Reed Hastings set out to build a service that would destroy traditional video rental. Irritated with late fees from a popular rental store, he began work on what would be one of the most interesting growth stories in the 2000s: Netflix.
Hastings guided the company with unusual focus. His forward-looking approach led him to launch the service as Netflix, rather than DVD-by-Mail – another name under consideration. His thinking was simple: Netflix would eventually be more than DVDs by mail.
The company caught on, and quickly. Customers raced to Netflix’s physical media business, which was unique in a world where brick and mortar rental services still owned the lion’s share of the industry.
The Downfall of Competitiveness
Netflix had one very clear advantage in cost. Netflix, through a string of warehouses, could provide less expensive rental services to its customers. Traditional rental companies had much higher overhead – retail spaces on well-trafficked roads, and employees earning hourly wages at all hours of the day. (Video stores used to be open late!)
We know how this story turned out.
Netflix destroyed every brick and mortar company in existence. Today, only unmanned Redbox machines survive.
But what Netflix did for the consumer in making rentals easier to access at lower prices, Netflix will never duplicate for investors. Netflix is game-changing for us – the many millions who use its services – but that hardly makes it a good investment.
Netflix in Competitive Markets
Netflix operates in one of the most competitive markets on the planet: distribution of digital media. While Netflix still owns the entire DVD by mail business, the DVD is not the future – digital distribution is.
Consider the value proposition that Netflix offers consumers. Those who use its services do so because it is inexpensive. Netflix’s extreme value is the only thing capable of creating agreement in the personal finance blogosphere.
But Netflix fights dangerously against the powerful tides of economics. Netflix grew by grabbing new subscribers who were marginal cost consumers. That is, Netflix sold media to people who might not otherwise purchase it – people who wouldn’t pay full price for a full service like cable. This worked out splendidly until cable subscribers dumped cable for online streaming.
Eventually, content producers realized that Netflix was cannibalizing their more profitable customers. Content producers who might make $.50 per month from cable fees per user would instead make $.10 per month from Netflix subscribers. Once cable started losing to Netflix, content producers inevitably pushed back.
Netflix’s Shooting Star Burns Out
Wall Street was completely smitten by Netflix’s extreme revenue and user growth that it forgot what really mattered: profits. The company soared to new heights, selling more and more subscriptions. It seemed like this was the game changer.
Everyone forgot the economics of the business, however. Netflix’s glory years were the result of:
- Contract Mispricing – Netflix purchases the rights to carry streaming movies over several years. The contracts were not pricing in the extreme growth of Netflix’s service. Multi-year contracts signed in 2006, for example, were exceptionally cheap when you spread the cost out over the user base in 2008 or 2009. When these contracts came up for expiration, Netflix paid far more per user to keep the same content it had always had.
- Unforeseen Competition – Technology likes to use the phrase “first mover advantage” to imply that a company that moves first usually has the scale in place to keep customers and to thwart competition. When it comes to a commodity product, however, it does not matter who moves first. ExxonMobil, a commodity producer, is a company with a long history – it is related to John D. Rockefeller’s Standard Oil. But just because Exxon moved first doesn’t mean that it could keep all other oil companies away from the oil business. Amazon, Apple, and Redbox all have their sights set on digital media distribution; entering this business isn’t as difficult as people tend to think.
- Misunderstanding of Cost Savings – Analysts and investors wanted Netflix to explore streaming content. Going from DVDs to digital content would save $1 billion in postal costs. But who would reap the savings? The obvious answer is Netflix, right? Not so fast! Netflix is merely a middleman; it is nothing without the content it contracts from other parties. The studios know they have the upper hand in negotiating, and it has become clear that the bulk of the cost-savings are flowing to studios in the form of higher content costs for streaming media. In effect, Netflix ticked off its user base (and lost millions of users) by separating DVD and streaming media into two products all for the financial benefit of the studios.
Use Netflix as a Very Valuable Lesson
There is much to be learned from Netflix as a case study of sorts:
- Examine Long-Term Contracts – Many companies perform exceptionally well for short periods when contracts work in their favor. Southwest Airlines looked like it had something special when it had the thickest margins of any airline in the boom years. There was nothing special at all – in fact, it was just a one-time, multi-year benefit from hedges on jet fuel. Those contracts eventually expired, and Southwest again looked merely mediocre.
- Competition Matters Most – Apple and Amazon could not be happier to push Netflix out of the digital distribution market. Both have their own services where they sell content on a pay-per-view basis, not an all-you-can-eat buffet like Netflix. Amazon is making a business of destroying the margins in retail, content delivery, and web services. Apple has $100 billion in cash it can throw around to push existing businesses out of commission. Netflix’s one trick pony of a product has to compete with two well-financed competitors who are willing and able to lose money for a substantial period.
The lesson is this: some businesses look as though they have an edge when they really do not. Netflix’s low-cost, long-run contracts made it appear to have a real competitive advantage until those contracts expired. Netflix looked like it could secure exclusive contracts without end…until competitors came into the market. The company also looked like it could replace traditional cable, until studios wised up to the fact that Netflix cannibalized consumers that the studios had in their back pockets.
Netflix is a great service for members. I use its product with regularity. However, Netflix is just a middleman in a business where many people want to be the man in the middle. To compete, you have to do it on price. For Netflix, that means giving up more and more of its would-be profits just to stay alive. It’s not the product; it’s the economics of the business.
A value investor and blogger who enjoys discovering the hidden gems available on the public markets.