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As telecom industry evolves, success of Netflix is its biggest threat

By Cecilia Kang
Washington Post Staff Writer
Sunday, March 6, 2011; 12:20 AM

By any measure, Netflix is having a marquee year.

It has 20 million subscribers, way up from 12 million just a year ago. Its stock has tripled in that time. During periods of peak Internet use, a full fifth of all American bandwidth consumption is people watching movies on Netflix.com.

But the more that consumers embrace the movies-at-home ethos of Netflix, the more uncomfortable major players in the entertainment industry have become. Now Netflix, a secretive company known more for the laid-back attitude of its founder than for sharp elbows, has emerged at the center of a titanic clash over the future of television.

Because if Netflix can bring movies straight into your living room through the Internet, it can bring a full slate of TV shows, too. Pretty soon, who needs cable?

On the other hand, if cable companies can bring you movies and TV directly over high-speed Internet lines, who needs Netflix?

Multibillion-dollar corporations are fretting over those questions and fighting to influence the outcome.

"No one can deny that Netflix has become a huge player in the industry," said Deana Myers, a research analyst at the investment firm SNL Kagan. "But there are big questions surrounding the company, and they have big obstacles ahead."

Netflix has been disruptive since its inception in 1997. That year, Reed Hastings, a former Peace Corps volunteer and MIT engineering graduate, received a $40 video late fee and thought, "There has to be a better way."

So he built a Web site with partner Marc Randolph for Internet users to sign up for seven-day DVD rentals. Two years later, the mail-order service copied the health-club business model and offered unlimited DVD rentals for monthly memberships.

People liked it. No more late fees. No lines. You didn't have to go any farther than the mailbox to get your movies.

For Blockbuster, not so good. Netflix almost single-handedly wiped out the retail video rental business. Blockbuster went bankrupt last fall.

But even faster than the business model could go from storefront rentals to mail-order rentals, it changed again. The spread of broadband Internet service led to the rise of online movie-watching. And this is where it gets messy.

'Just a middleman'

Netflix has shifted more of its business to streaming movies straight to your home and mobile gadgets. A lot of other powerful corporate interests, though, are converging on this spot - a fundamental change in the way people consume entertainment.

If you think it through to its logical conclusion, you wind up with TV and Internet merging. Much of the telecom industry thinks that in a few years, people will watch TV and movies and surf the Web all with the same gear.

So who brings you that service? It could be cable companies. Comcast just bought NBC Universal, which makes it a one-stop shop for cable TV, Internet service and movies.

Or it could be phone companies. Verizon has a huge mobile Internet operation, plus fiberoptic cables into more and more homes.

Or it could be Netflix, which has the advantage of its relationship with an enormous subscriber base and a total stock-market value - known as market cap - of $11 billion.

"There is every reason to believe that between their market cap and public access to funds, Netflix is a buyer of content with big dollars," John Calkins, executive vice president of Sony Pictures Home Entertainment, said in a phone interview.

Some in the industry think that is ridiculous. Time Warner Cable's chief, Glenn Britt, said in an interview that Netflix is just a middleman - that it will soon go the way of Blockbuster when people realize they can get all they want directly from the big telecoms.

Others in the industry fear Netflix. They worry that it will dominate the marketplace and make content less valuable by imposing a low-cost Internet business model (how's the music business doing these days?). Investors in cable companies fear that TV subscribers will flee, leaving them with Internet access businesses that simply manage traffic created by Netflix customers.

"There are many incentives to create hurdles for online video firms like Netflix," said Parul Desai, policy counsel for Consumers Union, parent of Consumer Reports magazine. "They are going up against powerful media and Internet service providers who are trying to come up with their own Internet video strategies and could limit access to content and access to their consumers."

So far, Netflix is last on Hollywood's schedule. Movies first hit theaters and then DVD services such as Redbox. Last to receive "Inception" and other blockbusters are on-demand cable services and Netflix.

That's partly because Netflix doesn't pay as much, and partly because the big studios don't want to undercut their DVD and cable licensing deals.

"What Netflix and other broadband distributors mean for us is another avenue of distribution for our content and brand," Philippe Dauman, president of Viacom, said in a phone interview.

He said that he had viewed Netflix with skepticism until last year, when it began offering more money for licenses to stream Viacom programming. But he also wants to proceed slowly with partnerships online. Delays and access to only certain, mostly older, content are key. Want to watch the previous four seasons of "Friday Night Lights"? It's easy on Netflix, but you'll have to watch the fifth and final season through NBC. The Super Bowl and Academy Awards won't make it to Netflix, Hulu or YouTube for a long time.

That dynamic doesn't look to change anytime soon, Barclays analyst James Ratcliffe said. About 90 percent of TV viewers pay about $70 a month for cable or satellite TV. The networks that create shows get about $30 a month from those subscriptions.

Many of the telecoms have also mounted a campaign in Washington to establish regulatory roadblocks to a Netflix takeover of the American living room. They've helped shape a federal policy on Internet billing that could make it more costly for consumers to watch streaming videos.

"There is no such thing as free TV or a free lunch," said Kyle McSlarrow, president of the National Cable and Telecommunications Association, a cable trade group. "It's expensive to run a broadband network, and I wanted to make sure my companies were able to experiment with new business models."

On the defense

In January, Netflix responded by hiring its first Washington lobbyist, Michael Drobac. He has told lawmakers and Federal Communications Commission officials that allowing Internet service providers to charge based on how much bandwidth people use is unfair and poses risks to online video services.

And Netflix is continuing to expand aggressively, offering service on gaming consoles, smartphones and tablets. It is also working to snare more top-rated video content. In the past year, it bought rights from MGM, Paramount, Sony Pictures, Viacom and CBS.

Next year, the company is expected to renegotiate a contract with Starz, a major distributor with extensive movie rights, in a test of how far the company is willing to go to meet Hollywood's pricing demands.

Netflix is also having to deal with unconventional new competitors. Last month, Amazon announced its own streaming video service. Since then, Netflix's stock has pulled back from a high of $247.55 to $203.37 on Friday.

Back at Netflix headquarters in Los Gatos, Calif., the last Silicon Valley outpost before the Santa Cruz mountains, Reed Hastings told shareholders in a January letter that he wasn't worried about finding a place in the Hollywood firmament.

Basically, he wrote, there is enough business to go around. And alluding to the rise of the Fox network 20 years ago, Hastings said that people always fear new competition.

"Some consternation about Netflix success is natural," he said.

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