How the epic 'Lord of the Rings' deal explains Amazon's slow-burning media strategy

When Amazon pursued the rights to a "Lord of the Rings" series in 2017, the company knew it would have to overcome some major obstacles to lure the J.R.R. Tolkien estate to its video-streaming platform.

Amazon was a relative newcomer in video, with no track record of shepherding a blockbuster series. HBO, meanwhile, could tout its long history of hits, most notably "Game of Thrones," a similarly epic series based on fantasy novels with a rabid fan base. Netflix, with more than 100 million subscribers, pioneered the on-demand model with hits such as "House of Cards" and "Orange is the New Black."

And not to be ignored, Apple was also in on the negotiations to acquire the rights for the upcoming TV show, according to people familiar with the matter.

Amazon didn't have much by way of Hollywood cred. What it had was the richest person on the planet in CEO Jeff Bezos, a big "Lord of the Rings" fan, who was promising the Amazon Studios team a huge budget to nab the series, a prequel to Tolkien's "The Fellowship of the Ring."

But money alone wasn't going to separate Amazon from the pack — Amazon's $250 million offer wasn't even the highest bid for the show's rights, according to a person familiar with the matter. The ultimate selling point, according to people with knowledge of the negotiations, related to Amazon's original business from over two decades ago: books.

The Tolkien estate was convinced that in promoting the series, Amazon could sell truckloads of Tolkien's fantasy novels, including "The Hobbit" and "The Silmarillion" as well as "The Lord of the Rings." During meetings with the Tolkien estate and publisher HarperCollins, Amazon's Sharon Tal Yguado, who was hired from Fox in 2017, demonstrated a near encyclopedic knowledge of Tolkien's characters, stories and geography, said the people, who asked not to be named because the talks were private.

Amazon's ability to connect content to commerce won over the Tolkien estate. But just in case, to seal the deal, Amazon sent representatives of the Tolkien estate and its law firm, Greenberg Glusker, several crates of brand-new Amazon Echo speakers. Tolkien's people were flattered, though they also joked that Amazon delivered the home assistants to eavesdrop on the negotiations, two of the people said.

The "Lord of the Rings" series will start production in the next two years.

The huge investment in a TV series has made Hollywood wonder just how much Bezos will spend on content. So far, Amazon has dabbled across the TV spectrum, with original content such as "Lord of the Rings," a growing back catalog of movies and shows, as well as live sports from the National Football League and the Premier League. Just last month, Bezos was spotted chatting with NFL Commissioner Roger Goodell at the Super Bowl, a reminder that Amazon has several opportunities in the coming years to make a big splash in America's most lucrative sport. Meanwhile, The New York Post reported Thursday that Amazon is nearing a $3.5 billion deal to acquire the YES network, the regional sports network in New York that carries Yankees games.

Bezos has always taken the long view when getting into new business areas. Amazon Web Services launched in 2006 with simple hosted services targeted mostly at start-ups and companies with an experimental bent. By the time the rest of the industry realized Amazon was on to something and raced to launch their own cloud competitors, the company had built a huge lead. AWS now dominates the industry with 34 percent market share. It's the main driver of the company's profitability, earning $7.3 billion on sales of $25.7 billion last year — about 70 percent of the company's overall operating profit on only 10 percent of revenue.

The company can afford to take a similar long view with its media business and try many different approaches. So far, Amazon has used video primarily as a way to build Prime subscriptions. But the company's investments point to blending content and commerce in ways the world hasn't yet seen, eventually pitting Amazon against Apple and other tech giants for control of the home.

"Amazon hasn't gotten to the place yet where it has put together all of the levers that would make the video opportunity great," said Fred Seibert, the founder of independent production studio Frederator Networks, which is launching the animated show Costume Quest on Prime Video on Friday. "But five years from now, they're going to be one of the giants in media. There's no doubt about it."

When it comes to building businesses, Bezos doesn't follow traditional playbooks. Entertainment is no exception. Unlike HBO and Netflix, which buy content and spend on marketing and try to make all that money back through monthly subscriptions, Amazon has a more complex calculation that involves signing people up to Amazon Prime and making the annual membership package so compelling that they never leave.

If same-day and two-day delivery, Whole Foods discounts and unlimited music aren't enough, perhaps your addiction to "The Marvelous Mrs. Maisel," "Catastrophe" or "Lord of the Rings," plus a steady stream of exclusive feature-length films, will keep you happy. Jennifer Salke, who took the helm of Amazon Studios about a year ago, told the Hollywood Reporter last month that her strategy in acquiring content is to enhance Prime and "invest in things that we think will be great for the service."

Apple has a similar plan in mind with its yet-to-be-released streaming service, which will offer device owners free video and subscriptions to third-party cable channels, according to people familiar with the matter. The idea is to give users enough value that it becomes a hassle to ditch the hardware.

Amazon is so confident in Prime that last year it increased the yearly price to $119 from $99, the first hike since 2014. According to estimates from Consumer Intelligence Research, the number of Prime subscribers recently topped 100 million, and on average those customers spend about $1,400 per year, compared with about $600 per year for shoppers who aren't members.

Amazon is playing many games at once with media: It not only offers its own Netflix-like service but also its own streaming hardware — Fire TV devices — and connections to other content channels. Once in the Amazon universe, cord-cutters can pay for streaming services separate from a traditional cable bundle. For example, Prime users can add Showtime or Starz for $8.99 a month. Amazon takes a cut of the revenue, typically about 25 percent for the largest companies, when a customer signs up.

Amazon Channels — as the third-party service is known — has given traditional media companies a global platform to launch shows, said Jeff Hirsch, chief operating officer at Starz, which last year expanded into the U.K. and Germany.

Hirsch said Channels has helped Starz, which is owned by Lionsgate, attract a broader audience of subscribers, because they can get the channel via the Amazon app rather than having to download the separate Starz app through Roku, Apple TV or another streaming device. Amazon also poses less of an existential threat in media than Apple, which blew up the music industry by eradicating album sales with 99-cent digital tracks, or Netflix, the original Hollywood disruptor.

"We view them as a partner," Hirsch said. "We have a wonderful relationship with Amazon, and it's gotten stronger. We've been very successful in terms of driving customers to their platform, and they've been great partners in helping us grow digitally."

The Channels business replicates the traditional TV model of aggregating video channels, but without forcing customers to pay for a package of stuff they'll never watch. And there's all sorts of niche content that can now potentially find an audience.

Think of it as an extension of Amazon's retail play: Create the world's largest online shopping mall and then invite smaller businesses to pay a toll in exchange for using the site to reach many millions of new customers. Seibert envisions Costume Quest, which is about supernatural monsters, being promoted alongside searches for physical comic books and related merchandise.

Amazon will be "one of the biggest friends to viable specialty channels in the next several years," Seibert said. "Offering media is a great service for customers looking for something special."

If Amazon Channels is the neutral platform playing nice with content creators, Amazon Studios is a different beast altogether. It competes directly with the entertainment industry for original shows and movies.

Amazon will spend $5 billion to $6 billion this year on content, according to an estimate from BTIG media analyst Rich Greenfield. That is a decent-sized bet for Hollywood but a tiny fraction of Amazon's operating expenses, which topped $220 billion last year. Netflix will likely spend about $15 billion on content this year, Greenfield estimated.

There's no questioning Bezos' willingness to up the ante. He's got an increasingly healthy balance sheet — net income tripled to $10 billion in 2018. And investors have given him plenty of rope when it comes to spending.

Still, Amazon hasn't rolled out a three- or five-year plan to reach Netflix-level spending. In fact, the company has no specific multiyear road map at all when it comes to content purchases, according to people familiar with the matter. Bezos and Jeff Blackburn, senior vice president of business development and digital entertainment, prefer not to plan more than 12 months in advance, the people said.

That lack of planning and strategic focus may help explain why Amazon Studios has floundered at times in recent years. Prior to Salke taking over last year, Amazon Studios had been run by Roy Price, who departed Amazon amid sexual harassment allegations in late 2017.

Like Salke, Price's stated strategy was to invest in shows that supported Prime. Amazon looked at who was watching a given show and saw how much that person was using Prime for other perks, mainly free shipping. If a Prime subscriber watched a show a lot and wasn't taking advantage of Prime's other benefits, the show got credit for that customer's subscription dollars, according to people familiar with Amazon's internal methods.

Price was focused on high-minded, potentially award-winning content to lure users into Prime. His team had several hits, including "Transparent" and, more recently, "The Marvelous Mrs. Maisel," which won the 2018 Emmy Award for best comedy series. He also bought "Manchester By The Sea," winner of the 2017 Academy Award for best original screenplay, and "The Big Sick," which received an Academy Award nomination for its screenplay.

Price's division also had some expensive misfires, such as Spike Lee's 2015 film "Chi-Raq" and a disastrous five-year movie deal with Woody Allen, who's now suing Amazon Studios in a $68 million breach-of-contract lawsuit.

In his three years running the business, Price purposefully avoided mass-appeal broadcast content, so that he could clearly differentiate Amazon from normal TV and justify the Prime membership. But buying niche, art house content wasn't a great approach to drawing tons of new people to Prime. David E. Kelley, the creator of shows such as "Ally McBeal," described Amazon's entertainment division in 2017 as "a bit of a gong show," in an interview with The Wall Street Journal. He added, "They are in way over their heads."

Insert Salke, who was hired because of her prior experience at NBC and 20th Century Fox, where she bought and developed shows including "Modern Family," "Glee" and "The Good Place." Her mandate was to deliver broader hits with more of a broadcast sensibility, according to people familiar with the matter.

Under Salke, Amazon has finally started to focus on "films and series with broader appeal that resonate with the wider consumer base that uses Amazon," said Floris Bauer, the co-founder and president of independent studio Gunpowder & Sky. "It's not to say you can't do award-winning films, but you're only hitting a certain group. It was a missed opportunity initially."

Amazon didn't make Salke available for an interview for this story. An Amazon spokeswoman declined to comment for the story.

Perhaps the biggest wild card in Amazon's role in the entertainment universe is live sports, a market that's still dominated by legacy networks and cable and satellite companies.

Amazon is tinkering around the edges. Last year, the company inked a deal with Ultimate Fighting Championship to air pay-per-view fights. There's no discount available for Prime customers, but Prime is still very much in the equation. In the negotiations, Amazon asked the mixed martial arts league if it would consider scheduling more pay-per-view female fights, people with knowledge of the discussions said. Amazon told UFC its internal data indicated that an increase in female matches would appeal to Prime users, the people said, thus offering opportunities to promote Prime before, during and after matches.

The pitch didn't work — UFC said top-level female fighting is still in its infancy and can't fill out a schedule — but the request underscored Amazon's broader effort.

In August, Amazon hired Marie Donoghue from ESPN to run sports programming, and the company will almost certainly become more aggressive at buying live sports rights in the coming years, according to people familiar with the company's long-term strategy. Separate from Amazon Studios, Donoghue's team also reports to Blackburn.

The NFL is by far the most-watched league in the U.S., and chatter about its potential future with Amazon has picked up since Bezos' appearance at the Super Bowl.

AT&T's DirecTV has locked up NFL Sunday Ticket, which allows millions of Americans to watch out-of-market games on satellite TV or their mobile devices, through 2022. Sunday Ticket was central to AT&T's $49 billion acquisition of DirecTV in 2015, and the joint company is now paying $1.5 billion a year for the rights.

But the NFL has an opt-out clause after the 2019 season that would allow it to end the DirecTV deal or potentially sell streaming rights separately.

That's not Amazon's only opportunity for getting into the action. ESPN's contract for Monday night games ends after the 2021 season, and Fox and CBS own rights to Sunday games through 2022. Thursday night games, currently on Fox, and Sunday night games on NBC come up for renewal at the same time.

Amazon has streamed Thursday night games globally for the past two seasons and will next year as well, but those rights are digital only, so they don't require fans to choose Amazon over traditional TV. The company has also been pursuing baseball, holding talks with the New York Yankees for joint ownership over the YES Network, CNBC has reported. And Amazon struck a deal last year to exclusively stream 20 Premier League soccer matches.

It all adds up to a hodgepodge of assets that Amazon could potentially own as it expands its empire.

"This is not just about showcasing football games on Thursday night," Greenfield said.

"This is selling you a jersey. This is potentially selling you a ticket. There's so much more that Amazon can do than just simply stream a game. They can probably sell advertising better than any TV network because of the data they have and they know exactly what I like."

Amazon has one other weapon that gives it a distinct advantage over Netflix and its other media peers: the Echo. As more of the Alexa-powered devices populate consumers' homes, it's not hard to imagine tighter integrations with smart TVs. That opens Amazon up to all sorts of untapped opportunities with advertising and cross-selling products.

"Amazon knows how to run a store," said Seibert of Frederator Networks. "They're walking toward how to make media work. If they can marry the two, everyone else in the media business will start to scramble."

It was the Echo, after all, that Amazon used to sweeten its offer to the Tolkien estate for "Lord of the Rings."

"There is an all-out war for the control of your media life," Greenfield said. "I think the reality is these big tech platforms, who have valuations and market caps and cash piles that are massive relative to traditional media, they are just getting started."

— With assistance from Michelle Castillo

Disclosure: NBCUniversal is the parent company of NBC and CNBC.