Netflix's Valley of Despair

If you follow the markets, you’ll know that earnings season is a lot like the Kentucky Derby. Two minutes of excitement followed by a lot of money either won or lost. Earnings for me represent large data dumps, a fresh set of data to comb through and digest for updating my models. For Netflix’s Q1 2022 earnings, I thought: “it can’t possibly be that bad right? No way can NFLX puts pay out again? They got taken to the woodshed in their Q4 earnings, surely it won’t drop another 25%?!?”

And I couldn’t have been more wrong. The headlines speak for themselves, losing subscribers for the first time in a decade. It didn’t even matter that if you looked deeper, you realize most of the subscriber loss is due to pulling out of Russia. Inconsequential! Algos will always sell first, ask questions later. It was so bad that Bill Ackman dumped his entire stake. Say what you will about the man given all the fear mongering during COVID crash, but at least he knows better than to baghold.

In hindsight this article looks pretty hilarious, but hey it was at least true at the time. Everyone and their dog thought Netflix would dominate the media landscape for the foreseeable future. It was one of the four horsemen of FANG (Cramer lol). They have some of the best technology and talent in the world. They invest tremendously in quality content, culminating in a dominant performance in the 73rd Emmy Awards.

The thing with making your own content is that the content game itself is akin to a hedonistic treadmill. In order to keep people on the platform, you need a continuous conveyor belt of fresh content. New content, especially new intellectual properties, are not easy to create. For every Bridgerton, there are probably 10 pilot hopefuls languishing on the cutting room floor. And like any good high, yesterday’s hits are forgotten as soon as the next new hot series comes along.

Netflix has to continuously back up the proverbial dump truck of money into content creation with the hope of getting a few shows that resonate with the current cultural zeitgeist. Irrespective of the focus testing and the audience surveys, you generally don’t know how well a show is going to fare after it’s produced and aired, making each series somewhat akin to an options play, risking everything for a huge upside payoff if it hits.

You can almost see Netflix these days as a venture capital firm for content; they don’t need every show to be a hit, just a few big ones and they can keep their audience hooked for another quarter. The pareto rule and the power law are some good mental models that are applicable here. If they have the means to guarantee a cultural phenomenon like Tiger King or Squid Game every quarter, Wall Street would be over the moon and the subscriber numbers would take care of themselves. But unfortunately, no system like that exists in our world.

So where does Netflix go from here? As of this writing they’re instituting hiring freezes and toying with an ad-supported model, cracking down on password sharing and potentially raising prices (again), topped by whatever the hell Tudum is. These are not the typical actions taken by a business who believe that they have a good grasp of the future, but they do sound suspiciously familiar…

I’m a strong believer that our history informs the future. To find out where Netflix could be headed, we should look back at the precise thing that they’ve substituted: Cable TV.

Back in the 1950s, when television was just finding its footing as a popular mass-media platform, there were very few choices to choose from. The competition was over the air, quality was bad and you were constantly fiddling with the antennas to avoid watching static. There was no such thing as recording so if you missed your favorite 8 o’clock show, well sucks to be you.

In comes the new fangled thing called cable TV. It provided a huge leap forward in picture quality as the signal is provided directly through a coaxial cable, a huge explosion of fresh content categorized by interests ranging from food to cartoons, no ad interruptions for a token subscription fee, and oh yeah, you can now watch your favorite shows in all of the colors of the rainbow. Does any of this sound familiar to you?

Cable TV grew rapidly in the latter half of the 20th century, and before you knew it, the market had become saturated. There’s now more content than a single person can ever hope to watch in a lifetime and broadcasting executives are struggling to figure-out where the next incremental revenue is going to come from. Their solution was to have a tiered approach: offer basic cable supported by ad revenue with the option of bundling premium cable with channels such as HBO and Cinemax that offered no ads for an additional fee. As you could imagine, this had a huge boost to customer lifetime value and much cigars and champagne was consumed.

At some point it was just socially accepted that getting cable TV was something we did as an adult, along with having a car and a landline. It became one of the first things we got set up when we moved into a new place. The cable TV gravy train continued well into the early 2000s, until a relatively unknown upstart called Netflix made its way onto the scene.

At first the business model was quite modest: kill Blockbuster. Technology has produced this thing called the DVD which made it cost effective to have a centralized distribution model from a warehouse instead of retail stores filled with VHS. Goodbye crappy video quality! Goodbye late fees! Goodbye having to rewind tapes! After Blockbuster was summarily vanquished in the early 2010s, Netflix set its sights firmly on its next target: Cable TV.

The timing and conditions couldn’t have been more perfect. Broadband internet adoption was at an inflection point and cable TV packages were inching towards $100 per month if you wanted the premium channels. Netflix realized in order to compete in this space, you can’t just sell other people’s content, you need to create your own. To differentiate themselves further, they made the content non-linear, you watched what you wanted to watch, on your time. All for the low price of $8 a month and oh yeah, no ads.

As you can imagine, this deal was far too irresistible for people to pass up. Nearly unlimited entertainment for the cost of a fast-food meal. And if that was too rich for your blood you could share your password with a friend or family to reduce your unit cost to a pittance. The future is now, old man.

Exponential growth promptly followed and the brand entered into the popular lexicon with “Netflix and chill”. They became a poster child of disruption with their inclusion in the mighty FANG index and kicking off the cord-cutting revolution that became a never-ending nightmare for cable TV executives. Early investors saw a 3,000+% return and the once David has truly morphed into Goliath.

Life is good when you have the first-mover advantage, but you can never rest on your laurels because the competition will eventually catch up. The success of Netflix convinced tech companies to jump into media to broaden their reach and convinced media companies to jump into streaming because it represented an existential threat. As competition flourished, media companies recalled their IPs from Netflix and at the same time Netflix found themselves being outbid by the likes of Apple and Amazon for new content. The proverbial box was closing in from both sides.

Looking back, COVID proved to be a double-edged sword for Netflix. On one hand, people signed up in droves and binged-watched content as one of the few lockdown-compatible activities. On the other hand, COVID itself shut down or delayed the production of new content, meaning many viewers burned through the existing library and found themselves without anything interesting to watch.

Which brings us to today. After two consecutive quarters of disappointing Wall Street, Netflix is at a crucial juncture. It was a masterful pivot from DVD rentals to streaming, but they need to make another bold change in order to stay at the top of the heap in the ever more crowded media landscape. If I were to use an analogy here: if the DVD rentals were the Macintosh, streaming was the iPod, and now Netflix needs their proverbial iPhone moment.

This article is not penned as the “Death of Netflix” as some of the other articles might have you believe. Just like how cable TV is still somehow alive and kicking, Netflix is at a size where it can wither away for years and hope to find a new business model to latch on to. And streaming itself is not an easy business to execute. Quibi and CNN+ are some great recent examples of: “When Streaming (Keeping it Real) Goes Wrong”.

For Netflix to re-invent themselves, they need a content production model that does not involve gambling billions in search of a few rare hits. They do not have a deep library of IP like Disney to fall back on, nor do they have an infinite war chest like Amazon or Apple. They also need to get their service in front of the eyeballs of Gen-Z and Gen-alpha, whose primary forms of entertainment are video games and Tik-Tok.

As much as I like armchair CEO-ing, I honestly don’t know what Netflix should do next. Some people think they should do something with Web3, some others think they should promote grassroots bottom-up content like YouTube or Twitch. Showing ads and preventing password sharing might provide a temporary respite to the bottom line, but long term they’re still in a quagmire. Can Netflix save themselves before the next David shows up? Well I can’t say for certain what the next dominant content distribution platform will be or even look like, but I can almost guarantee you that it’ll start its life promising no ads.

To quote Harvey Dent: “You either die a hero, or live long enough to see yourself become the villain”. Netflix is slowly morphing into the cable TV companies it once sought to defeat. Using Joseph Campbell’s Hero’s Journey as a template, this is either the valley of despair from which salvation is discovered, or the path of darkness for which there is no return. The saga of Netflix does not yet have an ending, and I will be waiting patiently to see if there is a redemption arc of a third act.

Psst…it goes without saying that this article is not a recommendation to buy, sell or even hold Netflix stock. I don’t own any Netflix stock nor do I intend to in the near future. The views and opinions expressed in this article are my own, and writing them down helps me solidify my ideas and put them in a logical container. I get annoyed when interesting articles gets gated behind a paywall and therefore I want to make my writings free and accessible. If you enjoyed this article then please share it with your friends! My goal is just to get as many views as CNN+ did one day.

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