HBO Will Have to Cannibalize Itself by Going OTT

HBO

As you may or may not know, I’m a big believer of the fact that HBO and Netflix can co-exist in a world where they both are offering an OTT option. Thus, HBO’s decision to go OTT in 2015 is of no surprise to me, just as it is likely of no surprise to most in the industry, as a digital world seems to be where the future of media resides.

That said, the Jeff Zucker term “trading analog dollars for digital pennies” is something we should be thinking about as HBO sets up to release HBO Go as an OTT option early next year. Sure, with Netflix’s growing domestic and international subscriber base, HBO has to go OTT in order to achieve the scale that will allow it to competitively pay/bid for content with Netflix. However, in the short-term, allowing users to get HBO via a digital option could prove costly for HBO. So contrary to what HBO topper Richard Plepler might tell you, cannibalization is a coming!

Let me start off by saying that, in the long-run, I don’t think HBO will mess this up. I believe full-heartedly that we will eventually live in a world where both Netflix and HBO make most of their money from OTT offerings, and they’ll both be very profitable. But if HBO comes out of the gate with this HBO OTT option, there could be some short-term cannibalization, that if not addressed, could lead to things going terribly wrong.

What could go wrong? Well duh…the money might not be right!

Currently, HBO cost you whatever your PayTV service charges you for basic cable plus ~$15. HBO gets a little more than half of that $15, about $8.00 on average per month, after the cable companies take their cut. Ivey Business Review’s Liam Bolukestimates that HBO’s costs are around $6.43 per subscriber per month, but that includes about $4.65 of content-related costs. If you remove the content-related costs out of that figure (because we’re going to spread content costs across both OTT and analog subscribers), you get a (makeshift) cost per subscriber of $1.78. Subtract the $1.78 from the monthly subscriber revenue of $8.00, and you get a Contribution per Subscriber figure of $6.22.

Thus, in order for HBO to offer HBO Go over-the-top and eliminate any chance of cannibilzation, the OTT option would have to contribute at least $6.22 per subscriber, accounting for the fact that we’re taking content costs out of the equation for now.

However, if you look at Netflix’s model, and most digital models for that matter, that high of subscriber contribution figure may not be possible. Having an OTT option is costly due to marketing, customer servicing and increased technical development costs. These are things that HBO’s Pay-TV partners do for them right now. PayTV companies market HBO directly to consumers, they handle all of the silly little technical questions we ask when our HBO isn’t working, and they help HBO manage content delivery both through cable and digital content delivery networks.

Ivey Business Review estimated that Netflix spent about $2.71 per sub per month on marketing, selling costs and technology development. That’s almost a full dollar more than what it costs HBO per analog subscriber ($1.78.). Thus, in order for HBO to make their digital sub contribution equal its analog sub contribution, HBO would have to charge $8.93 per sub. That’s good news given that Netflix is already charging $7.99, and has already announced a price hike that will take it to $8.99 per subscriber. And if HBO were to match that price, it would make their OTT subscribers about 6 cents more beneficial than their analog subscriber.

But not so fast my friend! By using Netflix’s cost model, we’re looking at a company that is spreading the costs of marketing, selling and development across 37 million US subscribers. HBO has a long way to go before it gets there. In fact, HBO believes the addressable market is a mere 20 million subscribers. So even if we were to assume HBO could get all 20 million of the addressable market, that would still make HBO’s digital per-subscriber costs 85% higher than the Netflix model, or $5.01/subscriber.

At $5.01 per subscriber, that makes the net contribution of a digital subscriber just $3.98 ($8.99-$5.01). The $3.98 contribution figure is way less than the $6.22 per subscriber that HBO is making off analog subs (again, this is not including content costs, as we’re assuming programming costs won’t rise as a result of the of the digital offering–which may or may not be a bad assumption). Using the cannibalization break-even formula, this means that the cannibalization rate must be lower than 63.9% (3.98/6.22).

Thus, for every analog user that drops analog HBO as a result of the new offering, HBO must sell roughly 1.56 OTT subscriptions. So if HBO acquires the full addressable market of 20 million additional OTT subscribers, that means HBO can’t loose more than 12.8 million analog users.

Back in October, HBO had ~30 million subscribers. And despite all of the chatter about cord-cutters, it’s unlikely that 12.8 million of those 30 million HBO subscribers were justifying paying an average of $80 a month for Pay-TV just to watch HBO. Then again, it’s also unlikely that HBO reaches the full addressable market of 20 million. Heck, it took Netflix 2 years to go from ~24 million US subs to ~36 million US subs, and now they only add about 1 million per quarter. HBO also has a very mature user base, so it’s unlikely to see a lot of growth in OTT subscribers after the first 2 quarters of introducing the new digital offering.

Thus, it’s quite possible that in the beginning, HBO’s cannibalization rate exceeds the break-even rate of 63.9%, because HBO’s most ardent fans are probably the customers that already have analog HBO, and if they are going to switch to save money, they are going to do it right away, and probably much faster than people who don’t have HBO at all.

That type of scenario could harm HBO in the short-term, causing it’s profits to drop and its relationship with Pay-TV partners to suffer. NBC Universal topper, Stephen Burke, has already suggested that he thinks HBO is making a mistake, citing cannibalization as one of the challenges they’ll face going over-the-top. And if HBO does something reactionary to favor its old Pay-TV partners, such as raising prices (ala Netflix) or restricting access on the service (circa Hulu), they could get some serious pushback from both customers and Wall Street.

All that said, I’m sure HBO has considered these numbers, and in their case, their numbers are a lot more accurate than mine. To prevent a scenario in which there is a mass exodus from HBO analog to HBO OTT, the company will likely roll this out market by market to test the cannibalization factor. In all likelihood, they’ll still find out that cannibalization is inevitable and that living off the teat of Pay-TV is the best thing that ever happened to them.

But if they want to grow and fend off Netflix from amassing a subscriber base so big that it can no longer compete on bids for licensed and original content, then HBO has to go the way of the world and cannibalize itself in the name of digital pennies, because those pennies will eventually add up to be a whole lot better than those ever-so-slowly disappearing analog dollars.

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