Netflix’s Defensibility Problem: Why Not All “Tech” Companies Are the Same

By Nicholas L. Johnson

Netflix is on a tear.

Since the beginning of the year its stock price is up nearly 50%, and Netflix  had its best quarter ever at the end of 2017. The company claimed it was profitable for the year, matching CEO Reed Hasting’s promise to investors a few years back.

Netflix appears to finally be justifying its frequent comparison to tech monopolies like Facebook, Amazon and Google, which are often collectively grouped together as “FANG,” the same way modern monopolies like Baidu, Alibaba and Tencent are known as “BAT” in China.

There’s just one problem. The true health of Netflix’s business isn’t fully represented in its income statement. And the comparison to the other three FANG stocks turns out to be a poor one. To understand why, and to see the challenges with Netflix’s business model, you need to look deeper.

Hidden elsewhere on Netflix’s balance sheet is an outlay of $9.81 billion for 2017 on “streaming content assets” – a number that’s up from $8.65 billion for 2016 and $5.77 in 2015.

Netflix has said this number will continue to grow over the next few years as it spends more on original content. In total, Netflix has nearly $16 billion already committed to future content deals, with more to come.

The result is a loss of $1.785 billion in cash this year, with a projected cash loss of $3-4 billion for 2018. Netflix claims this number will come down eventually, but will it?

Netflix’s Business Model

The genius of Netflix was in applying a digital distribution model to what is essentially the same linear business model of a TV network. Netflix’s business in fact looks a lot like HBO, but instead of relying on cable subscriptions and telecom relationships, Netflix goes direct to the customer. This strategy has greatly driven down the cost of distribution. The economics of scarcity that have driven TV – one new episode a week, drawn out release schedules and so on – disappear with a digital distribution model.

The five major networks launched 38 new original shows in 2017. Netflix launched 238.

With Netflix’s model, you’re no longer trying to please advertisers by getting viewers to tune in live. Instead you simply want viewers to stay hooked as long as possible. Goodbye live TV, hello binge watching.

The challenge, of course, is that you need enough content to keep those viewers watching. Which means Netflix always needs a lot of new content – a lot more than the typical TV channel will ever churn out. Hence the $16 billion. While Netflix’s business model drives down the costs of distribution, it doesn’t solve the considerable cost of creating all that content. Not unlike its viewers, Netflix has been going on a content binge of its own.

The company’s spending on content is now bigger than the budgets of all media companies combined in the second biggest market for content, the U.K., and is bigger than the content budgets of some of the biggest broadcasters in the U.S.

In the U.S., Netflix spends more than two major broadcast networks, CBS and ABC, and is only slightly behind NBC. Those three networks accounted for about a third of prime-time viewing last year, and they each spend significant sums on live sports content, which Netflix lacks. Also, Netflix’s domestic spending of $2.8bn is bigger than that of all other premium U.S. Networks (HBO, Showtime, Epix, Starz).

Further, the five major networks launched 38 new original shows in 2017. Netflix launched 238. The 1,000 hours of originals Netflix released in 2017 is close to that of the combined TV content produced by the two biggest TV studios in the world from 2016 – Sony Pictures Television and BBC.

In other words, Netflix’s digital business model requires a lot more content than traditional TV models.

Building a Moat?

The goal for Netflix is that it can get enough consumers hooked, and make enough from subscriptions, to make more money than the cost of serving up a nearly endless well of (hopefully quality) content. That’s Netflix’s business model in a nutshell: building scale on top of fixed costs and hoping that the growth of the former continues to outpace the growth of the latter.

Netflix claims its gambit is working – subscribers are going faster each year – but it’s still hemorrhaging cash for the foreseeable future. When will the investment pay off?

Per its own financials, Netflix’s original content loses almost all its value within four years, as that’s when the bulk of consumer viewing happens.

The key to Netflix’s success is defensibility. If Netflix’s spending on content today creates a lasting moat against competitors, its investment in original content is money well spent.

At that point, investors hope Netflix can:

1. raise prices
2. decrease its spending on content

Investors believe that once Netflix achieves a dominant position in a mature market, spending on content will eventually come down. Barring that, Netflix will be able to raise prices to lock in profits.

Are either of those goals realistic? Many investors seem to think so. We’d suggest no, and defensibility is the key reason why.

Netflix claims its spending on content provides an unassailable moat against competition. In this suggestion, it’s again often compared to the competitive moats enjoyed by fellow FANG companies Facebook and Google.

But is this a fair comparison?

Defensibility: What’s in a Network?

Unlike Netflix, Facebook and Google are both platform businesses characterized by strong network effects. Facebook has a social networking platform and a content platform that it ties into one product, while Google has multiple content platforms in Google Search and YouTube.

Driven by network effects, platforms grow to dominate their markets. Google has a more than 90% share of global search. Facebook is the largest social network by an order of magnitude. Collectively, these two modern monopolies hoovered up nearly every new add dollar in the U.S. in 2017, per Bloomberg.

Netflix has no comparable moat to Facebook or Google. Per its own financials, its original content loses almost all its value within four years, as that’s when the bulk of consumer viewing happens. When competitors like Disney move to digital, their spending on content will inevitably increase. And as soon as they start spending on content, viewers will flock to them instead – unless Netflix continues to grow its spending on content to match.

With TV advertising revenues finally in decline, Disney isn’t alone in launching a Netflix competitor. Fox and CBS are doing so as well, and you can expect more networks to do so over the next five years as the flow of TV ad money continues to decline.

Lacking the network effects of its other tech competitors, Netflix’s business depends entirely on it continually churning out new content.

Even worse for Netflix, it’s faced with growing competition from modern monopolies with much larger cash reserves, including Google and Facebook as well as Amazon and Apple. Internationally, Alibaba and Tencent are also becoming major players in premium content. This newfound and significant source of competition does not bode well.

As competition heats up, it’s unlikely that Netflix will ever be able to materially shrink its content spend, lest it quickly lose its market share to the competition. In fact, given the limited supply of high quality content and talent, growing competition means that the cost to just maintain the status quo will only go up.

Lacking the network effects of its other tech competitors, Netflix’s business depends entirely on it continually churning out new content. As soon as the content well runs dry, so will its subscriber base. The seemingly insurmountable market position it has built over a decade could feasibly be lost in just a few years.

In reality, heavily spending on digital content is likely no more of a competitive moat than that possessed by any linear business that’s dependent on investing in fast-depreciating assets. In other words, it’s not much of one.

Slapping digital distribution on top of a traditional, linear business model doesn’t much change the economic fundamentals.

While Netflix is the leading streaming service today, it’s market position and market share will never be as strong or durable as either of the two platform giants. Microsoft has lost billions of dollars on Bing and has only mustered less than 3% of the global search market. Despite pouring billions into acquisitions, Yahoo never became anything more than also-ran in search.

Does anyone really believe that competitors making similarly outsized investments in digital content couldn’t put a serious dent in Netflix’s bottom line?

Netflix DeFANGed: Lower Growth, Less Scale, Little Profit

The issue for Netflix all comes back to is its linear business model. The streaming company needs to license or produce all the content it creates. The only way to get more scale is to pay (a lot) to create more scale. Contrast this with the business model of its platform competitors. Almost all of Facebook’s or Google’s content, including both search and YouTube, is generated free of charge. Users create it, and the platform harnesses that value.

For these platform companies, their network effect naturally increases value and the ability to monetize as the network grows. The result is that as the business scales, revenue growth begins to rapidly outpace the growth in costs. For Netflix, not so much.

That’s why, compared to its platform competitors, Netflix shows slower growth and poor profitability.

As you can see above, Netflix’s growth pales in comparison to Google’s. Additionally, Google’s done it while maintaining an operating margin well north of 20%, despite sinking money into its many “moonshot” investments. As another point of comparison, Facebook has an operating margin of nearly 50%.

In contrast, Netflix’s original content growth strategy, embarked upon in 2012, was accompanied by a marked decline in profitability. Netflix’s margins will never come anywhere close to either Google’s or Facebook’s. Unless, of course, Netflix can greatly increase prices or decrease spending on content. Unfortunately, Netflix has no durable competitive moat that will enable it to do much of either.

As it turns out, not all tech companies are created equal. Slapping digital distribution on top of a traditional, linear business model doesn’t much change the economic fundamentals. Technology is an enabler, not a magic sauce that makes any business work. Creating content is expensive and hard to scale – unless you let others do it for you. The business model makes all the difference.

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