Can Verizon and Redbox bring down Netflix?


Telecommunications giant Verizon has announced it is teaming up with Coinstar’s Redbox DVD kiosk service to launch a new Internet-based streaming video service in the second half of the year. The move highlights the increasing importance of streaming video operations in the mainstream media marketplace, and at first glance a team-up between Verizon and Redbox would seem to have a lot going for it: both are widely recognized brands with strong customer bases, both are leaders in their industries, and they both have cash to sink into launching a major new service.

However, the online video industry is dominated by Netflix. Even though the company repeatedly alienated customers during 2011 it still accounts for more than half of the paid digital movie rental market, according to NPD’s VideoWatch Digital tracking service. And Netflix is not the only player in the field: Amazon Video on Demand is making inroads into the video marketplace (thanks to being rolled into Amazon Prime), and despite thinking it wants to sell out, Hulu has its adherents, particularly amongst TV fans. Can Verizon and Redbox hope to take on Netflix in a market it not only invented, but continues to easily dominate?

Verizon and Redbox’s Advantages

The first advantage Verizon and Redbox have in their streaming venture is instant brand recognition: Most consumers are already familiar on some level with both Verizon and Redbox and, therefore, are more likely to consider doing business with them than some brand-new streaming media outfit they don’t know anything about. Verizon and Redbox won’t have to work very hard for credibility with potential customers, which can be a huge advantage in trying to launch a new service.

Part of that brand recognition comes from Redbox’s significant retail presence in a vast array of retail locations — from Walmarts and 7-Elevens to drug stores, groceries, and pharmacies. Redbox operates more than 28,000 kiosks around the United States. Verizon also holds up its end of the branding deal: The company offers telephone and broadband Internet services in a 12-state area, and through Verizon Wireless (a partnership with Vodafone) is the largest mobile operator in the United States. Even if consumers aren’t in an area that offers Verizon phone or FiOS broadband service, odds are very good they have some awareness of Verizon Wireless.

Both Redbox’s retail operations and Verizon’s telecommunications offerings mean the companies can pitch a new streaming offering to their already-enormous customer bases, potentially luring them with special promotions or discounted rates to convince potential customers to give the service a try. If Verizon telephone, FiOS, and high-speed Internet customers get a discount on a new streaming service when it premieres, many will likely be willing to give it a try. Although a streaming video offering will compete with Verizon’s own video-on-demand offerings via FiOS TV, the company is probably willing to bet that any customers who drop FiOS TV in favor of the new streaming service will stick with Verizon FiOS for high-speed Internet service. And, where Verizon is only offering FiOS TV in a 12-state area, the new streaming service will be a nationwide operation, meaning any FiOS TV customer losses will more than likely be offset by acquiring new customers from outside Verizon’s current service areas.

Where might Verizon and Redbox find these customers? Some of them will undoubtedly come from Netflix. According to market analysis firm NPD, Netflix accounted for 55 percent of the digital video rental market in the fourth quarter of 2011; however, that was down from 59 percent in the second and third quarters of 2011. That decline didn’t come from competition, but because Netflix seems to be its own worst enemy, alienating customers first by splitting its streaming and DVD-by-mail services (leading to increases in customers’ monthly bills of up to 60 percent), then deciding it wanted to send its DVD-by-mail business out to pasture entirely as the ill-fated Qwikster. Although Netflix furiously backpedaled on that venture and kept the DVD-by-mail operations in house, the moves demonstrated that the company (and CEO Reed Hastings) don’t exactly have their fingers on the pulse of their customers. A new video streaming service might not have to do much more than wait for Netflix to drive customers its way.

Another advantage that will certainly be enjoyed by a Verizon-Redbox streaming video service will be Verizon’s vast network infrastructure, which could be described as the mother of all content delivery networks (or CDNs). Services like Netflix don’t operate their own networks: instead, they make arrangements with companies like Comcast, Time Warner, Cox Communications, Charter, Verizon, AT&T, CenturyLink, and others to carry Netflix content. Most major backbone network providers are happy to set up peering arrangements for data exchange when the traffic between the network is more-or-less balanced; however, the majority of Netflix content is unbalanced: It goes from Netflix to Internet operators’ end users. Access to ISP’s networks could be the Achilles’ heel for Netflix’s longevity. Major providers are already mulling a “Netflix tax” to profit from the disproportionate traffic Netflix dumps on their networks, and Netflix has already had scuffles over delivering content: Back in 2010, Comcast and Level 3 Communications (which had a content distribution agreement with Netflix) got into a public hissing match over access to customers on Comcast’s network.

A streaming operation run by Verizon and Redbox would be in a very different situation. The service will (obviously) not have any issues reaching Verizon Internet customers, since Verizon owns the network. And Verizon will likely be able to reach very favorable content delivery terms with other major Internet providers because those providers don’t want to lose the ability to deliver content to Verizon Internet users. In other words, Verizon’s costs to push streaming video to U.S. Internet users are likely to be lower than Netflix’s.

And let’s not forget Verizon is one of the most vocal opponents of the FCC’s new network-neutrality regulations. If Verizon (along with Comcast and other opponents) is successful in striking down the FCC’s new regulatory framework, Verizon could use its network muscle to degrade or raise the costs incurred by competing streaming video services. Put another way: Verizon might be tempted to make its own streaming service operate very smoothly for its own Internet customers, while limiting the performance of services like Netflix and Amazon Video-on-Demand — unless, perhaps, they were willing to pay for premium access to Verizon’s network.

netflix envelopesNetflix’s Advantages

But that doesn’t mean a team-up between Verizon and Redbox is an instant formula for a Netflix killer. After all, Netflix has been operating for 15 years now, and despite recent missteps has managed to grow from an upstart in a world dominated by brick-and-mortar video rental stores to a company that accounts for a huge portion of all Internet traffic in the United States. Netflix is unlikely to go away or go down easily.

First, Netflix has that 15 years of longevity in the market and a substantial user base. For the fourth quarter of 2011, Netflix reported some 21.7 million streaming video subscribers in the United States, along with 11.2 million DVD-by-mail subscribers. Most DVD-by-mail subscribers also get streaming, so Netflix’s U.S. user base in the fourth quarter was 24.4 million. Netflix lost almost 3 million DVD-by-mail subscribers since the third quarter of 2011. Much of the loss probably stems from the Qwikster debacle, but the DVD-by-mail business remains a significant revenue generator for Netflix: It produced $370 million in revenue in the fourth quarter, along with $194 million in profit. That’s a 52.4 percent margin, something almost any business would envy. In comparison, Netflix saw even greater revenue from its U.S. streaming operations — $476 million — but only generated $52 million in profit. In other words, Netflix is pulling in more money from streaming, but it’s keeping more money from the DVD side of its business.

Netflix also has another significant advantage on any new competitors: deep content. Redbox is primarily focused on the latest Hollywood releases. A typical kiosk offers only 65 to 200 titles, with high-traffic locations sometimes getting a second kiosk in order to speed lines along and offer a wider selection. Redbox has no licenses to offer streaming content. Verizon does, via its video-on-demand services to television subscribers. Verizon’s offerings are limited, with pay-per-view options garnered from a selection of recent studio releases and a small collection of back-catalog and special-interest titles. In contrast, Netflix offers more than 100,000 movies and television shows across streaming and DVD offerings. Although Verizon and Redbox haven’t indicated what level of depth their content offerings still have, Netflix clearly has an advantage over Redbox and Verizon’s current offerings for anyone interesting in anything but the most-recent Hollywood releases.

While many Netflix customers have complained about the delay between when films come out on DVD and when they’re available from Netflix (Netflix just had to agree to a 56-day delay getting Warner Bros. titles: Expect other studios to draw similar deals) A Verizon-Redbox service will almost certainly face the same constraints on the availability of new content. Hollywood studios are eager to milk every last drop of revenue from DVD and Blu-ray sales on new titles, and they see extending their own window of retail exclusivity as the best way to do that. Movie studios want folks who are eager to have the latest releases at home to go out and buy the discs; only when that demand has trickled down to nothing will the studios release the titles for streaming and bulk rentals. (Redbox hopes to work around this window by buying new releases at retail prices and offering them to consumers when they’re released on DVD. The strategy might work for kiosks, but can’t be applied to streaming.) In other words, Verizon and Redbox are unlikely to offer new releases for streaming any sooner than Netflix.

Roku-LTAnother feather in Netflix’s cap is the substantial presence it has already built up on consumer electronics devices. A huge array of smart televisions and devices that connect to televisions already have Netflix clients built in, including game consoles, set-top boxes (from Apple, TiVo, Roku, Boxee, and more) and even Blu-ray players. To compete successfully with Netflix, Verizon and Redbox will not only have to roll out a streaming service that appeals to consumers, they will have to work with developers and consumer electronics manufacturers to get the service built in to existing systems (where possible) and new devices. And, of course, they’ll need to work on clients for iOS, Android, and even old stodgey PCs.

And there’s one area where Netflix is way out in front of a Verizon-Redbox service: Netflix has already crossed the border. Verizon and Redbox’s service will operate exclusively in the United States; however, Netflix has long since started work on extending its streaming service to international markets, including Brazil, Latin America, and the Caribbean, and most recently in the United Kingdom. Although Netflix is currently losing money on its international streaming operations (the fourth quarter of 2011 saw it lose $60 million) the company is already a long ways ahead of any competition in securing deals with international content providers and network operators, as well as capturing customers in burgeoning markets. Even if Netflix were to start facing substantial competition within the United States, in a few years a major portion of Netflix’s revenue could come from international markets, effectively insulating the company and even allowing it to grow.

For Redbox, the writing is on the wall

Netflix CEO Reed Hastings may have misread his customers when he tried to get Netflix out of the business of mailing DVDs. Clearly, Americans who love movies and television are not prepared to say goodbye to discs. However, Hastings has always said his vision for Netflix is to be just that — net flicks — with no DVDs in the equation. So far, history is proving him right: Adoption of streaming video is skyrocketing.

Where Netflix used to be the company eating the lunch of brick-and-mortar video services like Blockbuster, now it’s Redbox: According to NPD, Redbox’s share of the Blu-ray and DVD-rental market jumped sharply from 25 percent in 2010 to a whopping 37 percent in 2011. Much of that growth came at the expense of brick-and-mortar services. Meanwhile, Netflix — despite its missteps — held relatively steady at 30 percent of the rental market (dropping in the fourth quarter). Blockbuster saw its share fall 6 percent to just 17 percent of the disc rental market in 2011.

Despite Redbox’s success in the disc rental market, the end is in sight. U.S. consumer rentals of Blu-rays and DVDs was 11 percent lower in 2011 than in 2010, and there’s no reason to suspect any increase for 2012. Very soon, Redbox will find its growth arrested by a shrinking market for disc rentals, and eventually it will find its business shrinking as consumers’ desire to rent discs fades away. If Redbox wants to survive — or, rather, if parent company Coinstar wants it to survive — it needs to transition to streaming. Partnering with Verizon is one way to do that. However, Verizon appears to be in the drivers’s seat on this deal: Verizon will own 65 percent of the streaming operation, in comparison to Redbox’s 35 percent. That means Verizon will be calling the shots… and Redbox is just along for the ride.

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