Netflix may be playing a dangerous game, but it's not doing so recklessly. To the winner, goes untold spoils.

Even when underestimated, Netflix’s ever-escalating, industry-leading content spend remains a point of fear and fascination in the media industry. Each year, Netflix’s subscriber base and revenues grow (an average of 29% and 35% over the past five years), but its content spend grows faster (39%). And as the company has embraced its streaming business and washed its hands of its profitable DVD business (which Netflix stopped marketing in 2013), cash losses have swelled. In 2014, Netflix generated $16MM in cash from operating activities, but by 2017, it was losing $1.8B. In 2018, cash burn is expected to grow to $3-4B and CEO Reed Hastings has promised negative free cash flow will persist for “many years.” The company also reports more than $9.1B in debt payment obligations (up 93% year-over-year) and has $18B in content obligations (up 27%).

As a result, Netflix bears and competitors claim the company’s content spend is reckless. Not only does it imperil the company and its stakeholders, they say, but the company’s largesse and imprudence has also destabilized the industry. There’s no way to disprove this allegation, of course, but it misses the point on what Hastings is trying to achieve. Netflix’s goal is to have more subscribers than any other video service in the world, and to be the primary source of video content for each of these subscribers. The company doesn’t want to be a leader in video, or even the leader in video – it wants to monopolize the consumption of video; to become TV. This ambition has several important consequences, especially relating to the company’s spend.

 

#1: Content Ceilings

Netflix’s content ceiling (in terms of volume and spend) is its monetization ceiling. The more subscribers the company amasses and the higher it can push its pricing, the more content it can produce – which in turn drives more subscribers, more engagement and more pricing power. This flywheel is endemic to SVOD, but unique in the history of television. Linear television networks have always been bound by a finite number of primetime slots and the size of the total primetime audience. Accordingly, a network with 15 viable slots would only add a new show (say #16 or #22) if it replaced one of its existing 15; the only thing that matters is relative outperformance. Netflix faces none of linear’s limitations – any series that can meet the company’s target cost per hour watched contributes to its penetration and engagement (as do those that don’t, albeit less efficiently). Accordingly, there’s no reason the company’s share of English-language original scripted TV series (as an example) can’t or won’t grow from 15% of national US output in 2018 to a third or even half the industry. And those figures exclude Netflix’s foreign-language original series (whose US viewership numbers Hastings and chief content officer Ted Sarandos continue to promote). Free of structural limitations, Netflix’s output is bound only by the company’s ambition and its ability to attract audience – both of which are unprecedented in its category. It follows that content spend would be, too.

 

#2: Monopolization Dynamics

Also unique to the SVOD era is the fact that, whether deliberate or not, a dominant market player will crowd competitors out of the market. While watching ABC at 9pm has historically meant missing whatever was airing on a competing network, no network could monopolize time or competition. In addition, the pay-TV bundle meant that most networks benefited from both guaranteed distribution and a substantial revenue floor (i.e. affiliate fees); failing out of the industry was essentially impossible. The bundle also meant that competitors were never more than a remote click away. Viewers could just as easily discover, access and watch a market leading channel as a laggard. A competing show only had to be marginally better – if just during that specific episode – to steal a customer attention. Cumulatively, this meant no network could satisfy all audiences simultaneously (nor could the consolidated footprint of the major network groups); there was always a competitor airing something more precisely targeted a given viewer. Moreover, the differences in TV “daypart” audiences and economics meant that success (or even monopolization) of one daypart (e.g. 7am-10am) was of limited consequence in others (e.g. primetime). Every pay-TV household had access to hundreds of competing networks, financially supported almost all of them, watched dozens and routinely used more than 15.

Conversely, online distribution encourages audiences to concentrate their watching time and enables networks to monopolize their viewers’ attention. Much of this comes from the fact that unlike pay TV, most online video subscriptions are sold a la carte and on a month-to-month basis. This has four major implications. First, it’s harder for viewers to discover competing networks or sample their content, as they’re no longer a channel change away. Second, it’s harder for any network to acquire new paying customers, as this requires each would-be subscriber to first decide they’re willing to spend more money each month, then go through the process of signing-up. And even when a paid customer is acquired, retention is a challenge. A few great shows each year isn’t enough to sustain 12 straight months of paid subscriptions and avoid “binge-and-churn” subscriber behavior. Fourth, the viewer experience of managing multiple streaming networks is rough. Unlike pay TV, which bundles all channels onto a single output with a consistent UI and centralized guides, OTT video requires audiences to contend with multiple apps, with different watchlists and interfaces (e.g. some have individual user profiles others don’t; some boast great UIs, others are horrid), not to mention variable definitions of reliability and streaming quality. On top of this, internet-enabled personalization and on-demand distribution allows a digital network to be all things to all people at all times – no longer are dozens of channels needed to satisfy the various interests of a single zip code. And finally, digital networks are free to air any content at any time – and as such, any consumption lubricates additional consumption and prevents consumption of a competitor.

Collectively, this produces a powerful positive feedback loop for any market leader – which we’re already seeing with Netflix. In an unbundled environment, audiences will only leave a streaming service for another if they need additional or different content. As the streaming service’s reach, output volume and value become more dominant, each of the aforementioned the challenges become even harder for competitors to overcome. Even the central dynamic of network/SVOD competition, content, has distorted. Today, Netflix is able to launch B-grade shows to greater results than the A-grade shows released by its competitors. This also means Netflix can not only reach a larger audience with a given title than its competitors can, but it can do so more cost efficiently. This makes it easier for the company to economically outspend for A-grade content (e.g. forthcoming series from Barack and Michelle Obama, Ryan Murphy and Shonda Rhimes), and discourage existing suppliers from withholding their content in order to go direct-to-consumer themselves. Accordingly, Netflix’s ever-increasing spend and output continues to get less risky, not more, and further insulates the company from competitive pressures.

This is the key to understanding Netflix’s total market potential and its willingness to overspend. Netflix’s critics often point to the fact that while Netflix’s volumes (and viewership) have far outstripped those of its direct competitors (e.g. Hulu, HBO, Showtime, FX), it’s a fraction of the total marketplace. What’s more, competitors such as Amazon and Apple are rapidly re-aggregating channels such as HBO and Showtime at scale – and the price of both pay-TV bundles and a la carte subscriptions continues to fall as bundles are slimmed and strategic underpricing proliferates. However, Netflix’s goal is to functionally replace the entire bundle– to have so much content that customers don’t need another general entertainment aggregator, be it Hulu or DirecTV Now. Audiences would still have a few focused carve outs, such as HBO, ESPN or Disney, but rather than enlisting for Discovery + AMC + ABC + Nickelodeon + Showtime etc., the average household would just need Netflix. Not only does the company benefit from a virtuous cycle in pursuit of this goal, this would save the average household hundreds of dollars per year even if Netflix doubled or tripled its monthly fee. This end-state might seem ambitious, but that’s why Netflix’s spend is both substantial and aggressive – the goal isn’t just satisfying current subscribers, it’s to replace almost all its competitors. (For those who think this is far-fetched, we’ll get back to Hastings’ overt declarations of war in a bit).

 

#3: The New Scale

In the cable era, “scale” was defined by having your channel distributed to 85MM of 100MM TV households out of 110MM total households, then having it watched by 25MM, regularly watched by 10MM and valued by fewer still. Netflix, meanwhile, has already amassed 55MM a la carte US households, each of which actively pay for the service and use it an average of two hours a day, plus another 65MM paid subscribers outside the US. At this scale, content costs will inevitably outstrip the precedents set by the company’s single-market competitors (who, again, are in bundle-based oligopolistic competition). More important, the largesse of this spend is justified by both the enormity of the opportunity (the $450B TV industry) and the company’s attempt to dominate it. This is the crucial point.

Hastings knows that if Netflix falls short of, say, 250MM subscribers, his business will buckle and break. His spend is predicated upon it. Accordingly, some say that company’s strategy – which Sarandos claims is “more shows, more watching; more watching, more subs; more subs, more revenue; more revenue, more content” – more closely resembles that of a Ponzi scheme: Netflix takes on more debt to finance more content in hopes of getting more subscribers so that past content investments can be recouped, but then needs even more subscribers to pay for the new content spend, and so on. However, this is largely a question of time horizon. Unlike a Ponzi scheme, Netflix’s spend can level and its market leadership solidify. Yes, if Netflix were to have its 2020 subscriber count in 2018, it would likely still burn cash – but that’s because the company is optimizing for neither year. It’s not even optimizing for 250MM target, per se, it just needs to hit it.

Though more than twice the company’s current subscriber base, 250MM is achievable. Hastings believes the company can hit between 60-90MM subscribers in the United States, which would represent 50-75% penetration. By applying similar rates to the most similar markets, Canada and the United Kingdom, you can add another 23-35MM households. Netflix’s priority EU countries (Germany, Italy, France, Spain) contain another 112MM homes, so 25% (half of the US minimum) penetration would add another 29MM while 50% would provide 56MM. Australia and New Zealand are likely to contribute another 5MM, with South Korea and Japan a likely 25-35MM. This provides a low of 150MM and a high of 225MM before addressing other major markets, such as Brazil (64MM total homes), India (280MM) and Mexico (30MM), and the rest of the world (ex-China). It’s safe to say Netflix is planning for the upper end of its achievable range, which many estimate is as many as 400MM. Even at the low end, Netflix would have achieved greater dominance than the media business has ever seen.

And embedded in the company’s global ambitions is the opportunity to substantially raise prices. In the US, for example, Netflix is primarily displacing significantly costlier video time (e.g. $80-100 pay-TV subscriptions). Furthermore, the company remains deeply discounted on a usage basis versus its core competitors (Hulu, HBO, Showtime, Starz, etc.) – and arguably even on a quality basis, too (Netflix had three of seven Outstanding Drama Series nominations and two of seven Outstanding Comedy Series nominees at the 2017 Emmys). To date, Netflix has prioritized low prices to drive penetration. Accordingly, the streaming service’s pricing growth has substantially lagged growth in penetration, usage and content spend. But if/as the company achieves de facto monopolization, pricing power will surge and the need for strategic underpricing will have expired.

 

Know Thy Enemy

Netflix has never been shy about publicly giving away its strategy. It was in 2012 – four months before the premiere of its first originally produced series, House of Cards – that Netflix first declared it wanted “to become HBO faster than HBO can become us.” The company regularly declares how many series it plans to release; how many US subscribers it believes it will hit; what its competitors should do; what it expects long-term margins to be; how much it anticipates spending to increase each year; how long it expects to continue losing money; how it makes content investments; why, how and to what ends it makes technology investments (notably, Netflix has a large GitHub presence); and which parts of its business it cares to own and operate and which it doesn’t; which decisions it outsources exclusively to data, and what data it considers and ignores.

Even Netflix’s plans to not just surpass HBO, but to monopolize and replace TV altogether is reiterated daily on Netflix’s Top Investor Questions page:

We compete with all the activities that consumers have at their disposal in their leisure time. This includes watching content on other streaming services, linear TV, DVD or TVOD but also reading a book, surfing YouTube, playing video games, socializing on Facebook, going out to dinner with friends or enjoying a glass of wine with their partner, just to name a few. We earn a tiny fraction of consumers’ time and money, and have lots of opportunity to win more share of leisure time, if we can keep improving.

Netflix first communicated this in its late-2013 “Long-Term View” – back when the debate du jour was whether Netflix was a TV network, such as AMC, or MVPD, like Comcast (the answer was neither):

If you think of your own behavior any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.

We strive to win more of our members’ “moments of truth”. Those decision points are, say, at 7:15 pm when a member wants to relax, enjoy a shared experience with friends and family, or is bored. The member could choose Netflix, or a multitude of other options.

And then there’s Netflix’s April 2017 tweet “Sleep is my greatest enemy.” Understanding this mentality is critical to understanding what Netflix does and why. It isn’t fighting to win a timeslot, an overnight rating, or an advertiser. It’s after every minute of leisure time available – an economic term that refers to all time not spent working. The magnitude of this ambition is without comparison in media – and it follows that the spend and investment losses required to realize this ambition would be similarly shocking. What’s more, it means the company is ultimately in competition with content platforms such as Facebook, YouTube, Instagram and Snapchat – each of which primarily provides content that is free to both the platform and its users.

This is why the company’s biggest question is what will inevitably come next, and why the answer is unlikely to be just linear pre-recorded video. If Netflix has 250-400MM subscriptions (with an average of three user profiles per subscription), each spending at least three hours a day on the service (and thus accessing it multiple times per day), the company will have built a paid consumer platform with greater engagement than Facebook. This reach (defined by users x frequency) is phenomenally powerful, and when added to the “all leisure time” ethos and virtuous cycles, it’s hard to imagine the company will stick with premium non-linear content.

Cloud gaming, which everyone is scrambling to “be the Netflix of,” seems like a natural fit. Netflix has the most sophisticated at-scale video delivery and compression technology in the world, to the point of accounting for 20% of global downstream bandwidth. The video gaming industry is looking to cloud gaming as an opportunity to attract those who don’t consider themselves gamers (and are unlikely to buy a console or standalone cloud gaming subscription). When the technology is ready, Netflix is the perfect on-ramp.

Similarly, Netflix is likely to be at the forefront of interactive storytelling. On-demand distribution, ad-free delivery and binge release strategies have certainly unlocked greater storytelling complexity, but every original series released by Netflix and its competitors could be shown on a 1960s CRT TV. The color and resolution would be worse, but it would still be the same Stranger Things and Orange is the New Black. However, the devices we are instead using to watch these series are vastly more complex than even Y2K-era cars. Not only do they include a dozen sensors (including facial recognition/tracking, gyroscopes and accelerometers), they also know everything about us (from where we were earlier that day, to who our closest friends are and what they look like). By tapping into these capabilities, storytellers can create experiences that are more immersive, emotional and personal than ever before – and in doing so, enhance the most foundational element of storytelling: the suspension of disbelief. Given Netflix’s reach, product expertise and predilection for creative experimentation, the company is unlikely to let this opportunity for content reinvention go to waste.

Adding live sports to Netflix seems unlikely for at least the next decade as few rights are available and the streaming service is better positioned to dominate non-linear content (which is both cheaper and less competitive). But if Netflix is able to out-monetize every other video service on the planet and wants to further grow its share of time, the option will always exist. And this is the point. Whether Netflix pursues any of these opportunities or all three, this is what the company’s “reckless spend” is buying. Not just a shot at market leadership or even category dominance, but the option to pursue everything we do when we’re not at work. And that’s exactly what Hastings wants.

Part 1 of this series explained that Netflix spends far more on content than is typically reported. Part 2 explained how (and why) Netflix uses product and technology to economically outspend its competitors. Part 4 explains why the term ‘Original Series’ if often a lie – and how Netflix uses this fact to beat its competitors.

You can reach Matthew Ball at mb.ball@gmail.com or @ballmatthew