“The clock on the wall’s moving slower

My heart it sinks to the ground

And the storm that I thought would blow over

Clouds the light of the love that I found”

– Fool in the Rain, Led Zeppelin

More often than not, we here in Silicon Valley are prone to idealism. We see a scenario the way we want to see it, and make predictions that fit our view of how we think the world should work, or perhaps even how we would like the world to be. This is especially true when it comes to technology. Outsider “luddites” who do not immediately grok the remarkable disruptive power of our latest and greatest technologies are doomed to the business trash heap – driven there by obsolescence and an obstinate refusal to accept their fate. Often times, our version of them “accepting their fate” would require them to abandon everything they know, walk away from the majority of their revenue, and terminate 80% of their employees. But hey, that’s their problem, not ours. We love disruption. It serves our purpose.

One often discussed target of such criticism is the media industry. There is a widespread belief that Hollywood now faces the same digital threat that has plagued the music industry over the past ten years. The argument goes something like this: There is nothing Hollywood can do to stop this train. The problem, you see, is that technology is merciless, impersonal, and unforgiving. Video can be turned into bits; Moore’s Law will make a pile of bits smaller and smaller over time; and efforts to erect pay walls will prove fruitless and even Quixotic. Studio heads should simply throw in the towel now and take what’s coming to them. Denial equals delay, and delay costs you time away from learning how to execute within your new constraints. All content will be free, and you simply have to live with that fact. The sooner you get in touch with it the sooner you will learn to execute in the new reality.

There are three key reasons why Hollywood is under less duress than Silicon Valley wants to believe. For starters, the leaders are wide-awake. Ever since Boxee offered Hulu (and were told to stop), the executive ranks at the major cable companies have been alert and engaged. Second, Hollywood has a solid track record of enforcement. They understand the stakes are high, and they are willing to invest in lobbying, regulation, litigation, and enforcement. They are also unafraid to throw around their weight (witness Viacom vs. Google). The final and most significant reason is that this is a massive, massive business, and it is critically important to understand where the money flows (most people don’t). You can spend plenty of time talking about other issues, but when it comes to understanding the key factor at play in nearly every major business decision in television, you will find affiliate fees – all $32 billion of them.

For those who do not know, affiliate fees are the primary revenue stream that funds today’s mainstream television content development. These are basically a “share” of the subscription fee you pay to your cable or satellite operator that is then shared back to the content owner/distributor (typically on a per subscriber basis). As an example, you will hear that some less notable cable-only channel was able to negotiate $0.25/sub/month, or that ESPN can negotiate $2.00/sub/month, because any aggregator would be afraid to market a television package without ESPN. Over the past 30 years, these fees have become the lifeblood of the TV content business – affecting how the major aggregators think and operate, and also affecting how content is produced, financed, and packaged.

Here are some specifics to help frame the issue. According to Matthew Harrigan at Wunderlich Securites, in 2009 DirecTV paid approximately $37/sub out of an ARPU of $85/sub to content owners for programming costs (i.e. affiliate fees). In this case, affiliate fees represent roughly 43% of total revenue for DirecTV. Similarly for Comcast, Matthew estimates programming costs at 37% of video revenue (Comcast has high-speed data and voice revenue that are separate). These are just two examples, but to give you a sense of scale these numbers represent around $7-8 billion/year each for Comcast and DirecTV. The recent, and very well written Business Week cover story on this same topic pegs the aggregate fees of all content providers at $32B per year. These are big, big numbers. To put things in perspective this is about 33% higher than Google’s annual global revenues including revenues for its advertising network.

These affiliate dollars flow through to the content producers. Estimates suggest that the annual affiliate fee revenue at companies like Viacom and Disney is around $1.5B and $2.0B respectively. On their own, numbers this large would obviously be motivational to corporate executives. But the reaction is even more intense because affiliate fees “feel like” 100% gross margin revenue. From a cost accounting perspective, a studio should allocate these fees across the content development costs, and therefore, they are not explicitly 100% GM. But as there are no significant variable costs related to the deployment of these programs to the carrier, most content owners cannot help but think about affiliate fees as 100% gross margin and therefore the key contributor to overall profitability.

Affiliate fee optimization is the key objective behind many of the industry’s most high profile strategic moves. Here are a few examples.

Cablevision vs WABC. Recently, there was a high profile stand-off between WABC in New York City and Cablevision. As is often the case, the content owner here was threatening to cut-off access to their content precisely before a very high profile and high demand piece of content was set to air. This particular piece of content was the Oscars. A cable channel owner holds up a cable company to extract a higher per-sub affiliate fee for the next contract. They always put the customer in the middle, and both sides try to argue that they are virtuous and that the other is greedy. There have been numerous examples like this over the years, and it is common to see one of these showdowns each and every year. Modern Day Cable Channel Strategy. Comcast Acquires NBC. Why would a cable distribution network want to own content? First, it’s a hedge against rising content costs (affiliate fees). Second, it offers leverage vis-à-vis their competition. DirecTV needs NBC. DirecTV will have to negotiate affiliate fees for NBC with Comcast (Comcast also owns other channels like E! Entertainment, The Golf Channel and Versus). This helps keep Comcast’s business model in check. It’s also why Comcast made a huge play for Disney in 2004. Affiliate fees have been rising for some time. Networks Ask for Fees. For the longest time, the major networks were not part of the affiliate fee gravy train. In fact, due to “must carry” laws, most networks never considered intentionally restricting their own distribution. They were simply pleased to get redistributed over cable and satellite. As these fees have grown in size and importance, the networks have changed their position and have come to the table asking for affiliate fees also. The WABC case above is one such example. Oprah Asks for Fees. Sports Networks Ask for Fees. Affiliate fees are driving an endless supply of channels for anyone that has “must see” content. The NFL has a channel, and had some high profile disagreements with the carriers over the “need” for its affiliate fee. You also see an NBA channel, an MLB channel, and pro wrestling is vying for one as well. If you own exclusive content, you might as well build a channel around it. This endless proliferation of channels will one day reach a limit, but for now it’s the game on the field. Hulu/Boxee.

In addition to not appreciating these money flows, most of the digerati in Silicon Valley have huge misperceptions about the content owner’s preferences. They assume that content owners would like to distribute directly to consumers precisely because the Internet allows them to do so. They would no longer be in the “death grip” of the content packager (cable and satellite companies) who take an unreasonable fee for their services. This is simply not how these content owners view the world.

Content owners absolutely prefer to be aggregated in a bundle of channels and, as a result, to receive affiliate fees. They also have little interest in “a la carte” packaging, a concept dreamed up by regulators in Washington but not desired by the heads of the content studios. Simply put, there is adequate value provided in distribution and revenue collection. To launch a direct channel (and forgo these fees), and then attempt to regain your customers one by one is a harrowing experience. Why earn your customers one by one when you can get to mass volumes, and a fixed amount of recurring revenue, through a distribution partner? If you create a new piece of camping equipment would you sell it online or try to obtain distribution through REI?

ESPN360 is a solid example of content owner’s preference for the affiliate fee driven/ distribution partner model. As the Internet became fast and pervasive, ESPN (owned by ABC/Disney) saw a clear opportunity to deliver more programming to their users and launched an online-only product called ESPN360 (recently renamed ESPN3). This on-demand, “over the top” offering is a killer product for the true sports fan, offering access to significantly more live games that was ever possible on a traditional linear cable channel. Despite the fact that ESPN has the brand, the reach, the market power, and the technology to charge users directly for this new product, they chose a different path. ESPN sought out distribution partners to bundle ESPN360 in with their standard video television packages, even though this was confusing and even baffling to most Internet users.

So against this backdrop, the cable companies have developed a remarkably shrewd strategy to simultaneously leverage their broadband infrastructure and affiliate-fee money flows. This concept, known as TV Everywhere, has two main components (once again, this move by the cable companies is extremely well articulated in the recent Business Week cover story on the same subject). First, you tell your customers that you want to provide them with a killer new service. They are already paying for all the content they receive through the linear channel stack. What if that same content could be viewed at any time “on-demand” and also through multiple devices (TV, PC, and mobile)? Sounds great so far. Who wouldn’t want this? And “everything” on a service like Comcast is more than any digital aggregator has yet even dreamed of aggregating. Ignore for a moment that this is not completely working just yet and focus on what they will “eventually” deliver. It’s also helpful to show the FCC you are being innovative, and not resting on your laurels the way a true monopolist would. Check.

Next comes the clever part. The cable companies go to the content owners and make the following argument. With Internet-connected TVs on the horizon, you can no longer separate the Internet from the TV or the office from the living room. We pay you an affiliate fee to distribute your content to the homes we serve. We understand you have multiple distribution partners. What we don’t understand is why you would give content to some of them for free, and still expect us to pay our fees. Check-mate. This is the move that forced Hulu to a subscription model. The content owners, struggling with depressed advertising rates as a result of the global recession, quickly acquiesced to Rupert Murdoch’s assertion that maybe all their content should have a price. Disruption disrupted.

Some have even suggested that Comcast has approached the large networks and offered an “extra” affiliate fee of around $0.50/sub to pay for over-the-top rights. Proactively increasing your own costs is a fairly unique business strategy. But this move also increases the costs for the disrupters, who are far less likely to be able to afford it.

As a result of these maneuvers, the current trend in the market is for less rather than more prime-time content to be openly available for free on the Internet. Do you remember when South Park boldy made all episodes available for free on the Internet? Check out where things are today. Try to watch the recent Facebook parody “You Have 0 Friends,” and you will receive the official message “DUE TO PRE-EXISTING CONTRACTUAL OBLIGATIONS, WE CANNOT STREAM THIS EPISODE UNTIL 05.08.10.” They may have wanted it to be free, until someone threatened to take their affiliate fees away. Viacom also recently removed shows like “The Daily Show” and “The Colbert report” from Hulu noting that “we could not agree on a price.” Suggesting there is a “price” at all would indicated they were discussing affiliate fees, as opposed to ad splits.

While this likely enrages the disruption enthusiasts, expect this trend to continue over the next year. More and more content owners will rip their shows “over the paid wall” as they get reacquainted with their own affection for affiliate fees. There is much speculation about Hulu’s forthcoming subscription launch with many journalists hopefully optimistic that Hulu as we know it will remain free and that all sorts of new features (TV support, iPhone support) and content (movies, back catalog) will be behind the paid wall. They may be surprised to find that “paying” may be necessary just to obtain what users see today. Affiliate fee parity may demand it.

So does this imply the end of all digital packagers? Not at all. Most clearly, NetFlix has successfully built a hybrid physical/digital strategy while maintaining its “all you can eat” model. It is also going toe-to-toe with other packagers by striking deals to lock up digital content (including TV programming). Furthermore, Hulu has executed well beyond anyone’s original expectation, and there is no reason to expect that to change as they move to a new model. One would expect them to continue to lead in terms of ease-of-use and simplicity even within a new model. Also keep in mind that Amazon has a strong VOD offering integrated into its overall purchasing experience, and many suspect both Apple and Google will enter the game as well. Despite this level of competition, all of theses vendors will need to find unique ways to compete against TV Everywhere. And with “free” off the table, the dimensions of competition will be inherently less disruptive.

There are two other potential challenges for non-facilities based content aggregators. First, as was the case with Satellite radio, we may see a “no holds barred” price war break out in an attempt to grab “exclusive” content to distinguish one’s package. As we all know, exclusive deals with the likes of Howard Stern nearly killed XM and Sirrus. DirecTV already pays $700 million per year to the NFL to have an exclusive offering of every NFL game on every weekend (NFL Sunday Ticket), and they recently coughed up over $4 billion to extend this deal. Wow. What if other digital “packagers” look for unique differentiation by leveraging the cash on their balance sheet? If this happens, any digital aggregator without deep pockets will be holding a knife at a gun fight.

The second externality that could cause trouble is “bandwidth limits” or “metered usage” on the Internet. While some people assume this will never happen (especially the idealist in Silicon Valley), the quiet momentum is building. There are continuing tests at AT&T and Time Warner, and AT&T’s president Randall Stephenson spoke openly about metered Internet pricing as recently as a month ago. Also, the Supreme Court recently put the kibosh on the FCC’s deliberate effort to make net neutrality one of its defining policies. This is perhaps an entirely separate post, but one should be confident that the rate charged the consumer by the owner of the transport for one hour of Internet video would be quite a bit higher than that for one hour of the same video over their own “optimized” TV infrastructure (backed up with an ample helping of technical analysis and white papers). The fox isn’t just guarding the henhouse, he designed it.

There are still two legitimate arguments that trump all these discussions of affiliate fees and deft corporate strategy – piracy and content democratization. Let’s start with piracy.

What if “BitTorrent 2.0” in whatever form it takes is just blatantly unstoppable? No matter what you do, content has become too small relative to the big broad pipes and storage devices. Technology trumps determination, and the minute something has been shown once, it will be free for all takers. Isn’t this true in China today? It’s a big leap from expecting this to happen “someday” to expecting a content creator/owner to throw caution to the wind and immediately adopt a strategy that is congruent with unlimited free distribution (what is this strategy by the way? can’t ads be removed also?). Technology is inevitably a tough competitor, but so is regulation and enforcement, and you should expect that a mighty effort on the part of a multi-billion dollar industry would mute any expectation of an overnight transformation. In her latest post at All Things Digital, Kara Swisher suggests that a recent increase in the number of intellectual property enforcement officers at the DOJ may be a direct response to the immediate needs of the entertainment industry.

Other cheerleaders of the disruption bandwagon point to the undeniable future where the availability of low-cost, high-feature camcorders at BestBuy will lead to a mass democratization of content creation. In this brave new world, the bloated and lavish infrastructure of Hollywood will give way to thousands of mini-Tarantinos who produce hit after hit on shockingly low new-world budgets that redefine the content creation business. This is the video equivalent of the infinite monkey theorem. While this may be true when it comes to low-budget formats like game shows, talk shows, and reality television, today’s fussy television viewer has come to expect a product that is much more equivalent to feature films than home movies. Each episode of Lost costs well over $1mm to produce. Cheap cameras do not disrupt “production quality”. And let’s not forget that The Blair Witch Project was over ten years ago, and desperately stands alone as an exception and not a rule.

In the long run, the disruption zealots may be right. It may all come undone in the unstoppable Armageddon of unlimited “all you can eat” content enabled by the undeniable liberation of all bits big and small. But with $32 billion on the line, don’t expect it to happen overnight. You will be sorely disappointed.