Starz goes from second-tier movie channel to Hollywood power broker

In the battle over home video distribution, the Hollywood studios may finally be realizing they have to give up some control, or risk losing millions.

Earlier this month, Disney announced that it is renewing its licensing agreement with Starz Entertainment, giving the premium movie provider behind the Starz and Encore movie channels exclusive pay-TV rights to show content from Walt Disney Studios.

But this deal was a little different than most: industry watchers predicted that it was never going to happen or that it would come only after a long, ugly battle.

The fact that there’s been so little uproar raised around it signals one thing: the studios are realizing that they have to give up some control in how their movies get to consumers. And the companies that stand to benefit are Netflix and whichever startups inevitably rise to challenge it.

Let’s go back a step: The contract renewal is another key installment in the turf wars over video’s migration online, which revved up in October 2008 when Netflix struck a deal allowing it to stream Starz movies to Netflix’s now 12.3 million subscribers, whether they were sitting at their PCs and or TVs. Netflix subscriptions begin at $8.99 per month and TV streaming requires the use of an Internet-enabled set or a set top box with Netflix’s software such as a Roku, Sony’s PS3 gaming console or various Blu-ray DVD players. As of November 2009, 62% of Netflix subscribers had tried the streaming service.

When Netflix first started streaming movies, it had the rights mostly to indies and back catalog orphans. That’s because for decades, the entertainment world locked out newcomers like Netflix. The protocol was simple: Studios sold the rights to their movies to the premium channels for hundreds of millions of dollars and the premium channels sold subscriptions to cable customers. Cable companies like Comcast then took a hefty chunk of each month’s movie-channel bill.

Netflix enters the picture

The Netflix/Starz deal proved to be an end-run. Suddenly Netflix’s customers who wanted instant access to movies didn’t need cable to see some of the most popular Sony Pictures Entertainment (including TriStar, Screen Gems and Sony Classics) and Walt Disney Studios (including Touchstone Pictures, Disney-Pixar, Marvel Entertainment.) More, Netflix became an instant challenger to cable’s video-on-demand offerings. “Starz was not one of the favorite outlets for Hollywood at the time,” says Colin Dixon, senior partner at research firm The Diffusion Group.

Disney’s deal with Starz wasn’t actually set to expire until 2012, but then came the recent news that the current agreement will be extended until 2015. Starz confirmed that it will continue to give Netflix access to Disney’s films, leaving many to wonder, why did Disney cave?

The answer shows a serious weakness in the studios’ business. The partnership between Disney and Liberty Media’s (LSTZA) Starz goes back to 1994, when the flagship premium channel first launched. Other premium channels like Showtime and HBO signed their own exclusive content partners. These relationships carried on for several years with some of the channels and studios trading partners every few years, and the channels continuing to pay the studios handsome fees. Then two years ago, this ecosystem shifted when Showtime and Paramount, both owned by Viacom , couldn’t reach an agreement. (Showtime had reportedly been paying Paramount $350 million a year for the rights). Showtime wanted to invest in original programming like the shows Dexter and Weeds, so Paramount went its own way, launching a new premium channel with Lionsgate and Metro-Goldwyn-Mayer called Epix.

Lack of outlets

These events may have put pressure on Disney, which suddenly saw that the premium channels had the ability to shut down the lucrative “output” deals. If Disney had pushed back on the Starz-Netflix deal, it risked leaving hundreds of millions of dollars on the table. With Showtime out of the picture and Epix struggling to gain traction, the only player left to shop the content to would have been HBO, which already has a slew of content partners including Twentieth Century Fox, Warner Bros., Universal Studios and Dreamworks Animation .

Furthermore, while Disney may not get a cut of the revenue Starz generates from its deal with Netflix, the arrangement isn’t actually impacting the studio’s key revenue streams.

“What we’re seeing is the studios looking to protect DVD sales,” explains Diffusion Group’s Dixon. “Content on Starz is well outside that window,” he says, referring to the initial period of time when studios release their films exclusively for sale on DVD. (Some 75% of the highly profitable DVD sales occur in the first four weeks after release).

Other studios have also begun making the films available for VOD on the DVD sale release date, a move being touted in a recent $30 million marketing campaign backed by the cable companies who would like a bigger piece of the home distribution pie as well. The studios allow this because the cable operators reportedly offer them a higher share of the revenue from VOD sales than other outlets offer from their sales.

Death of the DVD

DVD sales are slowing rapidly, down another 13% in 2009. So it seems likely that for now the studios will focus their energy on preserving this revenue source rather than on stopping Netflix. Evidence of this can be seen in a recent deal between Netflix and Warner Bros.: Netflix has agreed not to rent Warner Bros. titles during the first 28-days after the film is released on DVD in exchange for expanded rights to stream Warner Bros. content.

Video industry news blogger Will Richmond calls the deal a “win for everyone” and writes that, “Netflix is helping Hollywood gracefully wind down and milk the DVD business.”

But Richmond also notes that Netflix still faces challenges in building out its catalog for streaming. The other premium channels like HBO and Epix, have paid up for electronic distribution rights to their partners’ content, effectively boxing Netflix out.

Then of course there’s also the question of what happens when Netflix’s deal with Starz comes up for renewal. Some suggest that Starz may be in a position to negotiate better terms, thanks to its status as the new power broker in Hollywood.

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