Netflix Needed a Transformation—and It’s Working

Commentary about business and finance.
July 23 2013 10:28 AM

The Stock Is Down, but Netflix Is Winning

Don’t let Wall Street “disappointment” distract from the company’s incredible success.

Taylor Schilling in a scene from Netflix’s “Orange is the New Black.”
Netflix's plan requires more high-quality shows like Orange Is the New Black, seen here.

Photo courtesy Jessica Miglio/Netflix

Netflix’s shares tanked late Monday in after-hours trading, because the company’s second quarter results indicated a disappointing gain of “only” 630,000 new streaming subscribers in the U.S. That’s a marked slowdown from the numbers Netflix put up over the previous three quarters, and in a game where growth is king any slowdown can devastate share prices. But this is a fairly shortsighted perspective. The game Netflix is playing—in which the object is to convert from a streaming service into a producer of original content—is a difficult one, but it’s also one in which scale matters. The company’s subscriber base is still growing quickly, and that growth lays the foundation for further growth.

If Netflix has in fact found a consistent way to produce compelling original content—and the episodes of Orange Is the New Black that I watched over the weekend on June Thomas’ recommendation certainly suggest that it has—the company is poised for financial success as well.

To see the promise of the New Netflix model, consider the problems with the old model. Paying content owners for the right to stream their shows and movies and then charging customers for access has a basic problem, which is that you’re counting on the content-owners making a mistake. Netflix’s original streaming success was built on the back of a content deal with Starz made back in 2008, which basically involved Starz underestimating the value of its own content. But that’s not the makings of a viable long-term business strategy: Netflix wasn’t able to renew the deal on advantageous terms, because once Starz saw how popular its content was, it drove a hard bargain the second time around.

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Value inevitably migrates to the original rights owner, so Netflix decided it should try to become an original rights owner. The business logic here is quite different. The first season of House of Cards will never again have as much value as it did when it was first released, but as with any old show there will always be some people who want to watch it, and the ability to do so will have some economic value. Having produced it, Netflix now has House of Cards in its bank of content until the end of time. The more subscribers Netflix attracts, the more content it can produce. Those mere 630,000 net new subscribers should be worth over $60 million in revenue over the course of a year. That’s more than enough to pay for a season of Hemlock Grove or Orange Is the New Black, according to Hollywood agent Peter Micelli’s relatively high-end estimates, and it almost equals the price of a season of House of Cards.

In other words, with each passing year Netflix has a larger stock of zero-cost content that it produced in previous years. And with each year that it adds subscribers, it gains the ability to produce brand new content at a more rapid pace. That means those $7.99-per-month subscription fees should become a more and more appealing value proposition, and give the company some scope to increase rates over time.

Which isn’t to say Netflix has no problems. The threat of competition is real enough. The positive news on this front is that Hulu’s owners seem to lack a clear strategy for the company, and HBO shows no sign of wanting to market its HBO Go service as a standalone product. Amazon, however, is dipping its toes into original content, and the barriers to entry here are not enormous.

Sappy though it sounds, the competitive threat underscores that the main challenge for Netflix is simply to produce quality content. Reliably making TV shows that people like is tricky. But the news here is all good. Their first original program, Lillyhammer, was basically garbage. House of Cards and Arrested Development are getting Emmy nominations. Orange Is the New Black is fantastic. The idea of relying on audience analytics to generate new content sounds a little daft, and raises the specter of bland paint-by-numbers features. But traditional content production can be bland and formulaic, too. (How many police procedurals feature a strange-bedfellows partnering of a regular cop with a quirky one whose special abilities are the key to cracking the case?) In some ways the Netflix formula seems to allow for more creativity. Knowing what combinations of talent and subject matter are likely to appeal to viewers lets Netflix get a bit quirkier in terms of what actually happens on screen.

It would be foolish to call Netflix’s success a foregone conclusion. But Reed Hastings and his team are trying to execute a strategic pivot from content licensing to content production that’s daring, difficult, and necessary. That they’re pulling it off while steadily growing their subscriber base is an enormous accomplishment. One allegedly disappointing quarter relative to arbitrary expectations shouldn’t distract from that achievement.

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