Netflix is considered one of the superstars of big tech, but that status should be determined by more than an impressive valuation and growth charts. Netflix is in trouble.
The streaming service is a part of the oft-cited FAANG club, whose members are the tech giants Facebook, Amazon, Apple, Netflix, and Google. Superficially, Netflix does seem to fit in, with a $145 billion market cap and 27% year-over-year revenue growth from September 2018 to 2019. Despite competition from Amazon Prime and Hulu, and the threatening rise of Disney+, Apple TV+ and WarnerMedia’s HBO Max (slated to go live in mid-2020), Netflix boasts a base of 158 million subscribers globally.
But a deeper analysis of FAANG reveals that one of these companies is not like the others. Netflix’s core business fails to take advantage of platform dynamics. FAMGA, on the other hand, swaps out Netflix for Microsoft, a true platform conglomerate with strong network effects in several of its businesses, from its Windows operating system and its Azure developer ecosystem to LinkedIn and the new video game live streaming platform Mixer. That makes FAMGA a better picture of companies positioned to stay on top for years to come.
Where has Netflix gone wrong? Its major challenge, as we’ve written about over the last year, is the lack of supply-side network effects. Other streaming video challengers like Disney face a similar challenge. But Netflix, as the biggest of them all, could fall the hardest.
For all its outstanding performance over the past decade, Netflix has been hounded by the dark cloud of negative cash flow for far too long. The company has reached $12.43 billion in long-term debt with no surefire plan to get on the road to positive cash flow.
Netflix is spending more and more to acquire premium content in the face of diminishing returns. Its content spend has reached $15 billion for 2019, far exceeding that of competitors. Not only are big media companies like Disney and WarnerMedia entering the streaming wars and shelling out hundreds of millions to lock down top production talent, but extremely popular TV series like The Office and Friends are being reclaimed or snatched away from Netflix by the highest bidder. While Netflix has invested billions in its own original content, its most popular shows were still these major licensed properties. Netflix is losing the very licensed content that has driven most of the viewership, which is forcing the streaming giant to ramp up spending on in-house production even more.
The big problem hurting Netflix’s defensibility and profitability is a lack of network effects on the supply side. Content producers cannot sign on to the service organically. The demand is there. But Netflix doesn’t provide an ecosystem to attract a growing network of content creators who can, in turn, freely create and connect with viewers.
Rather, Netflix either buys licenses to content or pours money into making original shows and movies. The only way the current model allows the service to compete is to grow the library of exclusive, premium content, which only continues to add red ink to the balance sheet.
This would be temporarily OK, if there were a solid plan to escape the cash flow freefall. In light of this, Netflix has been making strides in international expansion. But while the 98 million-and-growing non-US subscriber base is helping Netflix show growth, many customers in new markets such as India and Malaysia are not going to pay as much as American subscribers will. That puts a cap on profits. At the same time, domestic subscriber growth is slowing, with Netflix missing on domestic subscriber growth in the most recent quarter.
As long as the fundamentals are bad and Netflix stubbornly sticks to its guns in the content arms race, going international won’t work to secure long-term profitability. A plan based simply on the hope that scale will outpace costs is a flimsy one at best.
The lack of network effects isn’t only a problem faced by Netflix. With an average churn (subscriber loss) rate of around 18% across the industry, all the big players crowding the streaming space will likely find themselves on the same hamster wheel, constantly pouring huge sums of capital into content and customer acquisition.
At the end of the day, Netflix is a traditional content creation business with a digital distribution mechanism. All of the important questions about Netflix’s business are the same ones that have faced traditional content businesses for decades. It hasn’t fundamentally changed the economics of the business. And unless it does so, it’s not clear that its business model can be sustainable, especially as it faces real competition for the first time.
Outside of the streaming wars, we see something the other FAANG firms are doing that actually does bode well for growth and profitability. They all own platforms with strong network effects, and they all leverage user-generated content (UGC) to some degree.
That UGC comes in many forms. Facebook, through its core platform and Instagram, allows users to crank out content for free consumption by others. In addition to its content platform in Google Search, Alphabet has YouTube, which boasts 1 billion+ hours of video watched every day. And with its huge demand base, YouTube can now look at sourcing premium video to add even more value for users.
Like the other FAANG giants outside of Netflix, Apple is a platform conglomerate. As it runs the hugely successful iOS development platform and App Store, it’s building out the ecosystem around the iPhone and Apple Watch and seeding network effects in electronic health records (EHR) and other areas.
Then, there are Amazon’s and Microsoft’s forays into the world of videogame live streaming. Amazon’s Twitch is dominant in the space, slated to hit $1.65 billion in revenue by 2021 according to NewZoo. And while Twitch holds the title for viewership, Microsoft’s Mixer saw explosive 149% year-over-year growth in 2019, second only to the growth of Facebook Gaming among the big players that year.
Outside of content, Amazon’s Marketplace, which accounted for 60% of sales in 2019, has strong network effects that attract millions of third-party sellers with hundreds of millions of products. Microsoft, of course, also has LinkedIn as well as a large ecosystem of third-party developers around Windows and Azure.
So if we subtract Netflix from FAANG, we see that Facebook, Google, Apple, and Amazon all have strong network effects that provide real defensibility. And where content is the main unit of value, the user-generated content doesn’t sit on their balance sheets, as it does for Netflix.
The tech platform giants are building sustainable scale by leveraging the consistent value exchange between their user groups. Netflix is chugging along based on how much it can spend, but at some point, the bottom has to drop out.
Netflix’s international expansion helps on paper and with growth in the short term, but it fails to solve the underlying problem of gigantic capital expenditures with no end in sight.
What would make for a solid plan? Embracing platform thinking, and building network effects on the strength of user-generated content.
There are many forms this could take, from viewer commentary to interactive, behind-the-scenes content from creators that engages loyal fans of certain shows. But however its done, given the diseconomies of scale that plague the industry, it seems inevitable that the big linear streaming companies will leverage UGC and try to harness network effects at some point in order to make a profit. All of Netflix’s profitable platform content competitors have done so. Yet the streaming company stubbornly has not.
Netflix is still on top today, but its chance to change course may not last for long.
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