Netflix and the economics of nonrival goods

By Felix Salmon
October 24, 2011
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.

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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.

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Comments
10 comments so far

In light of the exorbitant price paid by Netflix to stream movies of a single studio, Dreamworks, it will be interesting to see how the market for internet movie streaming plays out. Netflix risks losing customers if it doesn’t continue to pay high prices in order to offer complete libraries.

A new technology depends for its success on the level of costs set at the time of its introduction; these set the size of its customer base. The extraordinary prices for streamed movies have been established at the height of a bubble in Netflix’s profits. In order to recoup them, Netflix will have to continue to raise its subscription prices.

In the short run, the studios most likely can’t (or won’t) help Netflix establish more realisitc initial costs that customers are willing to pay. They can wait to see whether Netflix goes bankrupt paying costs at the former standard. Studios could, after all, decide to stream their own movies (99 cents per?). The technology of streaming potentially restores oligopoly to movie distribution, coming full circle back to the days when studios were permitted to own theater chains, excluding middlemen.

Posted by jbernar | Report as abusive

This seems overcomplicated. Here’s an easier version: Hastings, no matter what he says, wants to position Netflix as a competitor to HBO (or at least Showtime). That means offering content those networks don’t have – just as their pitches are based around their exclusive content.

You can debate the amount Hastings and crew are paying (though I’d be wary of placing too much stock in most reports about Hollywood dollar figures, period) for a particular product. But the strategy is straightforward.

Posted by peterkafka | Report as abusive

@peterkafka – Gee why didn’t you just say that over on ATD?

3 dreamworks movies cost more than Q3′s profit…hahahahaha, there is something wrong there, perhaps NFLX has been seeking help from the children in the EFSF math class

Posted by jpstrikesback | Report as abusive

Felix, aren’t you assuming that there is a market – beyond Netflix – for non-exclusive licensing? I actually don’t think that HBO et al. are interested in those rights, and so even if Netflix wanted to buy non-exclusively they probably wouldn’t get any discount from the content owners (here, Dreamworks) because they (DW) won’t have any additional buyers to add to their revenue pool. If this is the case then exclusive licensing is DW’s profit-maximizing choice.

also, jpstrikesback, the better measure would probably be (amortized) content costs versus revenue, not profit. wouldn’t a basic econ (perhaps naive) approach be to make marginal content spends until they equal marginal revenue generated, e.g., net sub adds?

Posted by dana.powers | Report as abusive

Comcast and Time Warner both charge more for the family cable package than they do for broad band internet access. The cheapest way to access a wealth of content is broadband cable + netflix. You lose a lot compared to the family cable package… mostly the live sports on ESPN and regional sports channels. You also cut the cost by almost half.

Netflix’s largest asset is not its freshest most expensive content it’s the long tail that makes NFLX so useful to most of its customers. They will not be able to keep spending as much as they have on content because they simply don’t have the revenue to do it. Industry anaylists and investment anylists alike will be shocked at how many customers NFLX retains just offering 2nd and 3rd tier programming.

What would a family with children pay for a service which offers over 1000 commercial free kids shows which you can start at the exact moment you want? The answer is more than NFLX charges for their entire streaming package currently.

Think of it another way… the #2 or #3 radio stations in every major market in the country play rock or oldies music. That’s people chosing to listen to content at least 20 years old that they have hurd dozens of times. Netflix’s value isn’t fresh A+ content… it it’s low cost long tail B+ content. The sooner Reed Hasting learns out the more NFLX shares will be worth.

Posted by y2kurtus | Report as abusive

Comcast and Time Warner both charge more for the family cable package than they do for broad band internet access. The cheapest way to access a wealth of content is broadband cable + netflix. You lose a lot compared to the family cable package… mostly the live sports on ESPN and regional sports channels. You also cut the cost by almost half.

Netflix’s largest asset is not its freshest most expensive content it’s the long tail that makes NFLX so useful to most of its customers. They will not be able to keep spending as much as they have on content because they simply don’t have the revenue to do it. Industry anaylists and investment anylists alike will be shocked at how many customers NFLX retains just offering 2nd and 3rd tier programming.

What would a family with children pay for a service which offers over 1000 commercial free kids shows which you can start at the exact moment you want? The answer is more than NFLX charges for their entire streaming package currently.

Think of it another way… the #2 or #3 radio stations in every major market in the country play rock or oldies music. That’s people chosing to listen to content at least 20 years old that they have hurd dozens of times. Netflix’s value isn’t fresh A+ content… it it’s low cost long tail B+ content. The sooner Reed Hasting learns out the more NFLX shares will be worth.

Posted by y2kurtus | Report as abusive

This is one of the worst posts I have ever seen on the internet. Do you not think there is a good BUSINESS REASON why HBO wants to have exclusive content? You think that TWC wants to preserve media monopolies “as a matter of principle” and that somehow HBO “prevented” Netflix from coming to a non exclusive deal w DreamWorks? That simply ridiculous.

This is seriously so stupid I almost think you are doing it for comedic effect. Do you not think that HBO, one of the most successful and profitable content companies in the world, might actually have a good reason for making exclusive deals? Do you not think that maybe, just maybe, Netflix might be thinking the same thing?

The arrogance of using uncommon terminology like “nonrival good” combined with the complete ignorance of economics or the topic at hand makes me want to puke.

Posted by McMath | Report as abusive

I like y2kurtus’ analysis. You make a lot more money being Walmart than being Tiffany

http://ycharts.com/companies/WMT/market_ cap

http://ycharts.com/companies/TIF/market_ cap

But as so instances demonstrate, many CEO’s make decisions that have nothing to do with a pragmatic, realistic analysis of the market. Ken Lewis wanted to be biggest, so he bought an obvious pig in a poke (Countrywide).

What is “Cowboys versus Aliens” worth 8 months after it comes out? I might spend 50 cents to see it…

Posted by fresnodan | Report as abusive

Felix, note the other end of exclusivity…the ability to give it up.
You make a key point that Netflix and HBO could both bid for and get a Movie, pay less then otherwise, and the studio would make more money. Win win?
Netflix could also pay 30 million for exclusive rights, turn around and sell share rights to HBO for 15 million, in effect transferring the profit from the studio to itself…if it’s allowed to do so.
Also a win-win, but profit to NEtflix instead of the Studio

==RED

Posted by REDruin | Report as abusive

Felix-

I think there’s a key point that you’re missing here with exclusivity, and that’s Netflix’s rising competitors beyond HBO. Netflix wants exclusivity not because it wants to prevent HBO from airing, but because it wants to prevent Amazon Prime and other rising competitors in the streaming business from ALSO carrying that good. At a time when customers are less loyal to Netflix than they were before, being able to market themselves as unique from their competitors is important.

Each exclusive contract they get differentiates themselves from ANYONE who wants to enter into the market (and now many companies are), and helps them maintain their market share.

Now, I’m not saying it’s still a smart business deal at the price they paid, but it’s certainly defensible for many legitimate business reasons you don’t address.

Posted by dontpush | Report as abusive
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