Is HBO's Deal With Amazon.com a Mistake?

Source: Amazon

On April 23, news broke that Amazon (AMZN -1.64%) and Time Warner (TWX) struck a deal where the latter's HBO services would be provided on Amazon Prime Instant Video and Amazon Fire TV. Although not all of the terms have been made public, it's probably not too hard to tell which of the companies is the likely winner in the long run and which might lose out down the road.

Time Warner's HBO is a strong business

Source: Google

Over the past three years, Time Warner's HBO operations have seen mixed but generally good results. Between 2011 and 2013, the segment's revenue rose just 9% from $4.5 billion to $4.9 billion. According to the company's most recent annual report, the rise in sales was driven entirely by its subscription revenue, which jumped 12% from $3.8 billion to $4.2 billion. This increase was due largely to higher rates domestically.

This was partially offset by the segment's content revenue, however, which declined 10% from $730 million to $658 million. In its annual report, management attributed the drop in content revenue to a combination of lower home video and original programming licensing revenues.

Source: Time Warner

While the growth rate experienced by HBO has been modest at best, its operating income growth rate was phenomenal. Between 2011 and 2013, HBO's operating income increased 28% from $1.4 billion to $1.8 billion. This improvement in profitability can be chalked up to the segment's rising sales, but it can also be attributed to its cost of revenue which fell from 51.7% of sales to 48.4% as direct operating costs came down.

Will Time Warner end up losing in the end?
Earlier this year, Amazon claimed that it had more than 20 million Amazon Prime members. While the exact numbers have never been disclosed, an estimate using this number and the service's $99 annual membership fee means that Amazon can be expected to bring in revenue of $2 billion this year if the subscriber base remains unchanged.

Source: Amazon

With the hopes of growing this portion significantly over time, Amazon struck this deal with Time Warner. Time Warner will, in turn, provide top series to Amazon Prime Instant Video. To complement this, HBO GO, which has 1,700 titles in its system, will begin streaming on Amazon's Fire TV by the end of 2014.

The main drive behind this deal is to increase customers for both parties. In the short run, the deal will create for Amazon's subscribers an incentive to not discontinue the service after the business raised prices by $20 in early March. In fact, for the fans of many of HBO's shows, the deal may even serve to draw in more customers.

For Time Warner, the incentive is similar but the payoff might not be as nice. In the short run, the company will likely see some increased revenue. Its goal of creating new HBO subscribers could be hard to meet, however. Yes, the company will have access to the 20 million or so members who utilize Amazon's platform, but it's hard to tell how many of these, if any, will convert to HBO-specific subscriptions who don't already have them.

Foolish takeaway
Based on the data provided, the short-term benefits for both Amazon and Time Warner are fairly clear. Amazon will have more content, which will make its service more appealing to any of the 127 million HBO subscribers who don't use Amazon Prime. Time Warner will get access to up to an extra 20 million or so viewers.

The real risk, however, is what the long-term implications will be. Yes, the deal should prove accretive to both parties now, but for existing HBO subscribers, there will be a greater incentive to axe their monthly HBO payment and opt for Amazon's services.

Source: Wikimedia Commons

On top of having access to HBO, the $99 annual payment will bring with it other content, while providing other nice perks like free two-day shipping on millions of items and access to free Kindle e-books. In short, Time Warner's agreement with Amazon could be setting it up for a customer exodus if viewers find Amazon's platform more economical, which could ultimately leave investors holding the bag.