Netflix (NASDAQ:NFLX) is now the most valuable media company in the world. That feat seemed all but impossible only five years ago when the streamer was still reeling from the "Qwikster debacle," its misguided attempt to rebrand its DVD service, and at a time when the streamer had only dipped a toe in original programming. In 2010, Time Warner (NYSE:TWX.DL) Chief Jeff Bewkes dismissed Netflix as the "Albanian army." This week, Bewkes sold his company to AT&T (NYSE:T) as traditional media giants have been forced to retrench and team up in the face of Netflix's meteoric rise.
It's not just Time Warner who's looking for a dance partner. Walt Disney (NYSE:DIS) is awaiting regulatory approval to buy 21st Century Fox, which just received a counteroffer from Comcast, and Fox have both made bids for British broadcasting giant, Sky. Elsewhere, Discovery acquired Scripps and Lionsgate bought Starz.
Netflix, meanwhile, is looking stronger than ever, with the stock having nearly doubled this year as the company puts up blockbuster growth numbers even as it recently raised prices. However, Netflix's path to media dominance hasn't been as complicated as you might think. In fact, a simple theory has guided CEO Reed Hastings' strategy for much of the way.
The Innovator's Dilemma
According to The Innovator's Dilemma, the seminal 1997 strategy book by Harvard Business School professor, Clayton Christensen, incumbents struggle to adapt to innovations and market disruption as they face an unappealing choice. Either they embrace the disruption, thereby sacrificing fat profit margins, or they don't innovate, and gradually lose market share and relevance.
Former Netflix executive Neil Rothstein told CNBC that Hastings doesn't fear the legacy media companies because he's such a student of the Innovator's Dilemma. Rothstein said the book served as a guide for the company's strategy, "Reed brought 25 or 30 of us together, and we discussed the book. We studied AOL and Blockbuster as cautionary tales. We knew we had to disrupt, including disrupting ourselves, or someone else would do it."
Indeed, arguably more than any other company, Netflix has been fearless when it comes to disruption, especially of its own models. Even in its early days when Netflix was a scrappy DVD mailer striving to disrupt Blockbuster, Hastings understood that DVDs were a transitional technology, and that the company must aim to become the streaming leader.
The stock collapsed when the company split the streaming service from the DVD one, as it doubled prices in the process, but it ultimately turned out to be the right move. Netflix's subscriber base today is many times bigger than it ever was as a DVD company, and pivoting to streaming allowed for rapid international expansion.
From there the company recognized that licensing content from traditional media competitors was a vulnerability, and moved into original programming, essentially vertically integrating so it could guarantee its own source of content. That also turned out to be the right move as traditional media companies have been slow-footed in their response, but are now seeing Netflix as a rival rather than a customer. Disney, for example, is pulling its content from Netflix as it prepares to launch its own streaming service.
A fundamental advantage
Even as legacy media companies team up to fight back against Netflix, the streamer still has a fundamental advantage. It doesn't have billions in legacy profits it needs to protect, and that is the fundamental dilemma for companies like Disney and Time Warner, and explains why they waited so long to worry about Netflix.
However, while mergers like AT&T-Time Warner or Disney-Fox may help the legacy media companies, it doesn't change the fundamental calculus that the high-margin profits from Pay TV services like cable and satellite are going away, and it won't be that easy to build a competing service to Netflix and attract a similar number of subscribers -- Netflix now has more than 125 million around the world.
Investors, meanwhile, aren't as keen on rewarding aging incumbents like AT&T or Disney for innovation as they are with upstart disruptors like Netflix. That explains why Netflix is worth more than its rivals, even though its profits are far smaller, and it also shows why Netflix is spending so aggressively on content. It wants to grab as many new users as it can before more competitors flood the market, thereby maintaining its first-mover advantage.
Whether Netflix's profits ever match those of the legacy media companies remains to be seen, but one thing is clear. Netflix is writing the rules in the brave new media world, and it won't be disrupted by the likes of AT&T or Disney.