Will Netflix be alright?

And has the techlash finally been replaced by the tech crash?

I’ve been trying to wrap my head around the sudden shift in fortunes for big tech firms. Throughout the techlash years (roughly 2017-2020), the big tech companies took huge reputational hits that had no effect on their absurd profitability. In 2022, that has all changed. And it isn’t just the cryptocrash, either. Apple stock is down 15% this year. Google and Microsoft are down ~21%. Amazon is down 28%. Tesla is down 31%. Meta has dropped 48%. And Netflix, worst of them all, has lost 63% of its value.

Netflix is the one company out of the bunch whose business model I can grok. And the company has kind of become the mascot for this recent tech decline. We’ve had months of dire predictions that Netflix is dying, or this is the end of the streaming era!

I’m pretty confident that Netflix is going to be fine, even if its stock is never going to recover. But it’s also an illustrative case — thinking through what’s happening with Netflix can help us make sense of the broader changes in the landscape.

---

Let’s start with the tension.

Netflix is dying. Everyone says so. The company has been freefall since its April Q1 earnings report projected that the company would lose subscribers for the first time in a decade. Even after last week’s better-than-expected Q2 earnings report (Netflix lost only 1 million subscribers so far, rather than the projected 2 million), it has lost something like $50 billion in value. The company has laid off employees, scaled back project development, announced a crackdown on password-sharing, and is hatching plans for a lower-priced, ad-supported tier.

But also, Netflix is fine. Just ask Kate Bush. Stranger Things Season 4 was such a cultural touchstone that it made her 1985 song “Running Up that Hill” the song of the summer.  Netflix is still the world’s biggest streaming service — it’s a goddamn verb, just like “Google” or “Kleenex.”

The gap here is that Netflix (and basically every tech company) is really two businesses. There’s the actual business, which brings a product to market and monitors success by comparing revenues and expenditures. Actual businesses are, as a general matter, evaluated based on their capacity to bring in more revenue than they spend in a given year. Then there’s the imaginary business of building the future. Imaginary businesses aren’t evaluated on their profitability. They are judged on their growth and on their ability to convince investors that today’s growth will disrupt markets and unlock unlimited future profits. The imaginary business determines the company’s stock valuation.

(Consider Tesla: Tesla is a small car electric car manufacturer, facing intense competition from bigger auto-makers who have decided to break into the electric car market. Tesla’s stock is more valuable than its top five rivals combined. What makes Tesla stock more valuable than Toyota and Ford is Elon Musk’s singular ability to convince retail investors that the future will belong to Tesla. If Elon keeps setting his real-life-Tony-Stark reputation on fire, it’s going to crater Tesla’s imaginary business.)

For years, Netflix has been a solid actual business and an outright phenomenal imaginary business. Netflix stock became so valuable that Jim Cramer listed it alongside Facebook, Apple, Amazon, and Google as one of the big five tech firms (FAANG). And, indeed, Netflix’s actual business transformed Hollywood. It ushered in a new golden age of television. Meanwhile Netflix’s imaginary business was so successful that it ignited the streaming wars. Creators and viewers have reaped the benefits for years, with studios spending wildly beyond their means and giving us more good television than we have time to watch.

Netflix has lost 1 million subscribers so far this year. That’s less than 0.5 % of its subscriber base. It translates to a loss of between $10-20 million in monthly subscription fees. That’s… not a lot for the actual company, which spends $17 billion/year on content production. But the subscriber loss is a bombshell for the imaginary company, because is wrecks the investor narrative about limitless growth and industry dominance.

The question is… why the hell did investors believe that narrative in the first place?!?

---

Netflix and FAANG – One of these things is not like the others.

Facebook/Meta, Apple, Amazon, and Google are all quasi-monopolies. The sheer scale of each company yields competitive advantages that make them phenomenally profitable. They don’t have to worry about direct competition; They worry that regulators might step in and break up the business model.

Think about the all the ways that Meta, Apple, Amazon, and Google make money from their products. Facebook and Instagram are free to Meta’s several-billion users, but the company runs a sophisticated advertising marketplace. Meta also has a hardware division that Mark Zuckerberg has declared is the future of the company. Apple is the most profitable computer hardware business in the world. (I’m typing these words on a MacBook Air, pausing to glance at my iPhone after I get a schedule alert on my Apple Watch.) It also takes a 30% cut of all sales on the Apple App Store. Amazon is the “Everything Store” – a boon to its Amazon Prime customers and a nightmare for local businesses and warehouse employees. But Amazon also operates Amazon Web Services, an absurdly profitable cloud computing provider. And Google doesn’t just dominate web search – its Android operating system runs on a majority of the world’s smart phones and it takes a cut out of practically all online advertising through its ownership of DoubleClick.

By comparison, even when Netflix was growing by leaps and bounds, transforming the entertainment industry, the company has suffered from two basic problems. The first problem is Intellectual Property (IP) law. Most of the content that Netflix offers its subscribers belongs to Disney or WarnerMedia or another one of the major studio conglomerates. Netflix would love to be the single source of all streaming video content, but it can only offer The Office or Mad Men so long as NBC/Universal or AMC decide to make those shows available. Meta, Apple, Amazon, and Google all grew so large that they managed to dominate their industry and faced no direct competition. Netflix could neither grow big enough or fast enough to ward off competitors. The more successful Netflix became, the more likely that Disney and HBO would reclaim their IP and offer competing services.

Netflix responded to its IP problem by developing its own original programming – House of Cards, Orange is the New Black, The Crown, Ozark, Queen’s Gambit, Stranger Things, Bridgerton, etc. Netflix became the biggest tv studio in the world. It won awards and became a centerpiece of the culture industry, all while building an IP firewall against the oncoming streaming wars. (This story is well-known by now, but the Netflix season of the Land of the Giants podcast offers it in glorious detail.)

But Netflix’s second problem is that, compared to the other FAANG companies, it has a ceiling on its revenue streams. Each new household that subscribes to Netflix is worth ~$10-20 per month, depending on which plan they select and which country they live in. The most that Netflix can make from a new subscriber is $240/year. If Netflix gains 2 million users at the highest price tier, and none of them unsubscribe, then it can count on $480 million more in revenues. If Netflix spends an extra $500 million on new original content in order to attract those new users, then the company spent more on subscriber acquisition than it made through subscription fees in the calendar year. The math is really pretty basic.

If Amazon signs up 2 million more Prime members at $15 apiece, Amazon gets those direct revenues and also finds plenty of other ways to capitalize on that relationship. Amazon was unprofitable for years, prioritizing rampant growth over profitability. Eventually it paid off with monopoly rents and the type of returns that can only be had by massive companies that face no direct competition (thanks, also, to lax antitrust enforcement that could and possibly will change).

This is why tech companies have, ever since the Netscape’s 1995 IPO, been rewarded in the stock market for growth rather than profit. Tech firms have been able to tell a compelling story that profits today are immaterial compared with the potential future profits that come from “disrupting” and dominating an emerging market. But Netflix is barely a tech company. It’s a media company! There is no internet-magic multiplier that will make new Netflix subscribers 50 times more valuable than their subscription fee. To earn 50 times the annual subscription fee, Netflix has to retain a customer for fifty years.

---

Netflix’s Business Model Is Simple Math, But People Keep Getting It Wrong

For years, Netflix has played down the threat posed by its direct competitors in the streaming wars. In January 2019, Reed Hastings told investors “We compete with (and lose to) Fortnite more than HBO.” The company has also had a habit of tweeting stuff like “Sleep is my greatest enemy.”

This posture is crucial for the imaginary Netflix business. (Netflix has already conquered Hollywood… Next up: REM cycles!). For Netflix stock to be valued like a tech company, it needs to maintain the swagger of a tech company. The company has also dabbled in video games, making a small investment that let Hastings and his team hand-wave at their big plans for the next tech frontier.

But if we look at the company’s actual revenue model, it turns out to be pretty simple arithmetic. Netflix doesn’t compete with Fortnite (hell, you can even play Fortnite while you’re watching Netflix!). Netflix doesn’t compete with sleep. Netflix charges you the same $10-$20/month whether you binge 200 hours of programming or zero hours of programming. The entire streaming video on demand (SVOD) economy, in fact, revolves around just two variables: (1) subscriber acquisition, (2) subscriber retention. Everything else is just fancy noise.

Streaming services acquire new subscribers by adding blockbuster shows (either through original programming or binge-able classics). They retain subscribers by having a deep catalog of interesting shows and/or upcoming releases that are attractive enough to keep subscribers from going through the headache of canceling a subscription.

The trick is that not all subscribers are equally appealing. The ideal SVOD subscriber is impulsive enough to sign up on a lark and lazy enough not to think too hard about whether they are still getting their money’s worth after they’ve binged the latest hit.

(I’ve thought a lot about this, because I happen to be the ideal SVOD subscriber. In early 2020, I signed up for Paramount Plus (back when it was still CBS All Access) so I could watch Pickard. After I was done, I skimmed their offerings and figured there were a couple other shows that seemed appealing in a maybe-someday-if-I-have-more-time sort of way. I then promptly forgot all about it. Once a month ever since, I get an auto-renewal reminder that I’ve paid yet another $10 to Paramount Plus. I pause for a moment, think to myself, “oh right, I should watch Evil. It’s supposed to be good,” shrug, and continue about my day. Paramount Plus got me through the door, and now they get my money. The company will continue to make $10 from me every month so long as it surpasses what we might call the minimum viable content threshold. So long as they have something I want to eventually watch, the ten bucks isn’t a large enough penalty for me to cancel.)

Three weeks ago, Peter Kafka noted what appeared to be a disturbing trend for Netflix in his newsletter: Netflix has a higher churn rate among new subscribers than any of the competing SVOD companies. 23% of the people who signed up for Netflix in 2022 canceled their subscription within a month. But the same data also shows that Netflix’s overall subscriber base is less likely to cancel than any of its competitors.

What this data likely indicates is that Netflix has already picked all of the low-hanging fruit. The ideal customers – impulsive and lazy, like me – all subscribed to Netflix years ago. (Really, how many households didn’t sign up for Netflix during the pandemic lockdown, but are just one show away from getting on board?) The newer streaming services are still acquiring those longtime, reliable viewers that Netflix scooped up over its past decade of constant growth. They just need a Ted Lasso or The Mandalorian to get them through the door.

The people who are left for Netflix to acquire are the households that pay close attention to their monthly entertainment budgets. (You know… responsible people.) They’ll sign up for a month when there’s a show they want to watch. They’ll cancel right away when the show is done. Maybe they’ll be more likely to sign up for a month with a cheaper, ad-supported tier. Maybe they are sharing a password, and will get their own if the company updates its enforcement policy. These are the same sort of people who never paid a late fee back in the heyday of Blockbuster video. At its peak, Blockbuster made $800 million per year in late fees from customers. You can bet those late fees weren’t evenly distributed across the customer base. Some were more fastidious than others.

For Netflix’s actual business, this shouldn’t be much of a problem. It has a giant, sustainable customer base, tons of cultural capital, and almost a decade of valuable IP that it controls. Netflix will keep cranking out hit programming to a loyal customer base. It will just start spending less wildly so its expenditures are more closely associated with its revenues. But it means that the stock price of Netflix and its SVOD competitors will likely be evaluated more like media companies and less like tech titans. The imaginary business is crumbling as the cap on subscriber revenues comes into stark relief.

---

What happens from here?

For Netflix and its subscribers, not much is going to change. The company is cracking down on password sharing, creating a cheaper ad-supported tier, laying off some employees and scaling back production costs. Netflix is going to start acting like its real competition is HBOMax and Disney+, not Fortnite and sleep.

This marks a new chapter for the golden age of television we’ve been living through. The outrageous spending of the past few years was never going to last forever. At some point, streaming video businesses were going to have to spend roughly as much money as they make. Creators are going to see fewer blank checks and bidding wars. Fewer risky projects are going to get approved. Some of the big streaming services will start acquiring the littler ones.

What will get really interesting is if this same trend holds for the extended tech ecosystem. Netflix isn’t the only company whose imaginary business was out-of-step with its actual business. All of the major tech firms are down, and Wall Street seems to have started treating tech companies as if they aren’t magic anymore. We’ve had an eighteen year stretch where Silicon Valley was the one bubble that never burst. Now industry analysts are now comparing 2022 to the dotcom crash of 2000.

I’m not sure why the tech stock crash has started now, in mid-2022, after so many years of permanent irrational exuberance. (I’m not even 100% sure that it’s real yet. But… it’s been enough months that it’s definitely not a blip.)

But what I am sure of is that, if tech firms are expected to be profitable just like any other company — if they are judged on their present business instead of on their ability to tell a good story about the future — then it will be a tectonic shift.

Netflix will be fine, because Netflix is an actual business with actual subscribers that actually use it. But, if you look across the rest of the tech world, we’re about to learn that a whole lot of industry “disruptors” were only beating the incumbents because they didn’t have to turn a profit.

This may turn out to be a bigger deal than the techlash. If tech companies stop being graded on their pedigree and potential instead of their actual performance, then a ton of imaginary value is going to vanish.

And maybe that will create space to build something better.