Opinion

Felix Salmon

The problem with Netflix

By Felix Salmon
April 24, 2012

Nick Thompson today asks whether Netflix is doomed, and gives a fantastic potted history of how the company managed to pivot from being a wonderful DVD-by-mail company to being a clumsy digital-platform play.

While I agree with Nick’s conclusion, however, that Netflix is in a very tough spot, I disagree with the way he gets there:

It’s not easy for a startup to build massive warehouses and systems for mailing discs. It is easy, however, to get into the streaming business. Yesterday, for example, we learned of a startup called NimbleTV, which plans to let you watch all the channels you subscribe to through your cable provider on your phone or your tablet…

Netflix fears that just distributing digital content is a mug’s game. Anyone can move bits around, which means that the price for doing so will just keep dropping. So it’s trying to create its own original content. But, so far at least, it’s not very good at doing so. “Lilyhammer,” a mobster show that Netflix introduced in January, has gotten killed by reviewers; I gave up on the first episode after fifteen minutes of mediocre acting and clumsy dialogue. Early next year, Netflix will release a new season of “Arrested Development,” which will surely be better. But the company is in an odd spot, facing the same competition problem it avoided when it spun off Roku. If its shows are bad, it’s embarrassing. If they’re good, they could irritate partners. Netflix needs content from AMC, for example. But will those negotiations get harder once Netflix is creating its own shows to compete with “Breaking Bad” and “Mad Men”? …

It won’t be easy for Netflix to find a way to fend off its new competitors while keeping its old partners happy.

The way I see it, Thompson has this backwards. I think he’s dead wrong about the barriers to entry in the streaming business: they’re high, and if I were Netflix I really wouldn’t be worried about other streaming companies right now. As far as I can tell, Netflix is the only company in the world which is great at persuading millions of people to pay a regularly monthly fee for streaming content online. And while it might have competition on that front in the future, right now that’s the least of its worries.

Rather, Netflix’s problem is with what Thompson calls its “old partners”. There is a stream of money coming from Netflix’s subscribers, and Netflix is competing with its “partners” for that money. The studios have learned that Netflix will pay astonishing sums for streaming rights — orders of magnitude more than it ever paid for DVDs. And while Netflix used to be able to rent out a DVD hundreds of times after buying it once, under the streaming contracts it has to pay the studios every time a movie or TV show is streamed.

This is why I’m fundamentally pessimistic when it comes to Netflix’s prospects: any time that Netflix builds up a profit margin, the studios will simply raise their prices until that margin disappears. Netflix needs the studios more than the studios need Netflix: no one’s going to subscribe to Netflix for Lilyhammer and Arrested Development alone. And while HBO has managed to build up a good business by producing original content, Netflix really doesn’t want to be HBO, it wants to be much bigger than that. It wants to be a one-stop shop for video content, rather than a single channel among hundreds.

The problem is that if you’re a one-stop shop, then you have limited negotiating power to tell any given studio that you won’t pay their price. Netflix’s subscribers are, ultimately, paying for the content, not for the pipe. And so it stands to reason that Netflix’s revenue stream will go the people making the content rather than to Netflix itself.

Comments
16 comments so far | RSS Comments RSS

Netflix seems to be holding on to a profit margin, so far. They just have to turn a profit between contract negotiations, which only come up every few years. They’re not lacking for a catalog of movies, either, since the studios seem content to let Netflix do the work of streaming all their older content that no longer sells DVD/BD.

That said, they’ll get forced into the role of “old content streamer for little to no profit” if they don’t grow the user base large enough. Growing their user base is Netflix’s best hope – if they have a truly huge number of subscribers, then even the studios can’t afford to simply cut off that audience.

Posted by Brett__ | Report as abusive
 

Of course studios can try to raise their prices to capture more margin, but if Netflix is the preferred consumption channel of a big chunk of consumers, what are the studios going to replace that royalty stream with if they walk away from the negotiating table? Is Hulu going to pay them more somehow? Are people going to start buying DVDs again?

Posted by right | Report as abusive
 

Economics 101….distrubtors are middlemen and therefore the first to get squeezed.

Posted by mfw13 | Report as abusive
 

I believe that Felix’s point dovetails nicely with the argument that there are relatively low barriers of entry in streaming, and in fact I think the view that Netflix needs content owners more than vice versa depends on it. If Netflix truly has a strong competitive position as the biggest distributor for streaming content, then it should have leverage to maintain a profit margin, at least if streaming is a more than miniscule part of the market.

I share Felix’s pessimism about Netflix’s prospects, however, even while I quibble with some of the logic. I look at streaming this way – content that belongs to a studio/production company is being delivered to a consumer over a wire (or spectrum) that belongs to a telco or cable operator, with a 3rd-party (Netflix or a competitor) coordinating this service, paying for content, and billing the consumer for it. Who has the least leverage? Who is most easily replaced in this equation? The logical end-game is for one or the other side of the equation to cut out Netflix. I think that the cable/telcos will do so if streaming takes off. They already have billing relationships with consumers as well as business relationships with most content producers due to overlapping ownership between content producers and TV networks.

Posted by realist50 | Report as abusive
 

I don’t get the NimbleTV model.

On the face of it, it’s rather quite stupid. The proposition is, that cable will retain its customers if they provide the means for customers to stream movies to all sorts of devices, whether their phone, tablet, computer or screen.

That’s not why people are cutting the cord.

People – like myself – cut the cord because cable is a bad value proposition. In many cases, you have to pay for HD signal, which would otherwise be free, over the air. That’s pretty dumb. Then you have to pay for a bunch of lousy channels that you really don’t care for, followed by dealing with the nonsensical remote control for their HDR boxes.

Have you ever wondered, for instance, why the volume up button moves the volume up, but the channel up button moves the channel down? Yeah, I’m talking about you, Comcast.

FWIW, Hulu+ is a far better value proposition than anything the cable companies and NimbleTV could offer.

Posted by GRRR | Report as abusive
 

GRRR – even with Hulu+, you’re still paying either a telecom or cable operator for the bandwidth that you’re using to access Hulu. If streaming to replace cable TV packages becomes a big enough phenomenon, telecom/cable will come up with a solution that may not be quite as good but is good enough for most people. Matching the competing price point will be tough for Hulu and Netflix since the telcos/cable operators are bundling their streaming services with broadband. Even if independent streaming services survive – and I’d say that Hulu will likely survive but is only quasi-independent since NBCU, Fox, and Disney all own stakes – this pressure will certainly limit the profit upside for a streaming operator.

I think that streaming services will suffer the same fate as the independent DVR makers like Tivo and ReplayTV, who could never make much money once cable (and telecom, in areas where it sells video) decided to bundle DVR functionality as an incremental service.

Posted by realist50 | Report as abusive
 

Felix and mfw13 are absolutely right.

I want the best content/value proposition.
I don’t care about the distribution method.

As NFLX steals more and more share from the cable guys they are simply going to have to pay more and more for the content rights.
No content = no subs.
The value in NFLX is as an AGGREGATOR.
They have to have a critical mass of content otherwise viewers simply won’t cut the cord.

The genius of providing your own content is that if you find yourself with a hit on your hands, that alone can justify the subscription fee for many people.
Back in the day, it would be fair to say that plenty of customers were paying $15 a month or whatever to HBO in order to watch 1 episode per week of the Sopranos.
Sure they were offered other content but the Sopranos was the killer-app.

Posted by TinyTim1 | Report as abusive
 

I’m not sure it is that big of an issue for Netflix, unless the tv companies just want to screw themselves over.

I know quite a lot of people who have Netflix but the choice isn’t between subscribing to Sky (UK) for a show or streaming it on Netflix. It’s download the show for free to watch at your convenience on your pc/tablet/phone or stream it on Netflix. As it is most new shows are not on Netflix here so it is being used because of the large back catalogue, range of movies, and good recommendation system. If the content providers pull it from Netflix we would just watch a different show there (or if desperate, download. If I started watching Breaking Bad today the odds of me finding a tv channel showing it from episode 1 are pretty much nil. It is Netflix or download).

So anyone who charges Netflix too much won’t get people watch it on their channel/online subscription, they will generally just lose viewers.

Posted by ABT | Report as abusive
 

I note that in the book and music markets, the preeminent digital distributors (amazon and apple, respectively) have considerable leverage, despite the fact that in each case, unlike with Netflix, there are serious competitors for the distributors (ironically, among them, Apple and Amazon, respectively). What accounts for the difference.

Posted by JonS311 | Report as abusive
 

ABT, your thesis, “I’m not sure it is that big of an issue for Netflix, unless the tv companies just want to screw themselves over,” ignores history.

Content companies have a long history of screwing themselves over in such cases (see Napster and Bit Torrent).

Basically, they value control over sensible business decisions, because they want to rent seek the next big thing.

Posted by Matthew_Saroff | Report as abusive
 

I tend to think that unlike online music streaming services, Netflix doesn’t really need to have all the content, just enough that you don’t feel an urgent need to go elsewhere. They don’t stream 2 Year Old Romantic Comedy Starring Katherine Heigl? Well, you can watch 2 Year Old Romantic Comedy B Starring Reese Witherspoon instead. That leaves them a little room to negotiate, and so they can hold on to a sliver of their margins.

It’s different in the streaming music space, where customers are a lot more disappointed if a service doesn’t offer a particular song. Streaming music companies’ contracts are written to guarantee that they will never be profitable. With Netflix, it’s only very likely that they won’t be profitable.

Posted by guanix | Report as abusive
 

I agree with Felix that Netflix faces serious long-term risks getting into distribution of streamed content. I also doubt that it could produce its own content efficiently; the entry costs are too high, given that it is a late entrant into content production for cable.

It is unfortunate that Netflix set the market price for purchasing rights to streamed video at a time when its stock price was at an all-time high. Now that the stock price has fallen, one wonders whether paying hundreds of millions of dollars for content from a single studio bears any relationship to the ability to recoup that that on a reasonable cost-per-subscriber basis. It would have been far better to work out a per-view deal with large studios.

There’s nothing more difficult for a farsighted company to do than walk back a premature price structure that it has set when it underestimated the time necessary to arrive at the future. But I wonder if that isn’t the best strategy. Pick up all the cheap streaming video they can (probably not from the major studios), and depend on their original strength: the efficient distribution of dvds. Rushing to become the next HBO, even if they correctly perceive the long-term trend toward streaming content, may be a recipe for an early exit.

There is one thing that Netflix does own: an excellent proprietary algorithm for telling its customers what movies they will like, based on their own ratings of previous movies. As the catalogue of visual content expands infinitely over the next century, viewers will need a lot more information in order to sort through what is available — not merely how they can get the latest movies most conveniently in their homes.

I think that Netflix should focus on its core dvd distribution, pick the cheap, low-hanging streaming fruit, and play itself as an innovative guide to new media, individually tailored to its customers. And hope that after others have made unsuccessful efforts to make streaming pay — including perhaps the studios — they can re-emerge as the major media aggregator/distributor of all producers of streamed content.

Posted by jbernar | Report as abusive
 

Netflix’s problem is not that it is a middleman. Netflix’s problem is that it is one of many middlemen, all of whom face tremendous uncertainty. The movie industry, measured by the revenues of the content producers, is flourishing, but the distribution channel is an ungodly mess of competing institutions and technologies, presently forced to cooperate just to keep the revenue flowing. The theater owners have had a vice-grip on the promotion of films: films are reviewed by newspaper critics when they are theatrically released (and given only perfunctory notice, if that, when digitally released). For most films, however, the theatrical audience contributes a barely significant portion of its revenue. The enormous cost of staging a film’s theatrical release is purely an advertising expense. (The simple fact is, and has been for more than two decades, that every movie is a ‘made-for-tv’ movie.) The studios’ power rests in their control of theatrical distribution channels. Eliminate the theatrical release (i.e. establish a more effective advertising channel), and the studios become obviously dispensable.

It should also be noted the extraordinary advantage that Netflix has in the industry: it is, in fact, the leader and has consistently displayed a better grasp of the market and where that market is going than any of its competitors. Moreover, from the producers’ point of view, the subscription model minimizes losses to piracy. The producers will always need a middleman, and Netflix may well be able to perform that function for a smaller commission than the others.

Posted by SBayer | Report as abusive
 

JonS311 – in the digital music (or app) market, Apple has clout a distributor because it sells hardware and uses that position to enforce a closed system that gives iTunes a monopoly (or near-monopoly) on distribution to its hardware. Amazon does something similar with e-books and the Kindle.

If you’re talking about Amazon in physical books, that’s more akin to Netflix’s DVD business because of the benefits of scale in physical warehousing and shipping operations.

BTW, also take a look at Amazon’s margins. It is a high revenue, low margin business (less than 2% operating margin). Netflix might be able to survive in some form as a streaming service, but if it does I (and Felix)doubt that it will make much money.

Posted by realist50 | Report as abusive
 

Netflix HAS done a great job of convincing people to pay a monthly fee for streaming, but I like my approach a bit better. I feel I get more content, and more varied content through my TV provider. I have Dish, and now that every company is jumping on the streaming bandwagon, I have the perfect combination of broadcast TV and streaming online. A Dish coworker told me about Dishonline.com, and I never knew how much was available. I have the Sling loaded 922 HD DVR, and I can now go to Dishonline.com and stream thousands of movies, shows and more. I can also enjoy or control my DVR, and all from my laptop or PC. I just have more options with Dish than with Netflix.

Posted by erussell715 | Report as abusive
 

I for one absolutely love Netflix streaming, it is the best thing since the ATM and microwave! I wonder what would be the outcome if Netflix was bought by a company with influence like a Wal-Mart? As Microsoft bought shares of Barnes and Noble Nook; the potential of those two together are endless. Netflix and Wal-Mart (once adversaries) would make a powerful entertainment team that would be able to make demands to studios and distribution companies rather than kneeling and surrendering to the entertainment masses.

Posted by Anthony52 | Report as abusive
 

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