprisingly silent with the press, preferring to confine their comments to quarterly earnings calls and the occasional forum with analysts.

How did Netflix manage to stay under the radar of the media establishment for so long? For one thing, it was long identified as a video-­rental company, and it stumbled, sometimes spectacularly, during its transition to on-demand digital streaming. Media companies initially viewed Netflix not as a threat but as an added source of income and gladly sold it rights to video-stream their reruns. “Without question, the media companies were outfoxed,” says BlackRock’s Kemp.

Netflix was co-founded in 1997 as a video-rental company by Reed Hastings and Marc Randolph, two Silicon Valley software entrepreneurs. In 1991, Hastings, a former Marine and Peace Corps math teacher, started a computer debugging company called Pure Software, which Randolph later joined. Following the 1997 sale of Pure Software for $700 million, Hastings invested $2.5 million as start-up cash in Netflix.

Randolph, who was briefly CEO of Netflix, left the company in 2004, two years after it went public. He has criticized his former partner for taking too much credit for the company’s early business model. Randolph takes special exception to Hastings’ account of how Netflix first differentiated itself from brick-and-mortar rivals. According to Hastings, he came up with the notion of flat-fee, unlimited rentals of videos distributed by mail after being forced to pay a $40 fine on an overdue rental of Apollo 13. Regardless of whether that was the eureka moment, it did not lead to immediate liftoff. In fact, after running up continuous losses, Netflix offered to sell itself to Blockbuster in 2000 for only $50 million but was refused.

The turning point for Netflix was its 2002 IPO and subsequent share sales that year, which raised $95 million. A year later Netflix posted its first profit. Success came quickly after that. By 2007 the company had become one of the largest users of the U.S. Postal Service, delivering a cumulative 1 billion DVDs to customers who were allowed to keep the discs at no extra charge until they were ready to order the next batch. That same year Netflix launched its video-on-demand service on the Internet.

Single Page    1 | 2 | 3 | 4