BLACK BOX BREACH SOLVING THE LIVING ROOM RIDDLE

May 4, 2013

By Joseph Mathew

School of Law | University of Virginia

J.D. Candidate, Class of 2013

Darden Graduate School of Business | University of Virginia

M.B.A., Class of 2010

josephmathew10@gmail.com | 706-255-9793

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EXECUTIVE SUMMARY .......................................................................................................... 3

I. THE SETTING ...................................................................................................................... 4

a. Space Race To Where? ...................................................................................................... 4

b. The Establishment: Telecommunications Providers ..................................................... 4

c. Overcoming Barriers To New Technology ...................................................................... 4

d. Emergently Influential Online Media Services ............................................................... 4

e. Venture Capital Disorientation ........................................................................................ 5

II. CONNECTING THE DOTS ............................................................................................. 6

a. The Question....................................................................................................................... 6

b. Data Point 1: Internet Data Consumption Skyrockets .................................................. 6

c. Data Point 2: Jet Speed Internet...................................................................................... 6

d. Data Point 3: Troublesome Youth ................................................................................... 7

e. The Answer: Crown The Internet ................................................................................... 7

III. THE TAKE AWAYS ......................................................................................................... 8

a. To: The Technology, Media, & Telecommunications CEO .......................................... 8

i. Evaluate Core Competency’s Validity ............................................................................. 8

ii. Conservatively Value Low Growth Properties ................................................................ 8

iii. Internet Impelled Acquisition Strategy ............................................................................. 8

b. To: The Average American .............................................................................................. 9

OUTLINE

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THESIS

The contest over the future of your living room will be won, in the near future, in

decisive fashion by hardware, content, and services infused with the internet throughout

their DNA

RATIONALE

As Millennials’ voracious appetite for streaming video steadily increases,

telecommunications providers will eventually meet that need, creating a virtuous spiral

for online media services

RAMIFICATIONS

Technology, media, and telecommunications CEOs should candidly assess their strengths

and weaknesses in this new internet order of home entertainment, diverting capital from

rapidly decaying assets and into growth generating businesses within their core

competencies

EXECUTIVE SUMMARY

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I. THE SETTING

a. Space Race To Where?

On a couch somewhere in suburbia the average American “Joe” is resting comfortably on

his favorite reclining couch, his flannel shirt not quite covering his well-deserved paunch,

directly in front of a massive, flat screen television, with a jumbo size bag of Cheetos on his

stomach. Little does Joe realize, though, that his safe haven is on the verge of being engulfed in

a war of epic proportions, being waged across executive suites spanning the continent from New

York to Los Angeles to Seattle to the Silicon Valley. In the aftermath of this coming maelstrom,

Joe’s living room will have encountered more disruptive innovation in a period of five years,

than in the last two decades.

In order to win this struggle, media and technology firms are investing billions of dollars

in their efforts. What makes this particular digital media pursuit so fascinating is that the players

do not even agree, what defines “winning.” To put this analogy another way, if the current chase

for control of your living room were equivalent of the Cold War’s space race, the United States

would be shooting for the moon, while the Soviet Union would be aiming for the Earth’s core.

b. The Establishment: Telecommunications Providers

Ever pervasive, laying in the background of this great race are the actual

telecommunications data providers, which include colossal companies such as Comcast, Dish

Network, Verizon, and AT&T on the domestic front, and behemoths such as China Mobile,

Vodafone, America Movil, and Bharti Airtel, internationally. These firms tend to have natural

monopolies or small oligopolies in the regions from which they operate, being the sole internet,

cable, telephone or satellite provider. These players having been firmly entrenched in the living

room for decades and are clinging to their stronghold in front of your couch with a vise like grip.

This is one of the reasons satellite and cable operators tout their latest “black box” as being

integral to your home entertainment experience.

c. Overcoming Barriers To New Technology

Telecom providers’ stronghold is the reason that state of the art technology firms have

met with limited success in the living room space, to date. Steve Jobs, in his last appearance at

the All Things Digital 8 Conference in 2010 noted this conundrum:

The problem with innovation in the television industry is the go-to-market

strategy. The television industry fundamentally has a subsidized business

model that gives everybody a set-top box for free or for 10 dollars a month. . .

. There isn’t a cable operator that’s national. There’s a bunch of cable

operators. And then it’s not like there’s a GSM standard where you build a

phone for the US and it also works for all these other countries. No, every

single country has different standards, different government approvals. . . .

It’s very balkanized.1

Leading companies such as Apple and Google have, though, attempted to breach the shores of

the market with their own supplemental boxes such as the Apple TV and the Google TV, which

allow consumers to connect to the internet as well as view their traditional television service.

Smaller companies, seeking to disrupt the traditional system, have also entered the scene over the

last decade, ranging from the relatively well-known digital video recorder TiVo to the

increasingly popular online streaming player Roku.

d. Emergently Influential Online Media Services

1 Steve Jobs, CEO, Apple Inc., D: All Things Digital 8 Conference (June 1, 2010) (emphasis added).

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Avoiding the balkanization of today’s living room altogether are companies such as

Netflix, the online streaming video service. Netflix is emerging as a major player in the home

entertainment space, investing $2.5 billion in 2012 alone on content licensing and original

programming, while Amazon reportedly spent hundreds of millions of dollars as well, on content

for their Prime service.2 Top tier media firms, for their part, are ecstatic about this new demand

source. The Walt Disney Company, for example, delightfully inked a deal granting exclusive

digital distribution rights, starting in 2016, for which Netflix is paying an estimated hundreds of

millions of dollars annually.3

e. Venture Capital Disorientation

On the other side of the technological divide, though, are elite venture capital firms such

as NEA, which invested seed stage capital in the television startup Tivli last year. The Tivli

service converts live feeds from satellite and cable distributors operating on college campuses

into online streams viewable on any gadget owned by students.4 With Tivli, college students

will presumably learn to be hooked onto cable television.5

Meanwhile, a later stage startup Aereo, which has raised $63 million in venture capital

financing, is attacking the young urban professional market in New York.6 Aereo captures live

broadcast television through a small antenna and then broadcasts the stream digitally to all your

personal devices, making the content available for viewing as well as recording. For their

efforts, the company has become embroiled in massive litigation pitting themselves against all

the major broadcast networks.

Making their case in the 2nd

Circuit, the networks, which include ABC, CBS, NBC, and

Fox, contend that Aereo is violating the Transmit Clause of the Copyright Act of 1976.7 By

retransmitting broadcasts, the networks allege that Aero is basically infringing on their

copyrights. Aereo responds that they are merely providing the signal available to consumers,

who set up their own antennas. Amidst the pending legal actions, News Corporation’s COO

Chase Carey and CBS’ CEO Leslie Moonves have both stated their intent go off the air and

morph into cable channels should the judicial decisions turn against them.8 This aggressive

stance is credible, since more than 85% of American homes are currently on a subscription

service, with Fox alone earning $472 million in affiliate and pay-TV payments.9

The Tivli and Aero concepts sound revolutionary at first glance, until one takes a step

back, places oneself in the Reef flip flops of a Millennial, and thinks about the future. After

walking through a simple thought experiment, you should come to the following peculiar

2 Netflix, Annual Report (Form 10-K) (February 1, 2013); Peter Kafka, Netflix CEO: Amazon Losing Up to $1

Billion a Year on Streaming Video, All Things Digital (May 1, 2013). http://allthingsd.com/20121116/netflix-ceo-

amazon-losing-up-to-1-billion-a-year-on-streaming-video/. 3 Brooks Barnes, Netflix Reaches Deal to Show New Disney Films in 2016, The New York Times (May 1, 2013),

http://mediadecoder.blogs.nytimes.com/2012/12/04/netflix-bests-starz-in-bid-for-disney-movies/. 4 Eric Markowitz, Harvard's Go-To Venture Capital Firm, Inc. (May 1, 2013), http://www.inc.com/eric-

markowitz/harvards-go-to-venture-capital-firm.html. 5 Brian Stelter, Start-Up Puts Streaming TV on Campus, The New York Times (May 1, 2013),

http://www.nytimes.com/2013/01/28/business/media/tivli-puts-streaming-tv-on-campus.html. 6 Aereo, CrunchBase (May 1, 2013), http://www.crunchbase.com/company/aereo.

7 Tim Kenneally, Aereo Lawsuit: Networks Seek Re-Hearing After Appeals Court Setback, The Wrap (May 1, 2013),

http://www.thewrap.com/tv/article/aereo-lawsuit-networks-seek-re-hearing-after-appeals-court-setback-86121. 8 Christopher Palmeri, CBS Could Switch to Cable If Aereo Wins Case, CEO says, Bloomberg (May 1, 2013),

http://www.bloomberg.com/news/2013-04-30/cbs-could-switch-to-cable-if-aereo-wins-case-ceo-says.html. 9 Andy Fixmer, News Corp. to Take Fox Off Air If Courts Back Aereo, Bloomberg (May 1, 2013),

http://www.bloomberg.com/news/2013-04-08/news-corp-says-it-will-take-fox-off-air-if-courts-ok-aereo-1-.html.

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conclusion: what these supposedly bleeding edge startups are attempting is tantamount to

handing out Gordon Gekko 1980s style boxy cell phones to college students and hipsters today,

expecting them to change their smartphone habits.

II. CONNECTING THE DOTS

a. The Question

Let us conduct a thought experiment. What will the average American living room look

like a decade from now in 2023? Will a television still be at the center of most living rooms? If

so, to what data stream will the television be connected to? Will some other device dominate the

space? Or will there be no piece of visible technology at all? Fortunately, there are some key

data points to take into account in answering these questions.

b. Data Point 1: Internet Data Consumption Skyrockets

If you have been wondering over recent years why your home internet connection slows

down during prime time viewing, let me, as a Millennial, be the first to apologize.10

In the

period from 2011 to 2012, the average monthly data usage per fixed network subscriber

increased 120% to 51GB, which is equivalent to 81 hours of video.11

Cisco Systems expects this

data utilization to continue, with 6 million years’ worth of video traversing the internet monthly

by 2016.12

Currently, Netflix accounts for 33% of peak period downstream traffic on fixed networks

in North America, while YouTube eats up 20% of peak downstream mobile network traffic.

Over in the Asia-Pacific region, BitTorrent, the popular peer to peer file sharing application,

represents 36% of total internet traffic.13

Netflix, alone has more than 36 million subscribers

worldwide, while competitor Amazon’s Prime video streaming and package delivery service is

estimated to have more than 10 million members.14

c. Data Point 2: Jet Speed Internet

While consumers have been steadily devouring more data, globally, Google has been

quietly testing their novel Fiber internet service in Kansas City, Kansas and recently announced

an expansion to Austin, Texas. Google Fiber offers Kansas City residents free basic internet for

a one-time $300 set-up fee as well as a swift 1 gigabit-per-second for just $70 per month, with no

set-up fee.15

Unfortunately, Google Fiber will most likely not be coming to a city near you anytime

soon. Providing the Fiber service across the U.S. would cost Google an estimated $140 billion.16

Google is using Fiber as a pressure point to spur traditional broadband providers into upgrading

their own networks at a faster pace. This strategy has already has met some degree of success

10

Individuals born in the early 1980s through the early 2000s. 11

Sandvine Global Report: Internet Data Usage Up 120 Percent In North America, Sandvine (April 30, 2013),

http://www.sandvine.com/news/pr_detail.asp?ID=394. 12

Bernhard Warner, Alcatel-Lucent Unveils World's Most Powerful Broadband Infrastructure, Bloomberg

Businessweek (April 30, 2013), http://www.businessweek.com/articles/2013-02-15/alcatel-lucent-unveils-worlds-

most-powerful-broadband-infrastructure. 13

Sandvine Global Report: Internet Data Usage Up 120 Percent In North America, Sandvine (April 30, 2013),

http://www.sandvine.com/news/pr_detail.asp?ID=394. 14

Netflix, Quarterly Report (Form 10-Q) (March 31, 2013); Owen Thomas, Amazon Has An Estimated 10 Million

Members For Its Surprisingly Profitable Prime Club, Business Insider (April 30, 2013),

http://www.businessinsider.com/amazon-prime-10-million-members-morningstar-2013-3. 15

Google fiber About, Google (April 30, 2013), https://fiber.google.com/about/. 16

Chris Marling, Google Fiber infographic: Will it take over the world?, Broadband Genie (April 30, 2013),

http://www.broadbandgenie.co.uk/blog/20130425-google-fiber-infographic-will-take-over-world.

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with TimeWarner Cable announced a free Wi-Fi service for subscribers in Austin.17

Fiber is also

providing Google with a platform for testing out their new advertising technologies.

While Google is at the forefront of broadband services stateside, across the pond, Alcatel-

Lucent and France Télécom-Orange announced on February 6, 2013 the activation of the world’s

most robust broadband infrastructure between Paris and Lyon, France, clocking speeds at a

smoldering 400 gigabits-per-second. The service will initially be available only to scientists, but

the firms promise to unveil business and consumer plans in the future. These types of speeds

hint at the tantalizing possibility of downloading high definition movies in seconds rather than

hours.18

The last piece connecting the internet speed puzzle comes in the form of wireless

transmission technology. Qualcomm’s CEO Paul Jacobs predicts that data traffic will eventually

be offloaded onto cellular base stations the size of a deck of cards. Base stations, which

historically have been large towers on mountaintops or on the sides of roads, will, according to

Jacobs, eventually be supplemented with mini stations plugged into home’s Ethernets, and

provide extremely fast download rates.19

d. Data Point 3: Troublesome Youth

The final essential piece to understanding the future of home entertainment is the

audience of the future. As Baby Boomers retire, and GenX-ers grow older and wealthier,

Millennials will continue to propel the elemental changes happening in media distribution,

outnumbering non-Millennials by 22 million people by 2030.20

This is important because Millennials consume media content in a unique manner. Only

26% of Millennials watch more than 20 hours of television per week, while 49% of non-

Millennials do so. Even more remarkable, is that 42% of Millennials prefer to consume

television content through their computer through services such as Netflix, Amazon Prime, and

Hulu, while only 18% of non-Millennials prefer the same. The Millennial generation represents,

therefore, a truly existential threat to the traditional network and cable advertising model.

If Millennials’ content consumption represent the future habits of the average American,

their online video demands continues to unwaveringly ascend, and the internet backbone

catapults forward in bandwidth to meet their proclivity, does the television even need to be

connected to a cable or satellite provider? Wherever you stand on this new question, the answer

to our original question should be clear.

e. The Answer: Crown The Internet

Synthesizing these three disparate data sources should lead you to a previously

unimaginable conclusion. The future living room will revolve, in large part, around the internet,

and the available apps, of which there will be hundreds, or even thousands. Each app on the

17

Stacey Higginbotham, Time Warner Cable sees the Google Fiber threat and offers Austin free Wi-Fi, GigaOM

(April 30, 2013), http://gigaom.com/2013/04/25/time-warner-cable-sees-the-google-fiber-threat-and-offers-austin-

free-wi-fi/. 18

Bernhard Warner, Alcatel-Lucent Unveils World's Most Powerful Broadband Infrastructure, Bloomberg

Businessweek (April 30, 2013), http://www.businessweek.com/articles/2013-02-15/alcatel-lucent-unveils-worlds-

most-powerful-broadband-infrastructure. 19

Don Clark, Qualcomm CEO Envisions Cell Base Stations in Your Home, The Wall Street Journal (May 2, 2013),

http://online.wsj.com/article/SB10001424127887324339204578173332194107300.html. 20

Christine Barton, Chris Egan, Jeff Fromm, The Millennial Consumer Debunking Stereotypes, The Boston

Consulting Group (April 30, 2013),

http://www.brandchannel.com/images/papers/536_BCG_The_Millennial_Consumer_Apr_2012%20(3)_tcm80-

103894.pdf.

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future “smart” television will be comparable to channels and services that are presently found via

your computer, mobile device, and television. The device may come in the form of a massive

flat screen that perhaps covers an entire wall, or in the shape of glasses, projecting your own

personal display, or some combination of the two.21

The key insight from this exercise, though,

is that the internet is king in the new regime of home entertainment.

III. THE TAKE AWAYS

a. To: The Technology, Media, & Telecommunications CEO

i. Evaluate Core Competency’s Validity

For the average tech, media, or telecom mogul, the results of our thought experiment

have some fairly clear repercussions for your corporate development and merger and acquisition

strategy. First, take a deep breath and remember that some of the most powerful states in the

world, such as China, are pouring billions of dollars into their economic systems in a furious

attempt to replicate your success.22

Then, sit down with your top management, discern your core

competencies and assess whether they still apply in the internet dominion of television.

Disney, for example, owns the computer graphics animation space, multiple epic

franchises, and the unique ability to monetize intellectual property across a wide variety of

businesses. In preparation for the internet connected living room, Disney should ensure that their

story generating machines (ABC, Disney Channel, ESPN, Marvel, Pixar, and Lucasfilm, to name

a few) have a coherent online distribution strategy that meets the vagaries of the Millennial

consumer. Could ESPN, for example, increase their financial footprint even further by offering a

$10 stand-alone online subscription? (ESPN currently sits at the top of the cable mountain,

extracting $5.13 in affiliate fees from distributors per month per more than 100 million

households.)23

ii. Conservatively Value Low Growth Properties

Second, internal valuations should depreciate soon to be antiquated distribution channels

to zero over the next two decades. Assets headed for obsolescence in the ten to twenty year

period include distribution methods such as television broadcast stations. Serious analyses

should be done on the feasibility of satellite and cable pay-TV services beyond two decades.

Valuing the viability of the long term primary cash flow generator in your firm could be a

controversial exercise but far safer than being competed into extinction, if your firm lacks the

ability to provide internet services.

iii. Internet Impelled Acquisition Strategy

Third, potential acquisitions for driving inorganic growth should focus on media content

delivered via the internet. On this front, two firms have recently followed the right strategy, one,

for the wrong reasons. News Corp.’s phone hacking scandal, which erupted in 2011, forced the

firm to drop a $12 billion bid for the outstanding share of British Sky Broadcasting (BSkyB), a

21

Tom Warren, Microsoft's Xbox chief predicts 'we'll all be wearing 10 sensors' in the next decade, The Verge (May

1, 2013), http://www.theverge.com/2013/3/7/4075196/microsoft-don-mattrick-sensor-predicitions. 22

David Barboza, China Yearns to Form Its Own Media Empires, The New York Times (May 2, 2013),

http://www.nytimes.com/2009/10/05/business/global/05yuan.html?_r=0. 23

Kurt Badenhausen, Why ESPN Is Worth $40 Billion As The World's Most Valuable Media Property, Forbes (May

2, 2013), http://www.forbes.com/sites/kurtbadenhausen/2012/11/09/why-espn-is-the-worlds-most-valuable-media-

property-and-worth-40-billion/.

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pay-TV provider.24

Based on our living room model, News Corp. will be happy to have avoided

the acquisition ten years from now.

On another front, Dish Network entered the bidding contest for Sprint, against Softbank

Corp., with an unsolicited $25.5 billion offer. Dish Network’s CEO, Charles Ergen, has publicly

remarked that four of his five children have stopped paying for TV. Sprint offers Dish the

opportunity to provide both wireless internet as well as satellite television nationally.25

Given

Qualcomm’s vision for the future, if Dish will most likely be in a stronger strategic position post-

acquisition, if their bid is successful, and they refrain from overpaying.

b. To: The Average American

For the average American, your home entertainment options are about to become far

superior in the next few years. You will have very real substitutes to traditional cable and

satellite subscription services, and should, eventually, be able to shift to a completely à la carte

pay television model, online or off.26

With the most content available in history coming to a

living room near you, your biggest issue will not be finding which show you want to watch, but

deciding what show you want to watch the most, or, perhaps more importantly, when to stop

watching. Stay entertained America.

24

Felix Gillette, Rupert Murdoch, News Corp. Dodge Phone-Hacking Ruin, Bloomberg Businessweek (May 2,

2013), http://www.businessweek.com/articles/2013-04-18/rupert-murdoch-news-corp-dot-dodge-phone-hacking-

ruin#p1. 25

Shalini Ramachandran, Sharon Terlep, Anton Troianovski, Billionaires Duke It Out for Control of Sprint, The

Wall Street Journal (May 2, 2013),

http://online.wsj.com/article/SB10001424127887324030704578424200831745578.html. 26

Roberto Baldwin, Intel Will Lead Us to à la Carte Pay TV, Wired (May 2, 2013),

http://www.wired.com/gadgetlab/2013/02/intel-a-la-carte/.