Amazon's movie deal with Epix could be a game changer

Amazon.com Inc's deal to purchase streaming movies from cable network Epix could transform the way such deals are done, thanks to a pay-for-performance sweetener that had not been previously disclosed.

According to an executive directly involved in the deal, Amazon agreed to an earn-out provision payable to Epix over time if the number of subscribers to Amazon's Prime Instant Video service rises above a certain threshold. That comes in addition to a fixed upfront fee, the basis for most subscription video-on-demand deals up to this point.

The generous terms of the deal, announced in September, provide the strongest evidence yet that Amazon is willing to pay up to be a player in this market as it faces a dwindling demand for DVDs - once its core entertainment offering - and tough competition for its Kindle Fire tablets.

Film studios and TV network executives, meanwhile, now have a worthy foil to play against Netflix - once the only major streaming player - and possibly a template for future deals.

"This could be considered online video deals 2.0. After doing 1.0 deals mostly with Netflix and a few with Amazon, it dawned on the media companies that they may want to get a piece of any future growth too," said Goldman Sachs media analyst Drew Borst.

The deal with Epix - a partnership between Hollywood studios Paramount Pictures, Metro-Goldwyn-Mayer, and Lionsgate - was structured so studios could capture any rapid Prime Instant Video growth, according to the executive involved in the transaction.

Amazon did not respond to a request for comment on details of the deal. An Epix spokeswoman also declined to comment.

But Epix Chief Executive Mark Greenberg did say of Amazon: "Internet delivery of content is a way in which a new, emerging younger audience wants to view content, and they know they can be a significant player in the space, we are happy to help them get there."

Epix previously had a deal with Netflix , which had been paying $200 million a year since 2010 for exclusive rights to the network's movies. When that exclusivity period expired, Amazon swooped in and quickly struck a three-year partnership to add about 3,000 movies from Epix to Prime Instant Video.

The deal sent a message that Amazon, which has not had a reputation for paying richly for anything, was serious about its digital video ambitions and was willing to spend hundreds of millions of dollars to secure content.

"There are times when it's frugal to make big productive investments," said Roy Price, head of Amazon Studios, Amazon's Hollywood studio. "When there are opportunities to do that we will do that."

Hollywood's new best friend

The studios are going to benefit.

"Hollywood loves it because they can say Amazon is paying us X and we want more from you," said Michael Pachter, an analyst at Wedbush Securities in LA. "It's a club they can use to beat Netflix over the head."

A Netflix spokesman declined to comment on the structure of its content deals.

"We never thought that we were going to operate without competition," Ted Sarandos, Netflix's chief content officer, said during an investor conference last month. "We were surprised that it has taken this long for anyone to really emerge in a meaningful way."

Amazon's Prime Instant Video service has more than 25,000 titles now, but that is still about half the number available on Netflix.

In addition to Netflix, Amazon also competes with Hulu, run by Jason Kilar, one of Amazon's former executives, which has a subscription video service called Hulu Plus. Earlier this year, Comcast Corp launched a rival called Streampix and Verizon and Coinstar's Redbox are expected to launch a competing service soon.

While Amazon's streaming deals cost less than Netflix's in raw dollar terms, it pays more on a per-subscriber basis, according to media executives and Wall Street analysts.

Amazon offers its streaming-video-on-demand service (SVOD) as a feature of its Prime program, which charges $79 a year in the United States for free two-day shipping on most products the company sells.

The company does not disclose subscriber figures for its Prime service. But some media companies that have done streaming video deals with Amazon have seen the data. One executive who has seen the figures told Reuters Amazon has about 9 million Prime subscribers. Prime Video subscribers - Prime members who have used the streaming service - total between 3 million and 4 million, this person said.

Netflix's larger customer base - it has about 25 million streaming video subscribers in the United States - means its total cost in licensing deals is typically higher than Amazon's, said the executive. But Amazon's cost basis, when adjusted for subscribers, is typically higher since its customer base is smaller.

Amazon does not disclose how much it pays for content. Barclays analyst Anthony DiClemente estimates that Amazon spends about $1 billion a year on content for its streaming service while Netflix spends close to $2 billion a year.

Netflix shares dropped as much as 11 percent the day Amazon's Epix deal was unveiled, although they have recovered since then.

Netflix stock jumped more than 10 percent on Monday after Morgan Stanley upgraded the company, saying Amazon was unlikely to separate its streaming video subscription service from its broader Prime offering, making it less of a direct competitor.

However, keeping Prime Instant Video packaged with its Prime shipping program will help Amazon pay more for video content, because it can subsidize content costs from profits made when Prime customers buy more physical products through the company, Wedbush's Pachter said.

The importance of Prime

Amazon, which ranks as the world's largest Internet retailer, has been a leading purveyor of DVDs, but sales are falling as more viewers download and stream video instead.

The downward spiral of DVDs sales dovetails with Amazon's face-off against Apple Inc in tablet computing. Amazon is pricing its Kindle Fire devices lower than Apple's iPad with the aim of using it as a loss-leader to generate profit from the products and services consumers buy on its site, including digital movies, TV shows and books.

That means that gaining access to digital movies and TV shows is crucial for Amazon's future.

Since the middle of 2011, Amazon has announced streaming video deals with more than 10 media companies, including NBCUniversal, part of Comcast, News Corp's Fox, and ABC, part of Walt Disney Co .

Amazon has been selective about which content it will buy, in contrast to Netflix, which has opted to pursue a broader range, according to media executives who have done deals with both companies.

"The fact that they have spent a lot of money on a few things has been very interesting," said Netflix's Sarandos during last month's investor conference. "We're obviously keeping a good eye on it."

Commodity concern

Some media companies are treading carefully with Amazon, though, given its track record of driving prices down.

In the book and e-book market, where Amazon grew to be the dominant player, it has battled publishers for the right to set its retail prices below wholesale.

Amazon will have more difficulty commoditizing movies and TV shows because it is competing for content with a growing list of streaming video on demand rivals. And Hollywood controls how and when its content is distributed more tightly, with big-budget films traditionally heading to theaters first, followed by DVD and pay TV.

For example, one media company has short-term agreements with Amazon that allow for quick exits if the deal does not go according to plan, said an executive.