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Has success spoiled HBO?

The jewel in Time Warner's crown experiences growing pains

If financial value could be pegged to industry kudos and Hollywood street cred alone, HBO would be the single most valuable property in the vast AOL Time Warner portfolio.

As it is, the pay net is more like buried treasure within its corporate parent. It’s grown cash flow by nearly 20% over the past three to five years, maintained a steady 30% profit margin (including an estimated $800 million off revenues of $2.8 billion last year) and has steadily increased production budgets for its programming thanks to a stable earnings stream from cable and satellite operators.

But the cost of its success as a genre-defining global programming brand and pay TV provider may not be cheap.

HBO’s decision to hinge its future brand and earnings strategy on the back of original programming has inevitably jacked up talent costs, not to mention increased expectations, so Chris Albrecht will have his hands full.

And with new subscribers harder to come by, the company must devote more of its time to minimizing churn and up-selling new services to its existing customer base.

But HBO’s continual reinvention in the face of pending obsolescence has been at the heart of its business model.

Brand building

And despite concerns that this now-mature pay TV business might be hard pressed to sustain its breakneck pace of sub-growth, network strategists are instead focused on building the brand.

“We’ve changed our financial complexion over the last three to five years,” says chief operating officer Bill Nelson. “It’s in our DNA to continually reinvent ourselves, and we’ve done that.”

Company execs say they saw subscriber growth stagnation in the increasingly competitive multichannel landscape sufficiently far ahead of time to devote resources to differentiating and building a brand around programs for which it owned 100% of the backend. Not only was groundbreaking original programming key to finding new subs and reducing churn, it formed the basis for a more diversified business and earnings stream.

“Most people think of us as only a pay TV company,” says Nelson. “They don’t see is as the dynamic, multifaceted media company that we are. Because of the breadth of our original programming, we’re more like a mini-Hollywood studio.”

But defining itself as a studio — albeit one with a captive paid audience of 27 million — rather than a pure pay operator carries new risk. The true test of just how far HBO can slice its audience without diluting its own market may come later this year if the network manages to find a basic cable or broadcast home for “Sex and the City.” Some doubt whether a watered-down version of such a signature show will entice new viewers or cannibalize alternative SVOD or DVD sales.

The company is also hedging its bets with its recently inked distribution arrangement with AOL Time Warner sister company Fine Line Features, allowing HBO to decide which movies to release. So far, HBO’s risk profile for production has remained adamantly different than its sibling Warner Bros. film studio, where co-financing of big budget projects is increasingly the norm.

Creative control comes first and won’t be sacrificed for financial aid, say company sources. What limited co-production HBO does tends to come in the form of advances.

But while the company is committed to fully financing its entire product in order to exploit the back-end globally, it risks the same issues of rising costs as its rival studios.

Buried as it is within AOL Time Warner’s corporate labyrinth, precise figures on HBO’s finances are a well-guarded secret. But not so well guarded that the network can’t brag a little.

HBO doubled its margin from around 14% to just under 30% in less than a decade, while boosting revenues 10% last year, even as its sub growth slowed. Even in a competitive market, it’s managed to sustain around 1 million adds a year for the last six years, mostly thanks to the boom in DBS and digital cable.

On top of that, company sources say the network can count on a steady 4%-5% increase in its affiliate fees annually, thanks to adding on new multiplexes for no extra charge to consumers.

But such success is both a blessing and a curse, since the pressure to repeat past performance is greater as its parent company labors under a hefty debt load and company-wide ethos of cost-cutting and risk-hedging.

At the core of HBO’s business model and comprising 80% of annual sales are fees from pay TV subscribers and affils. But that ratio is expected to fall in the next decade as the network looks to leverage its solid base of 27 million U.S. homes (plus internationally) to sell more programming through alternative channels.

HBO probably doesn’t get enough credit for its value, consolidated as it is within AOL Time Warner’s broad category of “cable networks,” alongside the Turner nets, say analysts. But it’s also hard to put a firm value on the pay TV net, since there have been no recent transactions with which to peg a true market multiple. The net generates approximately 17% of AOL Time Warner annual sales, a hefty burden for any single unit.

Nelson, the operations man behind Albrecht, admits it’s more difficult to maintain the sub growth rate given the slowdown in multichannel household growth in cable and DBS.

That’s why HBO is counting on subscription video-on-demand, for which it gets an incremental fee from digital cable ops, as well as premium high definition packages, a new theatrical distribution effort, and global TV syndication of some carefully selected titles to keep the top line percolating.

Year to year, however, there can be huge profit fluctuations, Nelson says, due to cash-flow dampening-mega-budget projects like “Band of Brothers.”

Much of the boost in the past three years has also come thanks to DVD sales of its original programming like “Sex and the City” and “The Sopranos.” HBO has also struck it lucky, with the windfall from owning homevideo and TV right to “My Big Fat Greek Wedding,” so far the No. 2-selling DVD of the year.

Nelson anticipates bigger gains from HBO’s growing emphasis on small theatrical releases, which enable some of its sub-$5 million feature to recoup at least half their production costs prior to broadcast or video release. First experimental outing “Real Women have Curves,” for instance, grossed around $6 million at the box office, easily covering a good chunk of its $5 million budget after theater splits.