Time Warner focuses on its growth strategy for HBO

Time Warner has unexpectedly found itself defending its HBO strategy

HBO typically needs a wheelbarrow to haul all of the trophies it collects during awards season.

Top-tier Hollywood producers, directors and stars, including Martin Scorsese, Steven Soderbergh and Matthew McConaughey, long have been lured by the rich canvas that HBO offers show creators. The premium channel boasts 127 million subscribers around the world, and a $1.8-billion profit last year, making it a reliable cash cow for parent company Time Warner.

But these days that might not be enough — Time Warner has unexpectedly found itself defending its HBO strategy.

Rupert Murdoch's 21st Century Fox's $80-billion takeover offer this summer for Time Warner prompted Wall Street to question whether HBO is being properly managed. Murdoch had been keen to add HBO and sister channel Cinemax to Fox's portfolio.

There has also been wild speculation on Wall Street that Time Warner should spin off HBO, or create a tracking stock to cash in on its popularity — moves that Time Warner flatly rejects.

But the scenario most discussed is for Time Warner to offer HBO as a stand-alone product — in addition to being a premium channel provided by cable and satellite TV operators. Such a dual offering may be the key to HBO's long-term prospects in an era when consumers increasingly are enchanted with streaming services including Netflix, Hulu and Amazon's Prime Instant Video.

"It's a real dilemma for HBO," said Deana Myers, a television analyst with consulting firm SNL Kagan. "How much growth can HBO get from pay-TV operators? Long term, they are going to have to look at alternatives."

HBO long has had plans to prepare for the day when consumers could get digital subscriptions, untethered from their cable TV packages.

The company three years ago launched HBO Go, an application that enables current HBO subscribers to watch the network's programming on their mobile devices. HBO also is experimenting with a stand-alone Internet video offering in Denmark, Sweden, Finland and Norway called HBO Nordic, which costs about $10 a month. Consumers in those countries also can get HBO as part of their pay-TV subscription.

In the past, when asked why not cut the cord and sell HBO directly to U.S. consumers, company executives would say there were "4 billion reasons" to prevent that. The reference was to the nearly $4 billion in revenue that HBO and Cinemax collect each year from U.S. pay-TV distributors, including Time Warner Cable, Cox Communications and DirecTV.

More than three-quarters of HBO's nearly $5 billion a year in revenue — or $3.8 billion — comes in the form of affiliate fees paid by U.S. pay-TV distributors, according to SNL Kagan. The company is expected this year to take in an additional $831 million in secondary revenues, including program license fees and DVDs.

International sales make up the remainder of HBO's revenue. A fast-growing segment, international revenue is expected to reach about $1 billion a year within a couple of years.

Time Warner Chief Executive Jeff Bewkes this month said he and his team were "seriously considering the best way to deal with alternate distribution."

Such a move could eventually mean offering its digital HBO Go as a stand-alone platform, although Bewkes said he wasn't ready to make such an announcement. HBO would have to spend hundreds of millions of dollars to set up its own marketing, customer service and billing departments.

Now, all of those functions are handled by pay-TV operators.

"We've got a very strong product offering," Bewkes said during a Goldman Sachs investor conference this month in New York. "So the issue of how to monetize it in the most effective way, which is a great problem to have, is the one that we're focused on now."

But Bewkes also must quickly adapt to fast-changing ways in which consumers are watching programs, and their needs to shave costs.

"It's a fait accompli that, over time, HBO will move closer to offering its service directly to consumers," predicted Nomura Securities media analyst Anthony DiClemente.

"Time Warner must decide if it is better off with HBO as part of the cable bundle — or not part of it," DiClemente said. "But the key question is whether this will have an impact on the broader television ecosystem."

That's what some people are worried about.

HBO has long been part of the glue that holds the TV channel bundles together. Distributors want HBO and Cinemax to remain exclusive to their premium packages — rather than being sold as a stand-alone product.

The television industry, after years of reluctance, has started to take small steps toward unraveling the pay-TV bundle.

Satellite TV giant Dish Network this year plans to roll out an Internet streaming service that is expected to offer a limited number of channels, including Walt Disney Co.'s ESPN and Disney Channel and Scripps Networks' HGTV. Dish's Internet TV package, which is expected to cost $30 to $40 a month, would be targeted at singles, young couples and others who don't want to spend more than $70 a month for a TV subscription.

Sony also is scrambling to create its own Internet video service, signing a deal with Viacom this month that allows Sony to stream 22 Viacom cable channels, including Nickelodeon, MTV and Comedy Central. Consumers will be able to watch the programming on Sony's game consoles and other devices.

Time Warner recognizes that younger viewers, particularly those in their 20s, are not consuming entertainment the way their parents did.

The company plans to shed more light on its growth strategy during an investor day scheduled for Oct. 15 in New York.

Time Warner shares closed Monday at $75.67, down $2.13, or 2.7%. The stock is trading at a 13% discount compared to late July, when investors were cheering a possible take-over by Fox. Still, Time Warner shares are up about 6% from trading levels before the Fox bid became known.

Richard Greenfield, media analyst with BTIG Research, said calls for HBO to do something radical are uninformed.

"HBO is one of the most successful growth businesses in all media," Greenfield said.

Bewkes might be positioning HBO for upcoming negotiations with cable and satellite TV operators. Several key contracts come up for renewal in the next few years, and Bewkes could use the threat of offering HBO as a stand-alone offering as leverage with distributors.

Currently, HBO gets about half of the roughly $15 a month that consumers pay for HBO service, with the pay-TV operators keeping the other half.

HBO doesn't collect revenue generated by about 10% of domestic subscribers. Formulas created years ago to provide incentives to pay-TV companies to get more customers to sign up for HBO allow the distributors to keep the subscription fee if they reach undisclosed bench marks for recruitment.

Time Warner would like to adjust those formulas in the next few years so more of the subscription sales go to HBO's bottom line.

Some analysts have said the company could accelerate partnerships with broadband providers. For instance, Comcast a year ago introduced Internet service and more than two dozen TV channels (including HBO) as part of a product called Internet Plus. It sells for about $50 a month.

AT&T also is launching in several markets a similar package — Internet service with a few television channels, including HBO and a year's subscription to Amazon Prime.

"It is a delicate balance," SNL Kagan's Myers said. "HBO doesn't want to risk making the operators mad."

But the channel is facing streaming competitors that are spending more on original content. On Monday, Hulu announced that it had ordered a new series, "11/22/63," based on a novel by Stephen King and produced by J.J. Abrams. The nine-hour series is about a teacher who travels back in time to prevent the assassination of President Kennedy.

"The competition is absolutely real," Myers said. "They can't dismiss that threat."

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