Netflix: Who Said Streaming Isn't Profitable?
Constant growth, $5 billion in profits and password crackdowns - it's all in a day's work for Netflix | #002
This is part of a series of deep dives into large companies in the media and tech space. These are the players that everyone knows from the outside - its time to know a bit more. Welcome to case studies.
Netflix looks like its in trouble. Its Q2 earnings report for 2022 showed a drop in subscribers for the second consecutive quarter. After years of fighting against ads, it finally planned to introduce an ad-supported tier in October of 2022. The latest plans to stop password sharing between households have not been received well by longtime customers. Artists appear to be unhappy with the company’s decision to use AI-generated images as part of a short. Then again, what looks to be true can also just be plain wrong.
The first few quarters may have been rough but Q3 2022 was a great quarter for Netflix, with subscribers up after previous drops. Q4 2022, the latest one, was even better – 7 million new subscribers, way above what was expected. Ads don’t seem to have driven away customers, in fact, sign-ups to the ad-supported tier are growing so fast, even Netflix is surprised. Password sharing isn’t coming to you yet, its still being trialed in a just a few countries before an expansion, although the guidelines seem a bit extreme (I’ll spend a bit more time on passwards later in this piece). As for AI-generated images, we are at a bit of a new frontier and what happens next is unknown but, I would be astonished to see no use of AI images in film and television over the next five years.
This is not unusual for the company. In fact, that’s how things have always been. For a company that has transformed the industry in more ways than one, Netflix is an oddball. A lot of marketing has gone into building an image of the firm as a technology company, one that relies on data and algorithms. Big data was called the “secret sauce” behind huge hits, including the one that started it all, ‘House of Cards’.
“We know what people watch on Netflix and we're able with a high degree of confidence to understand how big a likely audience is for a given show based on people's viewing habits.” - Jonathan Friedland, Netflix Communications Head
However, this doesn't paint the full picture. Netflix is an exceptional company, but not just due to its data. There are many factors - signing on large names, a quick international expansion, new models of business, cancellations at the right time and being prepared for the future. So, let’s explore each one and see what brought us to where we are and, what lies ahead for Netflix.
Part one: An offer you can’t refuse
David Fincher was already famous1 in 2013. He had multiple Academy Award nominations for Best Director. ‘Fight Club’ had earned him thousands of rabid fans. ‘Seven’ was its own masterpiece. And ‘The Social Network’? Timely and somehow even more relevant now. But he wasn’t done. It was time to turn to TV. Having spent years in the film industry, he didn’t lack connections or acclaim, so getting buyers for his project was hardly a challenge. What was shocking was the buyer in question – Netflix.
By purchasing broadcast rights to ‘House of Cards’, Netflix was wading into HBO’s territory. And in fact, it was not just wading in, it was arming itself for the coming battle. HBO was one of the other contenders for the show, and apparently, had been ready to sign on. The only problem was that Netflix didn’t just want a pilot2, it ordered two full seasons of the show. Sight unseen. Fincher could not say no. Who would?
But the data aspect of this is a little overblown. Although there is a lot of discussion about how Netflix made this call based on what viewers wanted to see, that’s extremely hard to know without any aspect of the show being ready. What’s more is that Netflix didn’t just back anyone, instead they picked Fincher who had a track record better than most directors can dream of. ‘House of Cards’ was also a known commodity – it had previously been a fairly successful TV show in the UK. Even more so, the rights to the show itself was part of a prolonged battle between multiple companies, which is another way to say that Netflix was not spotting something new. If this were just based on data, Netflix could ask anyone to come and direct a political thriller with a certain star cast, although that is unlikely to work. In fact, I think Netflix knew that this would not work. Instead, it is more accurate to say that Netflix made a bet on Fincher, a big one, but a bet all the same.
It paid off.
Part two: Subscribers? Yes, we have some
With original programming on the cards, growth was not a challenge. At the time, Netflix already had a large number of subscribers – a little more than thirty million at the start of 2013. Compared to today, this is obviously a small number, but, at the time, there was essentially no competition and Netflix was it. Everyone wanted to get their shows on the platform, with the so-called ‘Breaking Bad’ effect3 playing a role in this.
The years following the development of original content were even more explosive in terms of growth. Apart from the initial launch of ‘House of Cards’, ‘Orange is the New Black’ was another major win. This was followed by a deal with Marvel that enabled Netflix to create a number of shows based on Marvel characters including ‘Daredevil’ and ‘Luke Cage’. A little after this, Netflix also re-started ‘Arrested Development’ and acquired streaming rights to Sony Animation’s films.
But it was more than just deals, in fact, it was a different kind of launch that really changed the game – in 2016 Netflix announced that it would soon be available in another one hundred and thirty countries, taking its content to nearly every part of the world. This was a massive deal as most of Netflix’s subscriber base was located in the United States at the time. In addition, while it had expanded to Europe, its Asia ambitions had been tame, with a 2015 launch in Japan being its first foray into the continent. This was a dramatic reversal of that strategy. Still, the initial expansion didn’t have that much impact – subscribers continued to come from both the US and internationally, but there was no big upsurge that might have been anticipated.
This was about to change. Netflix was doing more than just launching everywhere, soon it would make international content as well.
French language shows starting in 2016. German from 2017. Hindi from 2018 and even Norwegian in 2019. Netflix was willing to venture even further, with a Tamil language original show in 2020 and continues to expand the list of languages its looking at. There is no shortage of experimentation here and no chance of stopping. The biggest win of course, was ‘Squid Game’, a Korean show that reached number one in over seventy countries within a few months of its launch.
This changes the cost composition for Netflix while also allowing it to create more content than ever before. Estimates indicate that ‘Squid Game’ cost just $20 million for its first season, while a comparably extravagant American production like ‘Hemlock Grove’ cost more than double of that. The difference is that you’ve heard of only one of them4.
Part three: More money, no problems
Netflix continued its spending spree, picking up Shondaland and its founder Shona Rhimes for a long-term deal. The who was not as surprising, Shonda Rhimes had created hit after hit, with ‘Grey’s Anatomy’ reviving the medical drama genre. The price on the other hand was a bit of shock – $150 million to start with. But Netflix wasn’t done, it also picked up Ryan Murphy, creator of ‘Glee’ and ‘American Horror Story’. High costs.
And yet, cost is also where Netflix innovated, to find a way to create more value for itself in the long-term – the cost-plus model. For years, networks have been covering only half (or a bit more) of the cost of production while letting the production company retain most of the rights to the show. This reduces risk by lowering the upfront cost for the network but, it also reduces the potential upside. In comes Netflix. Flush with cash, it decided to disrupt this by offering the total cost of production plus a bit more on top, maybe thirty percent more. The cost-plus model. This way, Netflix owns the upside (and the downside). To be sure, Netflix did not create the model, HBO has used it in the past. But once Netflix did it, its been hard to go back.
Along with this, Netflix has also innovated in terms of the genres they focus on, namely, documentaries and reality TV. A study from Netflix showed that people need breaks in between binging content and documentaries seem to be the perfect sweet spot for this. Reality TV is another place where Netflix has made major gains, with demand for its reality content outstripping the general growth in demand for the same.
“[Netflix is] equal parts HBO and FX and AMC and Lifetime and Bravo and E! and Comedy Central.” - Ted Sarandos, former Netflix Chief Content Officer
So, why did Netflix do this? What brought on the wave of investment on investment? What turned Netflix away from a rental + streaming service into a full studio? The answer is simple – Netflix needs subscribers and subscribers were watching content that Netflix did not own. The most viewed shows in the US were ‘The Office’ and ‘FRIENDS’, both of which have since departed the platform. But Netflix wasn’t just making mass market content, it also wanted the acclaim. It wanted a “gourmet cheeseburger”5, premium and commercial. Award winning and rewatchable. Only upside.
Part four: Second chances
With all this success, Netflix is bound to face some issues. But one particular aspect of its strategy seems to attract more controversy than others. I am talking about cancellations.
This is a challenging subject because, as mentioned earlier, Netflix does not operate like a traditional network with its lack of pilots.
Still, let's look at this with some data. Of the one hundred and seventy-eight original shows6 that Netflix has ended, ninety-nine were shut down after just the first season. That’s a little more than fifty percent of them. Including shows that were cancelled after the second season, the number rises to one hundred and forty, which is nearly eighty percent. So, there is truth to idea that Netflix is prone to shutting shows down early.
On the other hand, pilots get shut down at a similar, if not even faster rate. Plus, this list does not include shows that are yet to end (although the ones that have three seasons or more are very few in that list). Still, Netflix can make the argument that its giving shows the full-time treatment. It’s also possible that this is very reason that fans tend to react badly when shows get cancelled. And sometimes, it can cost them a good deal of money.
Part five: Competition, changes and even more content
Some time ago, Netflix was so comfortable in its position that Reed Hastings, then CEO of the firm, declared “sleep” to be their “biggest competitor”. Things have changed a bit since that festival in 2017. For one, the competition has decided to enter the market. And the numbers don’t look bad for them, especially for Disney. Including its big shiny new service Disney+ and some of the smaller ones (Hulu, ESPN+), Disney had more than two hundred and thirty million subscribers globally7. That’s more than Netflix (detailed in the chart8).
(I’m not including Amazon Prime Video as part of this as, the paid subscribers do not sign up only for streaming, rather its mostly for shipping advantages, although it had roughly ~200 million users).
There is also the problem of competitors expanding to new countries and developing local language content, encroaching on the space that Netflix has built up over the last five years. The threats matter even more from a US perspective as Netflix makes $12 per month per US subscriber but just $8.5 for a subscriber from Asia. If Netflix expands internationally but loses ground domestically, its revenues will drop.
So, facing a real challenge, Netflix decided to raise prices, bring in an ad-supported tier, crackdown on password sharing and begin a foray into gaming.
The first two have been relatively successful, with ads doing better than anticipated. However, there is certainly going to be backlash if and when the password guidelines are introduced. A Netflix guideline document was leaked earlier this month and it included signing into a home wi-fi every month, codes for access outside of home, a new subscription tier for households that want to share passwords, among other items. This is a change for a company that proclaimed to love password sharing just a few years ago. As of now its being trialed in just a few countries, but, going ahead with this idea changes what Netflix means – it is becoming more and more like the cable networks of the past, limited to household viewing and peppered with ads. To be sure, you can opt for a higher tier but, the company itself has shifted toward new models that it hopes will keep its revenue afloat.
A major challenge lies in the fact that Netflix only makes money from streaming while its competitors don’t. Instead, they make money from theme parks, the box office and TV. With no such support, Netflix cannot afford to lose money on streaming.
So, is gaming the next big move? Netflix has acquired some game studios and is planning to offer games as part of the subscription. In fact, it currently has some mobile games on the app store. This is of course just a small venture so far. And other gaming subscription models are already prevalent. The key will lie in Netflix’s userbase, which once there, might want to do a whole lot more than just viewing movies and shows.
Having worked its way through the industry with new original content, a dramatic international expansion and making the cost-plus model the standard, Netflix knows how to stay ahead of the competition. With this new bet on gaming, Netflix hopes to become the single source of all content. Will it pay off? History seems to indicate that it wouldn’t be wise to bet against Netflix.
A bit of an understatement, I know.
Pilots are generally an aspect of TV production in the US. They refer to the first episode of the show and are treated as a proof of concept. In many cases, after the pilot is made, the show doesn’t go ahead.
This refers to the idea that putting up a show on Netflix instantly boots its popularity even if the show was not considered to be that important. In fact, ‘Breaking Bad’ was fairly unpopular before being put up on Netflix.
Unless you’re a ‘Hemlock Grove’ superfan.
This comes from a New Yorker profile on Bela Bajaria, the current Chief Content Officer at Netflix. I would really recommend it if you want more information about the company: New Yorker article.
Excluding miniseries and animated shows. Animated shows are excluded as it would not be fair for a comparison to other networks, which tend not to make a lot of animated programming outside of shows aimed at children.
A small caveat here is that much of this is driven by Hotstar, which is Disney+ for India. This is a bit of a different service because its popularity doesn’t rest on just Disney content, but I’ll spend more time on this in a separate piece.
This chart only looks at paid subscribers globally. Some of these services are yet to expand to the number of countries that Netflix has and thus, could pick up even more subscribers. Q4 data is used, Q3 2022 data used for HBO and Paramount and Q4 was not available. Estimates used for Apple TV+.