The dissolution of the Netflix-Starz relationship is a meaningful loss to both companies as well as their customers. Without Starz's participation as an early partner and its access to popular brand-new movies from Disney and Sony, it's doubtful that Netflix Watch Instantly would ever have become popular. Additional exposure on Netflix gave Starz and its content more visibility than it ever had competing on cable with HBO and Showtime.

Together they helped create a business and business model that grew and metastasized to the point that both companies felt they were strong enough to take their part of that business elsewhere. They bargained, fought, and bargained again. In the end, they decided their differences were irreconcilable and that it was time to move on.

So what's next? For its part, Starz will shop its digital rights to one of Netflix's emerging competitors or maybe try to develop its own brand with a streaming service like HBO has with Go. You're going to find another way to watch Toy Story 3 on your computer again.

That doesn't matter. It's boring. We know how that movie ends. In the big picture, Netflix's story is much more worth watching.

I want to say that this signals Netflix's third and toughest phase in its evolution into a streaming video company. (We'll call mailing DVDs phase zero.)

Foundation: Netflix introduces subscribers to streaming video on their computers, partners with Starz to offset what's otherwise mostly B-grade basic cable content, finds a small-but-enthusiastic audience among "cord-cutters," people without cable subscriptions or even TVs. It builds up its infrastructure, goes multi-platform with Silverlight, works out the kinks. Building: Watch Instantly becomes a phenomenon, growing in subscriber numbers and viewer devotion. Streaming boxes, DVRs, game consoles, tablets and smart TVs add Netflix, making it much easier to bring it to the living room and on the move. The catalog of popular content swells, as does the bandwidth consumed by it. Netflix is triumphant, and begins to talk openly of its future being in digital streaming, not DVDs. Remaking: Competitors begin to catch up, and content and cable companies strike back. We're probably less than halfway through this phase. Starz vs Netflix is just part of the hardball that everyone in the television industry is playing with each other in negotiations — producers with networks, networks with operators, telecoms and networks with digital shops like Netflix and Hulu, all over how big a piece they each would like to extract from consumers. So the Starz-Netflix breakup is far from unique; but nevertheless, it may be the piece that will reveal the most about what will happen next.

In the short-term, Netflix loses. The company's suffering from really bad timing, because the Starz announcement comes right on top of a big pricing shift designed to make DVD mailing a premium product and digital streaming the mainstream one. Even though they'll have streaming Starz content until the contract expires at the end of February 2012, Netflix's customers will likely feel like they're stuck between either giving up access to popular new titles altogether or paying more for DVDs to get less in streaming than they had before.

The breakup also further dissolves the myth of inevitability around digital streaming in general and Netflix in particular. The path looked as if it were continually moving upward, steady and unbroken. Viewers were always going to get more shows, not less; Netflix was always going to add more subscribers, and never lose them; and the digital pie for network and content-making partners was always going to get bigger and bigger, so that everyone would gain and no one would lose.

This was always a fantasy, but for a moment it resembled reality just enough to be worth believing. Now everyone has taken two quick slaps and a glass of cold water in the face. Growth from this point forward is going to be harder for everyone, as they each fight each other both for share and to maintain what they already have.

The cable and content companies have been fighting each other for a lot longer than Netflix has, and have the battle scars to prove it. They were never going to melt away, or walk away from a new pile of money on the table. This fight, not permanent peaceful growth, was always inevitable.

Read on after the break for more on how the deal fell through and why I think Netflix still has a fighting chance.

Continue reading "How the Starz-Netflix Divorce Will Remake Video"

According to sources speaking to the Los Angeles Times, negotiations between Starz and Netflix fell apart not just over a dollar figure, but the pricing model:

Netflix offered Starz more than $300 million per year to renew their agreement, but the pay cable channel was insistent on so-called tiered pricing, according to people close to the negotiations but not authorized to speak on the record. Tiered pricing would require Netflix subscribers who want movies and television shows from Starz and other premium providers to pay more than the standard $8 per month.

Essentially, Starz wanted Netflix to treat its content like a cable company would, and be compensated accordingly.

From Starz's point of view, it makes sense. It took a huge chance licensing its content to Netflix years ago, let alone doing so for a lump sum payment not directly tied to user growth. Netflix's users and revenue skyrocketed, in no small part due to Starz's content, but most of that growth went into Netflix's coffers.

But from Netflix's point of view, caving in to these demands would have been a disaster. Its success has been tied to the simplicity of its pricing model and the universal access to content (at least barring regional restrictions). It introduces complications in billing and marketing, writing and rewriting software, how users search and share content, and so forth. These complications increase exponentially if all of its content partners were to ask for a similar deal.

Netflix also had the data on Starz's trajectory. In a statement released to the press, CEO Reed Hastings framed it like this:

While Starz was a huge part of viewing on Netflix several years ago because it was some of the only mainstream content Netflix offered… [its] content is now down to about 8% of domestic Netflix subscribers’ viewing. As we add even more content in Q4, we expect Starz content to naturally drift down to 5-6% of domestic viewing in Q1. We are confident we can take the money we had earmarked for Starz renewal next year, and spend it with other content providers to maintain or even improve the Netflix experience.

Eight percent of your content is big enough not to give up lightly. But Netflix's catalogue of television shows licensed from broadcast and cable networks, public broadcasting and directly from production studios now reportedly accounts for as much as 50 percent.

Netflix's growth area is the long tail of television and catalog content, not a small number of tentpole brand-new mainstream movies. If you have to have Toy Story 3, you'll buy Toy Story 3. There are plenty of ways to do that already.

This is partly because in the long run, Netflix's growth customers aren't cord-cutters looking for substitute for cable. They're cable subscribers and irregular media consumers who want big back catalogs and the ability to watch video on all of their devices. Even now, cable channels and operators, plus digital TV competitors, are scrambling to match that capability, but for the most part Netflix has gotten there first.

Netflix also has other routes to acquire content that its subscribers want to watch. It can reach out to other cable channels or directly from production studios. If it needs original, brand-new material, it can get that too.

Starz's mistake was treating Netflix as if it were a cable operator negotiating with a premium pay network, rather than what it's become: a premium pay network every bit the rival of Starz, Showtime or HBO with a distribution model that bypasses the cable operators altogether.

This is why I'm optimistic about Netflix's future. The company and its executives stood tough. They refused to overhaul their own model and pay a mint for content with declining relative value. They're sticking with the content acquisition strategy that's worked for them thus far, while innovating at the margins by purchasing content directly. They're sticking with a pricing plan that's as simple for consumers as possible, because they see that strategy winning.

Simply put, if Starz's team didn't believe that Netflix's user base was going to continue to grow, they wouldn't have insisted on compensation tied to number of users. They would have taken the money.

At the same time, if Starz's team didn't think that they had alternatives to Netflix, they wouldn't have walked away.

So in the short term, Netflix will have to fight through some chop, but over the long term, I think its model still looks just as good today as it did yesterday. Starz is not the problem, but a symptom of the problem.

Netflix frankly has more reason to worry about competing digital services — Hulu, Amazon Video, Apple TV, Microsoft Xbox Live, whomever — than losing one partner, however important they might be and certainly have been. If one of Netflix's competitors manage to match its range of content and devices, plus also put together a model customers find more compelling — say, unlimited streaming plus at-will downloads of individual movies that could still be viewed everywhere, like Amazon has been trying and Apple certainly could try — Netflix could suffer, as fewer users adopt its services and more users switch.

Netflix also has more reason to worry about cable channels like HBO, who have a big back catalog, exclusive content and increasingly popular "TV Everywhere" services. Remember, Netflix is now competing with these companies over the gigantic pool of cable customers for their last $10. Cord-cutters won't leave Netflix for HBO, because unless Time Warner does a total turnaround on its cable-subscription policy, they can't.

However, HBO and cable companies offering similar access to video can still bottle up Netflix's growth. Subscriber growth is crucial for Netflix, because if their pricing stays fixed and partners continue to drive tough negotiations, subscriber growth is the only route they have to more revenue and more profit.

Netflix's advantage, like cable's, is its simplicity. You pay a little bit of money every month in exchange for a wealth of entertainment. But what the company becomes now, and what its competitors become in response, will determine the future of how we watch video for years to come.

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