Weekly Update

For Wal-mart, There’s More to Vudu Than VOD

The initial reaction to Wal-mart’s acquisition of digital movie service Vudu last week, reportedly for $100 million, included a sizable helping of skepticism. Having failed in digital movie distribution twice before, some experts argued, Wal-mart was simply setting itself up for a three-peat with the Vudu deal. Others insisted consumers are unlikely to invest in a pricey new Vudu-enabled HDTV set just to get access to movies they can already rent or buy on DVD or stream from Netflix, making the deal a waste of money for Wal-mart.

And, if video-on-demand movies were all there were to the deal, those criticisms might be warranted. But the acquisition of Vudu has more to do with technology than movies on demand, and it’s both audacious in its ambition and potentially far-reaching in its implications.

From Wal-mart’s perspective, Vudu has two valuable assets. The first is the HDX encoding format, which Vudu introduced in 2008. With HDX, Vudu claims it can deliver full 1080p video over the Internet in 4.5 Mbs of bandwidth. Moreover, the format is optimized for screen sizes over 40 inches and includes a process Vudu calls TruFilm, which enhances the cinematic experience of a home theater through techniques such as preserving film grain and other textual qualities of the original source material.

That gives Vudu a distinct quality advantage over competing IP-video services like Netflix, iTunes, and Xbox Live, which rely on less-sophisticated encoding formats. Even the nominal HD content from those other services is typically encoded in 720p at best and at lower bit-rates. More critically, those encodes are typically optimized for smaller screens, so the quality degrades as screen size increases.

More critically for Wal-mart, however, HDX and TruFilm are proprietary. Content encoded in HDX will not interoperate with other streaming platforms because those platforms do not (and cannot) support the HDX format. Similarly, content encoded in other formats will not interoperate with the Vudu platform, unless Wal-mart chooses to support other encoding formats.

Which brings us to Vudu’s other valuable asset from Wal-mart’s perspective: It has deals in place to embed its streaming platform in HDTV sets and Blu-ray players with seven of the nine largest electronics makers by market share. Given Wal-mart’s size and global presence, those manufacturers have a powerful incentive to continue embedding the Vudu client and, more importantly, to not embed anyone else’s.

Over time, then, Wal-mart could end up with a very large installed base of connected TV sets and set-tops with its proprietary streaming platform baked in — potentially far larger than anyone else’s installed base, including current leader Netflix.

That will give the retailer even greater leverage with the studios and other content owners than it already has. Though DVD sales are declining, packaged media remains a crucial source of revenue for Hollywood, and Wal-mart is the largest buyer of DVDs and Blu-ray discs in the world. Soon, it could also have the largest, proprietary channel for delivering high-def video to the living room via the Internet. Together, those will  give Wal-mart the clout to dictate windows, pricing, technical standards and just about anything else it thinks it needs to reinforce its dominant position in the market.

They will also, over time, make Wal-mart a competitive threat to incumbent video service providers, like cable and satellite operators. Not only will Wal-mart’s Vudu platform lack the geographic restrictions of cable’s franchise systems, but TV set makers will actually bear the cost of rolling it out, helping to create a virtual, nationwide distribution platform at almost no capital-investment cost to Wal-mart.

Given the potential upside, paying $100 million for a VOD company could turn out to be a steal.

Question of the week

How worried should Netflix be by Wal-mart’s acquisition of Vudu?