Netflix, born an underdog, now eats underdogs
The Blockbuster I used to drive to for a weekend DVD is now a Goodwill.
Watching Last Week Tonight on Sunday, I thought about that during the segment about one of last remaining Blockbuster stores in existence. John Oliver awarded the store with a leather jockstrap (it makes sense if you watch the clip). Whether Oliver knew it or not, Sunday also marked the 20th anniversary of the day Netflix opened up its DVD-by-mail site.
Back in April 1998, Titanic had just swept the Oscars, the Dow Jones Industrial Average had just crossed 9,000, and The Big Lebowski was being ignored in theaters (before becoming a DVD cult hit as Netflix took off). And Netflix? It went by NetFlix.com, boasted 1,000 movie titles, sported a spartan home page, and, for $4, would mail you a DVD in the mail in two to three days.
Blockbuster, meanwhile, was the DVD-rental Goliath with more than 6,000 stores, 87 million members and a 27% share of its market. When Viacom spun Blockbuster off in a 1999 IPO, the prospectus didn't even mention Netflix as a competitor (although it did warn of adverse effects of “new technologies.” In 2000, in a rare moment of self-doubt, Reed Hastings offered to sell 49% of Netflix to Blockbuster for $50 million. Blockbuster, in a decision that looks suicidal in retrospect, declined.
Only 10 years later, Blockbuster would file for bankruptcy protection, while Netflix would be pushing into its second act: streaming video. Many have doubted Netflix along the way, but Hastings seems to be no longer among them. Instead, he's adhered fiercely to a lesson he learned back in the days when Blockbuster could have bought, or even squashed, his company: Never sit still for a moment, because sitting still brings death.
Few companies have been as transformative in the past 20 years as Netflix has. Few companies have also inspired as much speculation that is as relentless as it is bullish. None has so consistently rewarded such speculation. Netflix saw its stock surge 10% today after surpassing already optimistic expectations for its earnings, valuing the company at $147 billion.
Revenue at Netflix rose 40% last quarter to $3.7 billion, its highest quarterly growth rate in six years. And it expects revenue to keep accelerating to a 41% growth rate this quarter. The key reason is one that even few bulls expected: Netflix raised prices – subscribers are paying about 14% more on average than they were a year ago – and yet total subscriptions kept rising faster than expected.
Netflix counted 125 million subscribers last quarter, up 27% from a year ago and up 6% from the previous quarter. The company added 1.96 million U.S. subscribers and 5.46 international subscribers – both figures exceeded analyst forecasts – even though it's charging more to each subscriber on average in both markets.
This stands in contrast to the rare Netflix flub: the Qwikster crisis of 2011, when subscribers rebelled against a plan to raise prices and split the DVD rentals off from the streaming service. Netflix still has 3.1 million DVD subscribers in the U.S., which now account for less than 3% of its revenue. The recent price hikes are tiered by the number of users, which most subscribers aren't objecting to.
Asked about whether Netflix would keep raising prices, Hastings said “it depends on the quality of our offerings.” That echoed a bit of new jargon coined in Netflix's shareholder letter: “density of viewing,” which seems to be an internal metric of viewer engagement per title. The denser the viewing, the more Netflix will invest in a title or type of program. But “viewing" is another word for attention, and what Hastings is saying here is that if Netflix can “earn,” in his word, more of your attention, he's also deserving of more of your dollars.
Listening to Hastings, I couldn't help but contrast the calm confidence he had in describing his subscription-driven business against the tireless defense that Mark Zuckerberg waged last week in favor of Facebook's data-predatory ad-driven model. “I'm very glad that we built the business not to be ad-supported,” Hastings said. “I think we're substantially inoculated from the other issues that are happening in the industry.”
This is an important distinction between business models, one that startup founders might take to heart. But then Hastings went a step further, pointing out that Netflix spends nearly eight times as much on technology as it does on content and marketing, “so just objectively, we're much more of a media company than pure tech.” Maybe, but Amazon, Google, Apple and other “pure tech” companies are also spending heavily on content and marketing these days, so just objectively this argument is a little disingenuous.
The real distinction that separates Netflix from most of its rivals is one that was well articulated in a research note from Deutsche Bank on Friday. It was received as a mea culpa for not being bullish enough on Netflix, even after the stock had risen 60% in a year. "We had underestimated the market's willingness to underwrite several years of negative free cash flows to drive growth,” Deutsche Bank analyst Bryan Kraft wrote.
The free cash flow metric is worth unpacking a bit. Netflix has been burning cash for years and affirmed yesterday it will continue to do so for several more years, as much as $4 billion this year alone. It's financing much of its content through debt, a bold bet that can work until inflation arrives, which some economists are fearing will happen in coming years. Such concerns around spending had dogged many a fundamental analyst, but Netflix just kept navigating its aircraft to just fly higher and higher without crashing. And so Deutsche Bank capitulated, throwing in the fundamental towel.
We were wrong about that, but it's more or less irrelevant now... Netflix has changed the industry in a profound way and in doing so has given itself a significant lead, making it very difficult for the traditional media companies, or even other big tech companies, to catch up. Netflix has changed the economics of content production by leveraging a global [direct-to-consumer] revenue base and, in doing so, has changed the strategic direction for the rest of the industry, pushing them to follow Netflix's lead, not knowing whether or not they'll succeed. Netflix continues to capitalize on this lead by reinvesting in content, marketing and the user experience, which is growing subscribers and making it more of a magnet for talent, further extending the company's lead. Most of Netflix's competitors are held back by their dependence on advertising and their inability to control the user experience.
Hallmark could not have written a lovelier birthday card for NetFlix.com's 20th birthday. But Kraft's assessment was also a rough blueprint for Netflix's future as well, amending the Hastings credo of “don't sit still” with “even when you have the lead.” Netflix cares less that it's changing industries than that it's not being slayed by change. Its plan for world domination is no different from its early plan for survival: Be the change that will kill you if you're not careful.
One of the more telling lines on the conference call discussing earnings was from CFO David Wells: "We're a company that leans on experimentation.” Netflix doesn't know its way forward any more than anyone else, it's just more devoted to parsing through the possibilities.
On the earnings call, Morgan Stanley analyst Benjamin Swinburne asked Hastings about the future: Is Netflix one of the Big 3 streaming services the way 1950s television had its Big 3 networks, and therefore vulnerable to fragmentation? Could Netflix grow complacent? Hastings' answer again referred to a different kind of earning:
Well, it's all up to us and execution... If we earn more of consumers' time, then we continue to grow. And if we get lazy or slow, we'll be run over, just like anybody else... We're a fraction of the hours of viewing of YouTube. We're a fraction of the hours of viewing of linear TV. We've got some great momentum, and we're very excited about that, but we have a long way to go in terms of earning all of the viewing that we want to.
There remains, as ever, many reasons to doubt Netflix. There is now, more than ever, ample evidence of why it doesn't pay to doubt Netflix. Someday, something will catch up to Netflix. Either it will get too lazy and slow, or the risks it takes to be agile and fast will surpass its ambitions.
For now, the onetime underdog eats the underdogs now chasing it. The rest of us can't stop watching. Even if we're paying more to do so.