How Netflix Really Drives Its "Virtuous Cycle"

Would you sell a content deal to this man? Netflix CEO Reed Hastings, photo courtesy of Netflix.

Netflix  (NASDAQ: NFLX  )  is a fast-growing company where every new subscriber adds to the bottom line in a big way. If you build a great service, the subscribers will come. When they come, you can afford to build and buy even more and better content. CEO Reed Hastings calls this a "virtuous cycle" that's driving subscriber growth higher.

But not everyone agrees. Many critics would say that Netflix grew crazy fast in the first few years of streaming services because there was no competition to speak of. Not only did the company lack competition for subscriber eyeballs and dollars, but there was nobody else bidding against Netflix on new content deals.

These days, Amazon.com (NASDAQ: AMZN  ) takes streaming services seriously. Hulu came back from the auction block with $750 million in fresh capital and a commitment to produce 20 original shows next year. Verizon (NYSE: VZ  ) teamed up with Outerwall (NASDAQ: OUTR  ) to create a brand-new rival in Redbox Instant, focused on fresher content than any of the others. Even Google (NASDAQ: GOOGL  ) wants to break into the same streaming content space with a heavy emphasis on original YouTube content.

Sit all of these rivals down at the negotiating table for the next hot show, and what happens? Prices skyrocket! No more freebies for Netflix! The model crumbles to dust as content costs suddenly rise faster than the subscriber counts. And then it's bye-bye, virtuous cycle, as Netflix must tighten its belt or raise service prices to make up for the higher costs.

That's all good if content producers only cared about payments up front. Some of these rivals have a lot more cash on hand than Netflix, and should be able to win any bid they want. I'm looking at you, Google and Amazon. Maybe even Verizon, if the telecom is serious about its media service push.

But then you don't understand Hollywood.

It's not all about the up-front dollars. It's also about exposure. And that's a nuance that will help Netflix make up for a lot of the rising rivalry's bidding action.

A hit producer has a hot new concept. Maybe it's a teenage love story focused on cheerleading and zombies. Amazon steps in and offers a $30 million deal for 13 episodes. "Full creative freedom, let's milk these trends while they're hot!" says CEO Jeff Bezos.

Hulu counters with the same money and a premium marketing package. Suddenly, Doctor Hotshot is leaning in a new direction. Until Redbox trumps that bid with $40 million and a tie-in with Verizon's next tablet launch. More money and more exposure -- what's not to love?

And that's where Netflix enters the picture.

How about this man and his 37 million army of multinational customers? Chief Content Officer Ted Sarandos, photo courtesy of Netflix.

Content guru Ted Sarandos wields 30 million American customers and more than 7 million overseas. Both numbers are expected to grow substantially over the next few years, particularly the international figure. Give CheerZombies to Netflix, and you'll address about 10 times the viewership of an Amazon or Hulu option. The gap is even larger to Redbox, and who thinks of YouTube as a serious venue for professionally produced content these days?

Nine times out of 10, Doctor Hotshot will give Netflix a discounted price in return for a much larger audience. It would be both shortsighted and ridiculous not to do it, assuming that the producer wants to build a sustainable business of his own. What good is a big payday if nobody's watching your lovingly created content? That's how you build a one-hit wonder, not a franchise or a legend.

It doesn't hurt that Netflix sees its original content bets as long-term assets. They don't need to be overnight sensations, like broadcast or cable shows do. Instead, they're allowed to build an audience for years. The payoff for a large content investment isn't immediate, but a long-term, brand-building exercise.

So in this fictional example, I'll bet Netflix walks away with a $30million-$35 million deal thanks to its massive scale. Netflix's real business moat is not in its technology (which it freely shares with anyone who asks) and not in its content catalog either (which anyone can build, given enough money to throw at the problem).

No, the moat is about 37 million subscribers wide and took years to build.

As the customer count continues to grow, so does Netflix's pull at the negotiating table. The company won't win every deal it wants, because sometimes an opponent will be desperate enough to pay a huge premium for its lack of market size. That's a bonus for the content owner on the other side of the table. Netflix will just walk away and put its calculated budget to good use somewhere else.

"Hey, Reed, I hear Captain Silverscreen is shopping his 'mermaids on motorcycles' concept. My data shows it could be worth $25 million."

"OK, Ted. Let's go snipe at another auction."

The television landscape is changing quickly, with new entrants like Netflix and Amazon.com disrupting traditional networks. The Motley Fool's new free report "Who Will Own the Future of Television?" details the risks and opportunities in TV. Click here to read the full report!


Read/Post Comments (6) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 06, 2013, at 8:27 PM, AceInMySleeve wrote:

    Great point.

    Consider that a content producer gets the full monetary value out only after they've licensed viewing on every platform in every window, and DVD sales as well. So who is going to buy the DVD if they've never heard of the show? You are right that buzz is important, and it's a compounding thing. People watch shows because their friends watch it and talk about it.

    Netflix frequently hints at the importance of growing a positive reputation within Hollywood and it's not always clear exactly what they are saying. This points seems an important component.

    Of course you could argue that if they got money from Amazon and no one sees it, that means they can go and sell it to the next person and still address the entire country. I think that's easily dismissed by the rapid decline in the popularity of anything if it appears old or second hand (without a positive reputation already being assigned to it earlier).

    Still amazes me Amazon is even trying, and I wonder if that'll change. I still remember Walmart giving up on DVD by mail, and putting a large Netflix banner ad on their shut down page.

  • Report this Comment On August 06, 2013, at 10:53 PM, jhs39 wrote:

    You do realize that Walmart has its own streaming service called Vudu? They haven't exactly given up on the video rental business.

  • Report this Comment On August 07, 2013, at 12:42 AM, satika wrote:

    So producers will except less money for pride of having more viewers.

    That is very unusual way to conduct business.

    Amazon offers 30 mil

    Hulu 35

    Netflix wins for 20.

    That is not easy to swallow

    Also subscriber growth acceleration becomes kind of questinable

  • Report this Comment On August 07, 2013, at 1:17 AM, tom2727 wrote:

    I agree with satika. They might possibly give NFLX a 2% discount for the exposure or possibly a chance to match a competing offer, but nothing substantial.

    Money is money, and if everyone is giving you full creative control, you take the offer with the most cash. Anyone who is getting stacks of cash and full control has already got a name. How much "exposure" do you need if people are standing in line to bid for your next project?

    And if your stuff is "all that", then it will get seen one way or another. Eventually it will wind up in syndication or on DVD or whatever. And it will win awards if it's that good.

  • Report this Comment On August 07, 2013, at 7:58 AM, AndreWilliamson wrote:

    Ponzi schemes are virtuous circles, until they aren't. NFLX is already on the downside of its adoption curve in the US, picking up laggards.

    What you say will happen with content (chasing the largest number of eyeballs) hasn't happened.

    Netflix has almost no original content. The tiny number of programs it does has have received outsized attention simply because it's netflix putting them out, and that is a new thing. They and the hype and all-you-can-eat can keep tens of millions paying $8 a month, but where is the upside?

    Netflix has also heavily penetrated the (US) market already - the base can at best double and/or the company can raise prices, both of which suggest there are hard caps to where revenue can go over the medium term.

    "Netflix is set to dominate the future of television, and you can find out all about it in The Motley Fool's special free report -- just click here for instant access."

    And there's the motivation for you: the fool has a bullish report on NFLX it flogs on a daily basis - which explains why almost all the articles pump NFLX and belittle every other company in the space.

    Beware valuation.

  • Report this Comment On August 07, 2013, at 12:46 PM, duuude1 wrote:

    Anders,

    You say "Netflix's real business moat is not in its technology (which it freely shares with anyone who asks) ..."

    I believe what you are referring to is the suite of apps that enable more robust cloud operations - for example their Simian Army:

    https://github.com/Netflix/SimianArmy

    The core of their business, however, is their interactions with the customers and what they watch - so I do NOT believe that their recommendation engine is freely available:

    http://www.wired.com/underwire/2013/08/qq_netflix-algorithm/

    This forms one of the keystones of their business moat - collecting customer preference data - which enables them to:

    1. make sure their customers have enjoyable content to watch and remain customers

    2. walk away from dumba$$es like Starz when they demand too much for their content.

    3. predict what kinds of new content to purchase and what kinds of old content to bid for

    The 30MM subscribers (and growing) are a newer business defense, and is a result of that FIRST technological moat... You can say that their technology (and their 800 engineers) are their most important business moat. The increasing subscribers are like adding height to the castle walls behind the moat...

    Duuude1

Add your comment.

DocumentId: 2582079, ~/Articles/ArticleHandler.aspx, 4/20/2014 10:49:01 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement