Taking Stock of Netflix

Fred Wilson has a nice post on Netflix and vigorous discussion ongoing on AVC today.  Netflix has been a favorite topic on this blog. Fred’s post is a good opportunity to catch up on what I think of where Netflix has been and where it is now:

1) I am a huge admirer of Netflix in disrupting the video rental business, and in its efforts to disrupt the MVPD (i.e. cable and related distribution) business.  Netflix has been one of the gold standard examples of “disruptive innovation” over the last decade.  See this post.

2) The MVPD market (worth hundreds of billions in the US) has left itself massively exposed after at least a couple of decades of annual above-inflation price hikes, a primary driver of which has been the bundling of channels in basic-level tiers combined with the ever-increasing costs of sports rights.  As I noted in this post:

This model is threatened by Netflix and other such models.  To the extent that you are not interested in live sports and are willing to endure a certain delay in watching other programs (for example, when a series is available on DVD).  Netflix gives you the option to cut the cord.  You can fill in news online.  If non-sports watchers stop handing money over to the cable systems and subsequently over to the sports networks to help pay for the inflated sports rights, one of the stool legs making those ever-increasing prices possible — namely the willingness of cable and satellite subscribers to also pay higher rates for their television subscription packages– will be weakened, threatening the system.

3) HBO is an appropriate role model for Netflix, and it appears that Netflix has molded itself in that way.  Selling a service for $10-20/monthly both distributing non-original content and producing groundbreaking original content has proven to be incredibly profitable.  HBO is sui generis, but the advantage that Netflix potentially has is that HBO is “tied to the cord” and is hurt by the constantly escalating prices of basic packages which consumers are increasingly unable to pay, since consumers cannot access HBO without buying the bloated basic package.  As the Economist put it, “imagine a supermarket where, in order to buy the item you really want, you first have to buy almost everything else in the shop. Now imagine the price of all those other items is constantly rising.”  In contrast, Netflix can position itself as a cable alternative.  There is tremendous opportunity in this model and positioning.  See this post on the HBO model.

4) In order to be HBO-like, Netflix had to enter, at least in a small way, the original programming market, which it has done, with its acquisition of the “House of Cards” series.  See this post.

5) Perhaps even more importantly, HBO needs the studios to play ball to give it access to television and movie properties for its streaming service.  The studios — most who have a direct or indirect interest in the immensely profitable distribution business — have been vocal in their lack of interest in providing Netflix with the programming that would facilitate its undermining of the distribution business.   By becoming a competitor in the programming acquisition market, Netflix sent a “mutually assured destruction” message to the studio-distributors — if you don’t cooperate with us on the streaming business, we will compete with you in the content acquisition business, raising your costs if you are heavily invested on the distribution side.  See this post for an interview with Reed Hastings.

6) While Netflix’s game theory has been brilliant, a few recent developments make me very worried recently.  First, the content providers have seemed to decide that they are not playing ball.  The contents of the streaming cupboard were pretty bare anyway. Starz was the highlight, and its breaking off negotiations with Netflix, took out a lot of the little premium content that was there.  Netflix needs to figure out a way to get the content providers to the table.

7) Second, the 60% price increase was totally misconceived and has alienated customers.  See this post on the price increase.  It sent the message that Netflix was overvaluing the streaming content, when many customers clearly know it is not.  It also sent the message, probably not intended, that Netflix was undervaluing its DVD business.  In fact, Netflix’s advantages in the near-future are in the DVD business where it has built up a hard to match distribution infrastructure, and where it does not need the studios’ cooperation because of its legal freedom to distribute DVDs for rental.  In streaming, Netflix does not have an indefensible infrastructure, and it needs the studio’s cooperation.   As I said in the prior post:

Because of the limited available content, streaming is just not a compelling enough product yet for Netflix to hang its hat on.  There are a number of emerging competitors in that business including Amazon, Apple, and Google, and, in addition, Netflix does not control its destiny because it needs to negotiate with content providers for streaming.  By contrast, the mail part of the business and Netflix’s superior logistics in executing that business are what distinguishes Netflix, in particular as the video rental stores have been boarded up.  My guess is that Netflix will be quite happy for the mail business to continue given the strong defensible position it has there regardless of the infrastructure and postage costs, while it further develops the streaming business into an experience that resembles the original mail offering instead of resembling it’s less interesting and less capable step brother.

8) Perhaps most importantly, on the streaming side, Google, Amazon, Apple, Dish/Blockbuster among others, are in the market.  They have other ways to make market from streaming.  For example, Amazon can bundle the price into its Amazon prime delivery fee. Google will find a way to monetize its content through its core business of ads.  Apple obviously makes huge profits by selling high-margin hardware like iPads. These other companies also have other carrots and sticks to play with the studios because of their other businesses than Netflix has.  See this post on Amazon, and this post on Google, and this post on Dish/Blockbuster.

I have hope for Netflix, because it is led by visionary management, that it’s not impossible for it to find a way out of this snakepit, but at the moment I am not very bullish.

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