The Albanians strike back

Over-the-Top Back in December, Time Warner CEO Jeff Bewkes dismissed Netflix as a pip-squeak power in the media world, famously likening it to Albania. “It’s a little bit like, is the Albanian army going to take over the world?,” Bewkes told the New York Times. “I don’t think so.”

Even a pip-squeak army can inflict damage, however, if it picks its spots. And this week, the Red Envelope Brigade struck again, at a strategic but vulnerable spot in the Time Warner empire. On Tuesday, reported that Netflix had apparently managed to outbid several major cable networks, including Time Warner’s HBO, for rights to a big-budget original series, “House of Cards,” executive-produced by and starring Kevin Spacey. Other outlets have since more-or-less confirmed the report. Deadline put the price tag at $100 million for 26 episodes, although others put the figure somewhat lower. In any case, it was a lot of money, for a lot of episodes and it made a very big noise in the media world — just the sort of thing a pip-squeak, guerrilla army tries to do.

While some reports of the deal have portrayed it as Netflix venturing into the business of producing original content that is not what’s going on here. This was a licensing deal, for distribution rights to premium content that was going to be financed, produced and picked up in any case, if not by Netflix than by someone else. The reason the deal is significant is because it was the result of a competitive bidding process among would-be distributors, which HBO lost.

Bewkes’ animus toward Netflix has multiple sources. He is no fan of Netflix’s subscription DVD rental model, and Warner was among the first studios to force Netflix to accept a 28-day window. But its keenest edge comes from the growing competitive threat Netflix poses to HBO, which Bewkes ran and helped build for many years before being promoted to the top job.

Though known increasingly for its original series, HBO is still fundamentally in the distribution business, just like Netflix. It’s revenue comes almost entirely from monthly fees paid by cable and satellite providers and their subscribers for HBO service, with a bit of icing on top from DVD sales and syndication of its original series; very little of its revenue comes from programming as such.

With 28 million subscribers at the end of 2010, HBO is the largest pay-TV distributor around. But Netflix is closing fast, finishing its most recent quarter with over 20 million. Not all of those Netflix subscribers are watching streamed video on their TV, of course. Some still just rent DVDs. But over 60 percent of them stream regularly.

Worse for HBO, its subscriber base has been declining for four straight quarters and is now at its lowest point since 2005, while Netflix’s is growing almost exponentially.

Worse still, HBO is finding itself with very little room to maneuver as it tries to respond to the rising threat from over-the-top providers like Netflix and Amazon’s new subscription service. HBO has spent decades positioning and marketing itself as a premium service, built on exclusive content. Prices for exclusive, premium content, however, are starting to climb, and with them the cost of maintaining HBO’s premium brand, as Netflix and others start to bid up the rights, as happened with “House of Cards.”

Offsetting those higher costs through higher revenues won’t be easy for HBO, however, at a time when its own subscriber base is stagnant and its cable and satellite affiliates are worried about cord-cutting. The situation is critical enough that some analysts have urged HBO to reposition itself as a basic cable network to expand its distributions affiliate fees, but Bewkes put the kibosh on that in a recent earnings call, presumably because it would be too stark a break from two decades of branding as a premium service.

Another option would be to open its HBO Go online service to non-HBO subscribers, but that risks alienating the cable and satellite affiliates on whom HBO still relies heavily for marketing and infrastructure support.

Netflix, meanwhile, has no pretensions to being a premium service, at least not at this point. It’s built its brand on value, convenience and breadth of inventory. Netflix does not need any particular piece of exclusive content in the way that HBO needs exclusive, premium content. It has the luxury of picking its fights, snatching up a few plums when it sees an opportunity, bidding up prices for everyone else in the meantime, disrupting established business models.

Back in January, Netflix chief content officer Ted Sarandos cheekily vowed to be a bidder for Warner Bros.’ pay-TV rights when the studios’ current deal with HBO comes up in 2014, aiming to drive a wedge between the two Time Warner divisions.

It’s classic asymmetric warfare. And for the moment, at least, the Albanians are winning.