For the past few years the home video industry has been undergoing some traumatic changes. Although there was an almost seamless transition from the VHS to the DVD format, the shift to a high definition disc format has been stifled as a result of the format battle between HD and Blue-Ray. It’s also possible that consumers haven’t been convinced by a high-definition format will bring significant new benefits. In any case, it seems that the overall market has several challenges ahead.

Also while DVD sales grew strongly between 1999 and 2006, they have been dropped since then. During the same period DVD rentals grew at a slower rate but have plateaued around $7.5 billion during the past three years. Consumers are simply buying less discs, resulting in a greater importance for the rental segment.

This shift towards rentals may be led by the greater convenience of innovative subscription services like Netflix, and by lower priced rental options, as in the case of kiosks like Redbox that charge only $1 per rental. Since a kiosk requires a lower overhead cost, Redbox can offer rentals at $3 less than a video store. With its low price point and well placed distribution network of 18,000 kiosks, many at Wallmarts, Redbox has raised its share of the DVD rental market from 2.3% to 9% during the past year. This would be approximately half of the kiosk DVD business, based on figures from an NPD study. NPD also estimates that kiosks will grow to a 30% market share during 2010.

Unsurprisingly Redbox is seen as a threat both by Blockbuster, whose second quarter same store sales fell 18% this year, and by many production studios (although not Dreamworks) who see their DVD revenues flattening. In response Blockbuster is planning to open 10,000 kiosks over the next year and several movie studios have blocked Redbox from offering new releases for 28 days. This story is far from over since it remains to be seen how other factors like online video and VOD services will come into play but it does demonstrate that the DVD rental market while seemingly mature is far from settled.

CrunchBase Information on Redbox

Yesterday an article in The New York times highlighted the results of a media industry report from the private equity firm Veronis Suhler Stevenson (VSS):

An interesting shift occurred in 2008, the report said. For the first time, consumers spent more time with media they paid for, like books or cable television, than with primarily ad-supported media, like newspapers and magazines.

The VSS report also forecast internet media and subscription television to be sectors of strong growth during the next four years. These trends echoes the results mentioned in another report released a few weeks ago by Strategic Analytics (SA), which forecast that the global paid online video segment will surpass the ad-based online video segment in 2009. The SA report also forecast stronger growth for the paid segment during the next four years.

Both studies partly attribute the shift in balance towards paid content to the recession, which has stifled advertising budgets in both traditional and online media. In any case it is still surprising is to hear that paid video content will be a bigger moneymaker than ad-based content. While some companies like Apple and Netflix have made headway in the paid video segment a lot of studies have indicated that consumers prefer ad-supported models; an IBM study in November 2008 indicated that 70% of consumers prefer ad-supported models over consumer-paid models. Another study by Deloitte yielded similar results, indicating that 67% of US consumers aged between 25 and 34 would “be willing to be exposed to online ads in exchange for free content.

Although the majority of consumers would opt for ad-based video models, perhaps the smaller pay-to-watch segment is willing to outspend advertisers as a whole, in return for the following benefits:

• Zero or less advertising
• Access to a wider range of content (recent movies, old TV episodes, etc.)
• Ownership of the material or a longer viewing window
• Option to watch across more types of hardware (computers, DVR, mobile, etc.)
• Higher viewing quality

Given these trends in these reports during next two years the online community will see an expansion in paid video content. The ‘TV Everywhere’ partnership was recently launched by Time Warner and Comcast, allowing Comcast subscribers to view video online from TBS, TNT, CBS and HBO. I am also wondering if ad-based sites like Hulu will add paid content options; perhaps a subscription service similar to Netflix for accessing all the episodes for a series. Will hybrid sites emerge, offering both ad-based and pay-to-watch options? It is probably to early to guess which models will win (Hulu was launched only 17 months ago; see graphic above) but it is probable that a greater variety of options will emerge, resulting in a more choices and a very dynamic market.

Sometime on Wednesday February 11, Netflix passed the 10 million subscriber mark. This milestone was exceeded by how quickly the company reached it. During the past two months Netflix has grown by 600,000 subscribers; roughly double the rate of its previous quarter. At 1.2 million subscribers a quarter, Netflix would reach 14.5 million subscribers by the end of 2009, easily passing its projection of 11.3 million subscribers.

Many attribute the company’s quickening pace to the popularity of its video streaming service. Launched in 2007, it allows customers to watch video instantaneously on their PCs with broadband connections. This services was later expanded in 2008 to work via the Roku Player, Macs, Xbox 360s and Samsung Blu-Ray Disc players. Partnerships have also been anounced for 2009 via Tivo DVRs and Vizio and LG HDTVs. Equally vital to the device connectivity being offered with the service is the fact that broadband is now reaching roughly 60% of U.S. households.

Just as Netflix’s inital success was launched by the  popularity of the DVD platform this second stage in the company’s growth is being fueled by another rising adoption- broadband. Netflix is thus beginning a new s-curve.

There are other ways that Netflix is transforming. Using terminology from Chris Anderson’s book The Long Tail, Netflix is transforming from a ‘hybrid retailer,’ that is half digital and half bricks and mortar, to a ‘pure digital retailer,’ that has no physical inventory. Although the current streaming library is only about 10% of the total DVD library, this will surely expand in the future, thereby lowering operating costs as well as expanding customers options.

Personally, I believe this is just the beginning of a new trend in online video, which other companies like Google and Hulu are exploring, but which will come into light over the next two years as technologies further evolve and more deals get hashed out.