09 Aug 2017

Netflix: Out of the Frying Pan, Into the Fire

It’s always easy in retrospect to point out where major companies blew it, and squandered a huge lead over rivals; typically it’s difficult to see it when it’s actually happening, and nearly impossible to predict in advance.

However, we may be seeing such a situation happen right now, in the form of Netflix. But interestingly, and in contrast to Sears and other typical crushed-by-the-Internet 1990s cases, Netflix’s trouble is due not to inaction, but to conscious and deliberate steps the company has chosen to pursue as part of its strategy. In particular, its decision to abandon a dominant position where it had a structural advantage over rivals that was nearly impossible to compete with, and instead enter an arena where it has no particular advantage and faces a constant stream of new competitors.

I’m talking, of course, about their switch from an Internet-facilitated DVD rental service to a streaming-video one. Since this was at the time hailed as something of a bold and brilliant move, some explanation is probably in order.

Prior to their 2011 pivot into streaming, Netflix’s little red envelopes dominated home distribution of movies and TV shows. Their only real competition, Blockbuster, which had largely consumed the business of several other chains and countless mom-n-pop rental shops, went bankrupt in 2010. Prior to finally collapsing, Blockbuster even tried to bring the fight to Netflix with its own unlimited-rental-by-mail service, but couldn’t make the numbers work.

By most accounts, Netflix had basically perfected the DVD-by-mail business model. Their fulfillment centers were masterpieces of automation, locations chosen to minimize delivery times – many customers could select a DVD early on Tuesday and get it Wednesday – and inventory optimized against demand. Though the movie studios might not have liked them, Netflix held most of the power: if a studio refused to make a new movie available to Netflix, the company could always just go out and buy retail copies of the DVD as soon as it became available and rent those, protected by long-established legal precedent. Even their DVD mailers – which ensured low delivery costs and minimal disc damage – were the product of painstaking refinement over more than a decade, patented by Netflix CEO Reed Hastings himself.

Competing with 2009-era Netflix would have required a contender to replicate its entire distribution infrastructure, including hundreds of fulfillment centers nationwide, find viable alternatives to its patents (both on the envelopes and the entire business method of DVDs by mail, chosen via the Internet), and try to replicate Netflix’s vast catalog of content, some of which might require capital-intensive off-the-shelf purchases. As barriers to entry go, it’s an extremely high one.

In contrast, once Netflix decided to move aggressively into streaming, dragging the marketplace along with it, they became a much softer target. Running your own streaming-video service is no picnic, but it doesn’t require standing up hundreds of warehouses, either. You need content, and servers, and billing infrastructure, but that’s pretty much it. And, somewhat unsurprisingly, there are a plethora of streaming services to choose from: Netflix, of course, but also Hulu, Amazon Video, Google Play (admittedly, something of an also-ran at present), HBO Now, Sling, Crackle, Popcornflix, and a long list of others. And that’s without getting into the niche services, like MLB.tv, Chow, Twitch, Vevo… the list goes on.

Just yesterday, Disney announced that they were terminating their distribution agreement with Netflix, and moving forward with their own ESPN-branded one instead. That’s not something that a disc-based Netflix would have ever needed to worry about; in fact, you’ll probably still be able to get Disney movies on disc from Netflix’s legacy DVD-based service long after they’re gone from streaming.

Increasingly, streaming services are becoming akin to cable TV channels, with customers choosing several and then viewing them through a Roku or similar device that aggregates them into one place. (The Roku even calls them channels.) Newer Rokus offer unified search interfaces to aid viewers in finding content across many channels; the streaming service is, essentially, commoditized.

Though the eye-watering monthly prices that cord-cutting consumers were formerly paying for cable TV leaves quite a bit of budget available for more than one premium (that is, not free) streaming service, meaning that there’s no reason why Netflix and many other services might survive, it is unusual – to say the least – to see a company deliberately give up the high ground of complete control over a distribution channel, to slug it out in a low-entry-barrier one.

Further, a streaming service lives at the pleasure of the movie and TV studios; unlike a rental service sending physical discs back and forth, a streaming service operator doesn’t have the option (however expensive) of simply sending its employees out to Walmart to buy up retail copies of content from a balky studio to flesh out the “long tail” of its collection. The law simply doesn’t treat the two alike, even though they may fill the same market need.

So, why did Netflix pivot? I’m not sure. The standard wisdom is that Netflix’s leadership understood that a transition to streaming video was inevitable, and wanted to make that leap from a position of strength. This isn’t a bad explanation, but ignores the many ways that Netflix could have shaped the home entertainment market by virtue of its size and popularity. I don’t think it’s much of a stretch at all to suggest that Netflix could have chosen the winner of the Bluray / HD-DVD war if they’d wanted to, just by going exclusively with one or the other. But even that is thinking too small: I think it’s possible that Netflix could even have pushed their own HD video disc format, given the underwhelming reaction to Sony and Toshiba’s offerings.

Consider how many viewers bought Roku boxes (which were originally designed by Netflix, then spun off separately), largely or primarily for Netflix’s streaming service; then consider how much more dominant Netflix was at disc-by-mail than streaming when the Roku became a hit product, and how much money they would have had if it hadn’t been diverted into streaming: they could probably have designed a disc format and sent a free player for that format to new subscribers without breaking a corporate sweat. If they had, and timed it before Bluray’s slow-motion win, Netflix’s format would have been the HD disc standard going forward. Instead of begging and paying the studios for permission to distribute content as a streaming service, they could potentially have charged studios for the right to distribute on the proprietary Netflix disc format to Netflix’s base of customers.

As a consumer, it’s not clear that this alternative history would necessarily have been better. Netflix’s dominant position and very high barriers to entry for competitors (as a result of being in a capital-intensive business and having substantial IP assets) could likely have allowed it to raise prices over time. In some scenarios, where the same attitude that led them to attack Blockbuster with a business-method patent is in charge, it’s not hard to imagine them eventually running afoul of a court. (But as Microsoft has amply demonstrated, you can make a hell of a lot of money by engaging in very sharp practice before the courts seem to care.)

Netflix deserves some credit for basically creating the market for both VOD services and for streaming-video STBs to consume those services, but it seems unlikely that they’ll ever replicate as a streaming service the breadth of content or depth of separation from competitors that they enjoyed before their self-inflicted changeover.