Netflix and the economics of nonrival goods
Netflix released its third-quarter results this afternoon, showing net income of $62 million, down slightly from the second quarter’s $68 million. And things are going to get much worse before they get better: “We expect to report a global consolidated net loss,” the company said, in the first quarter of 2012. Maybe the company shouldn’t have spent $40 million, over the course of the third quarter, buying back 182,000 shares at an average price of $218 apiece. (In the wake of today’s results, they’re trading in the $80s.)
In hindsight, it’s pretty clear that Netflix CEO Reed Hastings let the bubblicious stock price — it briefly topped $300/share at the beginning of the quarter — go to his head. The company was swimming in money! And so, in September, Hastings signed a deal to pay $30 million per movie for everything that DreamWorks creates, in return for the right to stream those movies a few months after they’re released on DVD. It’s known as the “pay-TV window”, and in order to wrest those rights from HBO, Netflix had to outbid HBO, which was reportedly paying something in the neighborhood of $20 million per movie.
It wasn’t even the first time that Netflix went head-to-head against HBO in a bidding war: Hastings says that HBO was an underbidder back in March, when Netflix won the exclusive rights to TV series House of Cards. And in the case of the DreamWorks deal, remember that Netflix already gets all those DVDs the day they come out, long before streaming will be allowed. The $30 million per movie was just for the Netflix customers who have streaming and who either don’t have the DVD service, or who want to watch the movie but haven’t got around to watching it on DVD yet.
A lot of ink has been spilled over Netflix’s decision to separate its DVD and streaming businesses, and to increase its prices sharply. Those decisions are, surely, the proximate cause for its torrid present. But the big-money deals show the same amount of arrogance, with even less business justification. It’s obvious why companies raise prices: they think they’re going to make more money that way. But why would Netflix spend hundreds of millions of dollars preventing movies and TV shows from being shown on HBO? That’s much less obvious.
When he’s on the record, Hastings loves to say that his core market is simply people who want “unlimited streaming for $8 a month and a vast catalog”. Movies and TV shows are nonrival: if all he’s interested in doing is maximizing the size of his catalog, then there’s no need for Hastings to exclude HBO from running the exact same content. But flush with a soaring stock price, Hastings decided that he was willing to pay eye-popping sums of money to turn his nonrival good into an excludable good: if he has it, then HBO can’t have it too.
I can see why people might want to spend small amounts of money to do that. A certain part of Netflix’s actual and potential subscriber base has HBO, and some of those people will decide that HBO is good enough for them and that they don’t need Netflix as well, and maybe if Netflix keeps House of Cards from HBO then some of that subset will decide to subscribe to both, and Netflix will get extra subscribers. But there’s no way the economics can be worth the kind of sums being bandied about here.
Indeed, the whole DreamWorks deal, in particular, seems Pareto sub-optimal for all concerned. Wouldn’t all three parties have been better off if DreamWorks had agreed to license its movies in the pay-TV window to both HBO and Netflix? If Dreamworks got, say, $15 million from HBO and $25 million from Netflix, then DreamWorks would have made an extra $10 million per movie, while both HBO and Netflix would have gotten the movies for $5 million less each than they were willing to pay.
My guess is that it’s HBO which prevented such a deal from happening — it’s owned by Time Warner, which has its own interest in preserving big-media monopolies as a matter of principle. But I doubt that Netflix fought very hard to abolish the exclusivity provision — no matter how much money it was spending on content, its market capitalization was rising even faster, so the market was saying that it was doing something right.
Now, however, things are different. The market doesn’t trust Netflix to run itself efficiently and effectively any more, and deals like these are going to be scrutinized a lot more closely. As a result, I suspect Netflix will be much more open to sharing content with Time Warner than it has been up until now. Whether Time Warner is in any mood to reciprocate, however, remains to be seen.