What Hollywood Execs Privately Say About Netflix

As the company plans to spend $1.2 billion in 2012, some express relief that they are buying content no one else wants such as ‘Pushing Daisies’

The following story appears in the current issue of The Hollywood Reporter on newsstands now. Subscribers can click here to read the issue online.

Disgusted that a video rental store raked him over the coals for returning a movie late, Reed Hastings created Netflix. Seventeen million subscribers later, some people probably wish a clerk would have just refunded the man his 40 bucks.

Topping the list would be about 12,000 who have lost jobs at Blockbuster during the past couple of years as Netflix and its subscription DVD business have run circles around stodgy bricks-and-mortar storefronts. Next in line are pay TV executives, who wonder whether Netflix’s streaming business will encourage consumers to cancel expensive cable and satellite services.

But its relationship with the rest of the entertainment ecosystem is becoming much more complicated. Everyone wants to be in business with them but no one fully trusts its motives. Meanwhile, Hastings has proclaimed that Netflix considers itself more a streaming company than a DVD concern — with an estimated 17,000 (and counting) movie and TV titles available — and electronics manufacturers are rushing to build Netflix buttons into remote controls. Hollywood has learned from the way Apple blindsided the music industry with iTunes and knows how much is at stake.

Time Warner CEO Jeff Bewkes is openly hostile, refusing to license premium HBO content to Netflix’s streaming service while questioning the virtue of dealing with a company that might erode the perceived value of content. Phil Kent, CEO of Turner Broadcasting Systems, a Time Warner company, has gone further, warning TV executives who might be thinking about selling Netflix streaming rights to their shows to think twice about the impact those deals might have on traditional syndication pacts.

"We’ve been telling our suppliers — the various studios that we buy from — that in the future, [Netflix streaming deals are] going to have a significant impact on what we’re going to be willing to pay for programming or even bid at all," Kent told investors Jan 5.

But despite those gripes, just about every major content creator now has a streaming deal with Netflix. The company secured streaming rights to 49 percent of the domestic box-office tally for 2010 and continues to sign up Hollywood partners. “Even though it has a detrimental effect on their business, everyone keeps feeding them content,” BTIG Research analyst Richard Greenfield says.

Why? Despite the risks, many in Hollywood welcome another market for content, especially one as hot as Netflix. During peak surfing times, for instance, the Netflix service accounts for a fifth of downstream traffic on U.S. broadband networks, and the company says 66 percent of its subscribers watched at least a portion of a TV show or movie streamed during the third quarter, up from 41 percent a year earlier.

"What’s not to like?" asks a Disney executive, speaking on the condition of anonymity. “They’re another buyer, even for stuff that others don’t consider terribly valuable.” That’s especially important in light of declining North American home video revenue, which according to PricewaterhouseCoopers peaked in 2007 at $28.4 billion (including sales and rentals). But with Netflix leading the way, the industry should surge past that in 2013 as streaming makes up for declining DVD revenue.

Netflix is “absolutely a friend to producers and distributors — they are found money that is monetizing library assets as DVD sales fall,” says Mark Cuban, whose investments include 2929 Entertainment, Landmark Theatres, HDTV and HDNet.

In fact, Netflix is most interested in library stuff, says chief content officer Ted Sarandos, who has been running around Hollywood striking streaming deals with any network, studio and producer who has content to sell. Netflix even likes serialized dramas that traditionally don’t sell for much in TV syndication because, unlike procedurals, they must be aired in order. “I don’t care about last night’s episode,” Sarandos says. “I do want all of last season’s episodes.”

In that regard, Netflix is different from perhaps its most similar competitor, Hulu Plus, which also delivers unlimited streaming movies and TV shows to subscribers who pay $7.99 a month (Netflix users who choose more expensive packages also get DVDs in the mail.)

If Bewkes and others in Hollywood are worried about Netflix devaluing content, Public Enemy No. 1 would be Starz, which struck a deal with Netflix in October 2008 that analysts say is worth $30 million a year — an amount that seems paltry in retrospect. If Netflix increases its subscriber base to 25 million before the pact expires in October, which seems doable, it will pay 10 cents a sub each month for Starz content — compared with the estimated $4 a sub Starz gets for its premium movie service from Comcast, DirecTV and other multisystem operators, according to Greenfield.

And the content — about 2,500 pieces, split evenly between TV and movies — is nearly identical, save for the MSOs’ ability to offer it in HD.

But before 2011 expires, Netflix will be back at the bargaining table to hammer out a new deal that should earn Starz a whole lot more money. The most bearish estimate has Netflix shelling out $100 million annually, and the most bullish, from Greenfield, predicts Starz will get $300 million — assuming Netflix doesn’t purchase Starz outright. That means that in Netflix’s world, streamed content would be as much as 10 times more valuable in 2011 than it was only three years ago.

Starz knows it, which is why CEO Chris Albrecht is “in no rush” to renew a deal, as he told reporters Jan. 7. “This is a deal that has ramifications in the media industry,” he said. “Netflix has been a great partner for us, and if the deal makes sense, they may continue to be.”

Starz was simply early to the party when it stuck its $30 million-a-year Netflix arrangement, because others are already reaping the rewards of a more generous Netflix. “I expect licensing costs to go up because we’re bigger and we have more money to spend,” Sarandos says.

A deal with Epix, for example, added 1,000 titles to Netflix’s streaming selection from Paramount, MGM and Lionsgate, each of which owns a stake in the pay TV channel. Insiders say Netflix is paying Epix $200 million annually for five years for those rights. Greenfield estimates that Showtime, before Epix was created as a competing channel, offered $175 million a year for the same content. If those figures are accurate — the parties won’t confirm or deny them — then the negotiations mark a sea change by which digital rights are perceived as more valuable than TV rights. “Groundbreaking” is the adjective Lionsgate CEO Jon Feltheimer used to describe Epix’s deal with Netflix. Epix CEO Mark Greenberg said at the time that it made the fledgling venture profitable. “There’s not many channels that, within 10 months on the air, can say that,” he said.

The Epix deal also creates what Sarandos calls a window separate from that of pay TV, given that movies won’t stream until 90 days after Epix first shows them on television. Sure beats waiting around until 2016, or whenever, for pay TV rights to run their course.

“We had to change the paradigm,” Sarandos says. “We had to turn what would be a competitor into a supplier.”

But the Epix deal has a downside, according to a studio executive who also spoke on the condition of anonymity. “Everybody knows that Netflix doesn’t have enough money to do deals that value content at anything comparable to what they paid Epix,” the executive says. “That Epix deal was actually a big problem for them. Now Starz wants a deal that’s worth 150 percent of what the Epix deal was worth.”

The Epix deal in August came a month after Netflix struck one with Relativity that also had people using the word “groundbreaking,” because it will allow movies like The Fighter to be streamed on computers and TV screens a few months after its DVD release — rather than years later, as would have been the case if rights went to Netflix and other digital services only after the pay TV window was exhausted.

Netflix’s most recent big streaming deal was with Disney, and insiders value it at $150 million-$200 million for a year’s worth of content. Lazard Capital Markets analyst Barton Crockett estimates the value at $183 million, and he breaks it down by title, with the TV show Lost being the most valuable asset.

Netflix is paying $45 million for access to all six seasons of the former ABC drama. Next is Scrubs, valued at $26 million, followed by Hannah Montana ($18 million) and Desperate Housewives and Wizards of Waverly Place ($12 million each). Least valuable are TV movies, Crockett figures, with even big hits such as High School Musical and Camp Rock worth less than $1 million a year.

"Disney squeezed the crap out of Netflix," Wedbush Securities analyst Michael Pachter says. “Disney had the balls to tell them, ‘Take it, or you get nothing,’ and Netflix decided it needed those anchor shows. Netflix is probably the best thing ever for studios.”

Says Crockett: “Netflix is a friend, as long as studios are smart about how much they charge for their content rights. Disney is smart to do a short-term deal so they can change course if that looks prudent.”

Crockett figures Netflix will spend $700 million for streaming rights in 2011 and $1.2 billion in 2012. Those high costs are one reason some on Wall Street are bearish on Netflix stock — though this position has been a losing one for a long time, considering Netflix shares have risen from $3 to $187.88 during the past eight years.

Hastings, who declined an interview request for this report, defended the surging cost of streaming rights in a blog post that served as a warning to those who might consider shorting Netflix stock. “It is true that we are paying more for any given piece of content than we were two years ago, and that in two years we’ll pay more than we pay today,” Hastings wrote. “Part of our goal as a business is to make money for content producers and to become one of their largest and best revenue sources.”

Bewkes isn’t convinced of Netflix’s altruism. He recently told Wall Street that Netflix was trying to buy in-season TV shows for a “measly” $70,000-$100,000 an episode. Time Warner, though, has no problem selling Netflix streaming rights to such canceled TV shows as Pushing Daisies and Terminator: The Sarah Connor Chronicles. Details were not disclosed, but insiders say all six seasons of Nip/Tuck, for example, went to Netflix for $20 million a year.“Hollywood used to give library content to Netflix cheap,” says a Time Warner executive. “That has stopped.”

And if Netflix intends to get its digital mitts on some of Time Warner’s most popular TV content, including HBO’s The Sopranos and Sex and the City it will cost plenty, if it’s even possible, given that HBO considers Netflix more a competitor than a potential partner. Episodes of Curb Your Enthusiasm and Entourage, for example, are typically sold into syndication years after they appear on HBO and are licensed for about $750,000 an episode, more than Netflix might be willing to pay.

“HBO believes in content exclusivity, especially for high-value content,” says Jeff Cusson, the channel’s senior vp corporate affairs. “That’s our rationale for not selling streaming rights to a competing subscription service.” While HBO licenses shows to such pay-as-you-go streaming services as iTunes and Amazon, it has “no intention of making its content available for streaming on Netflix,” he adds. A high-placed Time Warner executive says that if Netflix expects to get a meaningful amount of HBO content, it would have to raise the price of its streaming-only service from $7.99 a month to $20 before the economics made sense.

Netflix begs to differ.

“They make incredibly great product that is very expensive to produce,” Sarandos says. “But we’re buyers and they’re sellers, so we’ll figure out a deal that makes sense. If we don’t, then the service doesn’t have everything, and that’s OK too.”

Collecting rights is no easy task. Sarandos oversees a work force of 80 in Hollywood, including about a dozen that make up Netflix’s content-acquisition group, with one team handling DVD and another focusing on streaming. For all of the concern over falling DVD revenue, there’s a positive to consumers’ embrace of streaming. “Nothing is licensed in perpetuity, so everything is subject to renewal,” Sarandos says.

That means licensing fees can keep climbing as Netflix moves more of its business to streaming and away from DVDs. Sending a disc round-trip can cost as much as $1, and Netflix mails about 2 million DVDs a day, whereas streaming a movie costs the company about a nickel. “We’re direct to the consumer, so we don’t give half our money to a cable company,” Sarandos says. “Our money goes directly to the content providers.”

Some content comes and goes, as in the case with the Timothy Hutton vehicle Leverage, to which Netflix obtained streaming rights through executive producer Dean Devlin. That didn’t sit well with TNT, so when the channel renewed the show for a third season, it made sure to secure digital rights, leaving Netflix with streaming rights to some seasons but not others.

“But TNT had to pay a lot more to secure the rights from Dean — it’s exactly why Netflix is exciting for networks and studios,” Sarandos says. “We’re an exciting new buyer in this space. We bid up the price of content.”

Some executives still aren’t convinced that the net effect of Netflix bidding on TV shows is positive. Turner’s Kent has said that TBS didn’t outbid USA Network for syndication rights to ABC’s Modern Family because the show is “a little too prevalent” online. USA paid about $1.5 million an episode for those rights. Time Warner is so agitated by Netflix’s streaming that Kent has spoken of “freezing those rights” to maximize a show’s value on traditional TV. He even claims to be freezing rights retroactively for shows his cable networks have licensed.

Statistics suggest Americans in general aren’t as eager as Netflix users to make the shift to instant digital gratification and away from physical product and TV schedules. A study from Horizon Media indicates that in first-quarter 2010, Americans spent an average of 158 hours and 25 minutes watching TV and only three hours and 10 minutes watching video online (even though the same study indicates that consumers could ditch pay TV and use various outlets to save $360-$860 a year). While a tiny minority has cut its TV cord entirely, it is alarming especially given that the pay TV sector lost subscribers for the first time in second-quarter 2010.

Pay TV is fighting back, in part through the TV Everywhere initiative whereby subscribers get television content through myriad broadband devices. Cablers are also lobbying for the ability to charge consumers for Internet data, as well as suppliers like Netflix. Hastings acknowledges that such a scheme is “a valid concern over the long term.” As for the near term, expect Netflix to keep rolling along, using money from a rapidly increasing subscriber base (and a rumored price hike coming soon) to feed its appetite for streaming content while enriching rights holders.

What could derail the Netflix locomotive? Competition from very rich sources, according to Pachter. Amazon and others allegedly are working on subscription video services, and YouTube recently hired Malik Ducard, a former senior vp digital distribution at Paramount, to help acquire streaming rights to Hollywood content.

“Right now, there’s essentially one buyer and lots of sellers,” Pachter says. “But God save Netflix if Amazon, Google, Apple or Microsoft get in the subscription movie and TV business. Google has more money than God; if Netflix offers $100 million, expect Google to offer $500 million to get it exclusively for themselves.”

STREAMING: THE BIG DEALS

One analyst believes Netflix will spend $700 million in 2011 and $1.2 billion in 2012 to license Hollywood content for its streaming-video service. A sampling of how that money is being spent.

STARZ

The Deal: The pay cable network offers about 2,500 movies and TV titles from Sony and Disney (though Disney has a separate deal for TV, which includes such hits as ABC’s Desperate Housewives and Lost and Disney Channel’s Phineas and Ferb, Hannah Montana and Camp Rock). The Starz deal has been valued at $30 million per year and expires at the end of 2011.

Content: Up, The Proposal, Alice in Wonderland, Cloudy With a Chance of Meatballs, Zombieland, 2012

TIME WARNER

The Deal: Expansion of an existing agreement gives rights to catalog movie titles and seasons of certain TV hits until end of 2011, but no HBO shows.

Content: Films Risky Business and National Lampoon’s Christmas Vacation; seasons of Nip/Tuck, Veronica Mars, Pushing Daisies, Terminator: The Sarah Connor Chronicles

FOX

The Deal: A recently expanded agreement includes hit shows produced by Twentieth Television.

Content: Lie to Me, Bones, Prison Break, 24, King of the Hill, Arrested Development, Buffy the Vampire Slayer

EPIX

The Deal: The fledgling pay cable network has a deal through roughly 2016 to offer films from Lionsgate, MGM and Paramount 90 days after they debut on the channel. The deal was pricey: Some analysts have said Netflix will pay $200 million per year.

Content: Shutter Island, Iron Man, Precious, Dance Flick, The Spy Next Door, G.I. Joe: The Rise of Cobra

RELATIVITY

The Deal: The upstart distributor will provide up to 30 films annually during the pay TV window, through roughly 2015.

Content: The Fighter, Skyline, Season of the Witch, more as Relativity greenlights them

NBC UNIVERSAL

The Deal: More than 200 movies are available for six months to 18 months, depending on the title, then they are pulled from the service for another title. The TV deal includes past seasons of such popular streaming titles as 30 Rock and The Office.

Content: Hundreds of old episodes of “Saturday Night Live,” as well as day-after streaming of new episodes through 2012; Battlestar Galactica, Monk, Friday Night Lights, Law & Order: SVU